Proper use of a reverse mortgage can extend the life of your wealth. Changes were made in reverse mortgages in 2013. The changes allow new strategies, and recent research revealed a few creative ways to use them. Today’s low interest rates also create an opportunity that will disappear when rates rise. Many of you should consider a reverse mortgage now.
Home equity is perhaps the least used asset in retirement planning, and that’s a shame. Home equity often is among the most valuable assets people own, yet many people consider home equity to be either something to leave their children or a reserve for late in life medical or long-term care expenses. They don’t know how to use it to generate income.
In a reverse mortgage, formally known as a home equity conversion mortgage (HECM), you borrow money and the loan is backed by your home equity. Unlike a traditional mortgage, you don’t make any payments as long as the home is your principal residence. The loan principal, interest, and fees accumulate until you move, sell, or pass away. The loan is paid from the sale proceeds of the home. Your heirs can receive any equity remaining after the loan is paid.
You and your estate never will have to pay more than the value of your home equity. Most HECMs are insured by the federal government. It reimburses the lender if the loan balance exceeds the value of your home. Federally insured loans are available up to a home equity of $625,500 in 2015. You must be at least age 62 to be eligible for a federally-guaranteed HECM. There are private reverse mortgages for those who want to use more home equity, though few lenders are in the market.
You can receive the HECM as a lump sum, annuity, or line of credit. However you take the loan proceeds, they are tax free. They don’t trigger any of the stealth taxes (higher Medicare premiums, taxes on Social Security benefits, etc.) or affect eligibility for any federal programs.
Traditionally HECMs were best used as a last resort, for someone in his or her late seventies or older who had no other source of funds. They were used to pay for essential home repairs or medical expenses in most cases.
Those still are good uses for a HECM, but there are other strategies to consider.
Under the new strategies, it is important not to wait until you need the money to set up a HECM. Instead, consider arranging the HECM now (or as soon as you turn 62) while interest rates still are low. Set up the HECM as a line of credit. You don’t draw on it until it is needed, and there are no costs other than the initial fees until you draw on it. This is being called a standby reverse mortgage.
You home equity now is liquid, and there are no limits to how the loan proceeds can be used. You can use the loan to pay unplanned expenses, give an early inheritance to loved ones who need the money now, help pay for education, or any other expense that arises.
An important element of the new strategies is that you can pay down the HECM balance after you tap the line of credit. That resets the amount you can borrow and stops the interest from compounding.
Suppose one of your cars unexpectedly breaks down. You need a new car. Because you’re retired and without a paycheck, you don’t qualify for an auto loan at a reasonable rate, or you don’t want to give the lender all the details they require. You also don’t want to draw down your investment portfolio. But you’re confident your income will be enough in coming months and years to pay for the vehicle. Or you want to sell some investment assets at a better time and use the sale proceeds to pay for the auto.
You can draw against your HECM to buy the car. No payments are due on the HECM. That allows you to pay the loan on your own schedule, or on no schedule. Your daily life style isn’t affected by the sudden need to make a major purchase, and your investment strategies aren’t disrupted by the spending need.
The standby reverse mortgage also can help make your investment portfolio last longer. Suppose there’s a market downturn that causes a significant decline in your portfolio value. You’re confident that it is temporary, though there’s no way of telling how long the balance will be down. If you continue to take distributions from the portfolio to fund regular spending, then you essentially are drawing principal by bringing the portfolio balance even further below your planned level.
Instead, during this period you can draw on the standby reverse mortgage. This allows your portfolio to recover, and it will recover to the planned baseline level faster, because you either aren’t drawing from it or are drawing less. After the portfolio recovers, sell some assets to pay the HECM. That stops the compounding of interest on the HECM and makes the full balance of the standby HECM available for future situations.
This strategy substantially extends the life of a portfolio when used systematically, according to research published by three financial planners: Shaun Pfeiffer, John Salter, and Harold Evensky.
Another advantage of the HECM is that there could come a time when you can’t pay down the loan and even have to continue borrow to the maximum allowed. While that means there might not be any equity for your loved ones to inherit, it also means you have a level of security. The really good news for you is that the balance due on the HECM can accumulate to something exceeding your home equity, but you and your estate won’t be liable for that excess. The amount paid from your assets can never exceed the home equity.
The amount you can borrow depends mainly on three factors: the value of your home equity (up to the insurable ceiling, which is $625,500 in 2015), current interest rates, and your age.
The older you are, the higher the percentage of your home equity you can borrow. That’s because you aren’t expected to live as long as a younger person, so there’s less risk that the principal, interest, and fees will exceed the home’s equity.
Interest rates are the reason you should consider arranging a HECM now if you are 62 or older, regardless of how you want to use it. Current interest rates determine the percentage of your home equity you can borrow, and the percentage declines rather steeply as rates rise. When the rate used is 5% or less, a 62 year old can borrow about 52.6% of the home’s equity. But when the rate used is 7%, the amount that can be borrowed drops to 34.3%. These are estimates, because several variables determine the borrowing limit. The interest rate used to calculate the maximum you can borrow is different from the rate that actually will be charged on your loan, and the rate used to limit your borrowing is higher than the rate you’ll be charged on the loan.
The major disadvantage to the HECM is that upfront fees and interest rates are higher than on other types of mortgages. If you’re confident of being able to obtain and make payments on a home equity loan, you might not want a HECM. But a HECM doesn’t require lifetime payments and allows the balance due to be more than the value of the home equity. The fees and higher rate on the HECM are like premiums on longevity insurance that help limit the possibility that you’ll run out of money or have to sell your home to raise cash.
RW November 2015.