New Look in and Uses of Reverse Mortgages

Many retirees in coming years will need to use at least part of their home equity to fund retirement expenses. They should consider reverse mortgages, and they’ll find some recent changes make reverse mortgages more attractive. But some other changes also limit their use and impose more work and restrictions on homeowners.

In the last few years several big players dropped out of the reverse mortgage market, including Bank of America, Wells Fargo, and Financial Freedom. But there still are plenty of lenders offering mortgages insured by the FHA. In addition, new types of reverse mortgages approved by the FHA can be very good financial management and cash management tools for retirees.

Traditionally I’ve recommended that reverse mortgages be considered only as last resorts for people in their late 70s or older who need money and want to stay in their homes. That’s because high fees and interest rates on the loans make them expensive. You could borrow a reasonable portion of your home’s value only if you were older. Because of the cost of traditional reverse mortgages, they should be used only when other options aren’t available.

That advice still applies to traditional reverse mortgages, also known as home equity conversion mortgages (HECM). Be sure you fully understand the costs and limits before taking a reverse mortgage. And don’t let anyone talk you into taking out a traditional reverse mortgage to buy an annuity, fund an investment, or take a vacation. Use the proceeds to fix your home or pay living expenses.

A recent innovation, however, potentially broadens the uses of reverse mortgages.

The HECM Saver has substantially lowers up-front costs compared to the traditional HECM. The mortgage insurance premium is only 0.01% instead of 2%. In exchange, the lending limit on the Saver is about 10% to 18% less than for the standard HECM. Lenders also tend to charge lower fees for Savers than for traditional HECMs.

In addition, the Saver is set up as a line of credit. You draw money only when you need it. You can repay the money when you no longer need it if you want, restoring your full line of credit. But you don’t have to pay the interest until you move out of the home or pass away. Or you can pay the interest earlier if you want to and have the cash. You also can decide not to repay the loan and interest, leaving it to be paid when the home is sold or you no longer use it as a principal residence.

When you set up a HECM Saver, you’re charged mortgage insurance of 1.25% of the outstanding loan value as mortgage insurance on an ongoing basis. You’re also charged a variable interest rate.

In addition, as you age and don’t draw down the loan, the amount you can borrow increases.

Because of these features, many analysts believe it’s unlikely that a HECM Saver ever would be underwater, with the accumulated loan, interest, and fees totaling more than a home’s value. That means heirs still are likely to receive something from the sale of the home, even after the homeowner benefits from the HECM Saver. With the traditional HECM, however, it’s not unusual for the loan to be underwater, meaning the heirs don’t receive anything from the home.

The lower costs and flexibility of the Saver provide several ways it can be used as a financial planning tool.

Suppose your investment portfolio’s value takes a dive. You don’t want to sell assets, because you expect them to recover. But you need cash to pay living expenses. Instead of selling assets while they’re at a low, you can tap the HECM Saver. Use the proceeds to pay living expenses for a while. As the portfolio recovers, you can stop drawing from the Saver and resume withdrawals from the portfolio. You can eventually use part of the portfolio to repay the Saver or you can let that loan be paid when you leave the home.

Or suppose you suddenly incur an unexpected expense. It might be a medical expense, a repair for the home, or a need by a loved one. You don’t have to sell portfolio assets. Instead, you can draw some money from the HECM Saver. Then, over time you can increase portfolio withdrawals to pay the Saver so it will be available in another emergency. Or you can let the Saver be paid when you leave the home.

Because a Saver can be used in such situations, you might be able to keep less cash in emergency funds and invest that money for a higher return. Some advisers recommend more aggressive use of the HECM Saver, such as paying for living expenses to delay receiving Social Security retirement benefits so that you can qualify for the higher level.

Some advisers believe a Saver would allow you to buy less life insurance or long-term care insurance, because you could tap the home equity when the cash is needed. That might be a solution for a single person but it probably won’t provide enough protection for a married couple, depending on the lending limit on the HECM Saver.

There’s a potential alternative to the Saver. You might be able to take out a Standard HECM and elect to have it be a line of credit instead of a lump sum. You also could elect a variable rate. Not all lenders will make these terms available. But if you seek this option you could have a higher loan limit and a lower initial interest rate than the Saver.

The HECM Saver generally has a higher interest rate than the Standard, so you probably don’t want to use a Saver for a large, long-term loan. But if you plan to repay the loan, use the loan as a bridge, or don’t draw down the maximum amount available, the Saver can be better than a Standard HECM.

With all types of reverse mortgages, the FHA and lenders are imposing tighter standards. They’re requiring potential borrowers to show that they’ll have enough income to keep their insurance in place and real estate taxes current. The loan agreements require the homeowner to maintain insurance and taxes. Failure to do so is a default, and there recently were several thousand borrowers in technical default. AARP filed a lawsuit seeking to prevent foreclosures due to these defaults.

You can find details about the reverse mortgage loans on the web site of the Department of Housing and Urban Development (www.hud.gov), and AARP also has a good publication on reverse mortgages. The HUD site also has links to reverse mortgage lenders and counselors plus a link to a calculator that lets you estimate the amount of your loan.

RW July 2012.