Key changes recently were made in reverse mortgages. You should be aware of the changes and how they affect the way reverse mortgages can help in-crease your financial independence. Properly used, they are tools for employing home equity to enhance your retirement.
The first change is that the Federal Housing Administration restructured the program again for the loans its guarantees. Since the FHA guarantees most reverse mortgages these days, it sets the rules for most borrowers.
The FHA calls the loans Home Equity Conversion Mortgages (HECM). In September 2013, FHA replaced two types of loans (HECM Standard and HECM Saver) with today’s HECM. The basic rules are the same. You have to be at least age 62 and own your principal residence outright or have paid-down a “considerable amount” of the debt. You can borrow only against your principal residence and must have sufficient resources to pay your property taxes, insurance, homeowners’ association dues, and similar expenses. You also have to participate in an information session with a HUD-approved counselor before taking the loan.
Under a HECM, you receive money from a lender today, but no payments are due on the loan until you no longer occupy the residence. The principal, interest, and fees on the loan accumulate and eventually are paid from the sale proceeds of the home.
A federally-insured HECM is made by a private lender but is guaranteed by the FHA. Any portion of the loan balance that can’t be paid from the home sale proceeds is covered by the government. If the home’s value exceeds the debt, your heirs can keep the excess.
You have to pay a range of fees: mortgage insurance, an origination fee, a servicing fee, and the usual third party charges (appraisal, title search, inspections, surveys, recording fees, etc.). The origination fee can be as high as $6,000, depending on the value of your home. You have the choice of paying most of the fees upfront or having them added to the loan balance.
A little-known provision of the law requires the lender to offer you or your heirs a choice when the loan is due. They can allow the home to be foreclosed and the sale proceeds used to cover the loan. Or they can extinguish the debt by paying 95% of the home’s current value, no matter how much is owed on the loan. If the loan amount is more than 95% of the home’s value, the government will make up the loss to the lender.
Another change since the financial crisis is most of the big-name lenders have left the HECM market. The number of HECMs issued rose steadily until home prices collapsed in many areas. For that and other reasons the major banks existed the market. Most HECM lenders now are smaller firms and not well-known.
The New York Times recently reported that some HECM lenders don’t offer the repayment choice to next of kin and proceed immediately to foreclosure. You want to choose your lender carefully and let your loved ones know what you’re doing and what their rights are when the loan is due.
The amount you can borrow depends on the value of your home, your age, and current interest rates. The older you are, the more you can borrow. The lower interest rates are, the more you can borrow.
For example, at recent interest rates, a 62 year old could borrow 52.6% of the home’s value but only 34.3% if rates rise four percentage points. A 75 year old could borrow 58.9% today and 43.9% at the higher rate.
The changes and low interest rates mean you should take a fresh look at the HECM. I’ve generally regarded the HECM as a last resort for people late in life who needed cash and wanted to stay in their homes. By waiting until late in life you maximize the amount that can be borrowed and limit lifetime expenses for the mortgage.
But now there are other ways to consider using HECMS.
You can choose several ways to take a HECM, including a line of credit. Some call this the Standby HECM. You lock in the amount you can borrow at today’s interest rates and use the loan strategically to preserve your nest egg.
One research paper showed how a line of credit HECM could be used to avoid drawing principal from the investment portfolio when markets are down. After a steep portfolio decline, instead of selling some investments and further reducing investment principal to pay living expenses, you draw on the HECM line of credit and keep more of the investments intact for the market recovery.
The study found that the retiree’s resources lasted longer if the HECM was tapped whenever the portfolio was less than 80% of its “glide path” or expected value in the retirement plan. But using the HECM more often was not an advantage. Tapping the HECM before the nest egg declined below the 80% level reduced the life of the nest egg. Another key to the strategy is that the HECM loan is repaid after the markets recover and the investment portfolio increases.
Having the HECM line of credit available also reduces the amount of cash and other short-term investments that need to be held in the portfolio. That increases the potential investment return over the long-term.
The HECM line of credit can have other uses.
It can help you delay Social Security benefits and a pension or other annuity payout. The older you are when these benefits begin, the higher the income. With Social Security, the benefits increase 8% for each year of delay to age 70. That is less than current cost of the HECM and higher than the return you’ll receive elsewhere.
A HECM also can help reduce your tax burden. Instead of taking more money from a qualified retirement plan or taxable account and getting pushed into a higher tax bracket, you can draw on the HECM.
Payments for large assets or unexpected expenses, such as automobiles or medical expenses, can be made by drawing on a HECM line of credit. You might not want to take additional money from your portfolio and forego the opportunity to earn returns. You can tap the HECM and either repay that loan with future investment gains or let it be paid after you no longer live in the residence.
There are other potential uses of the HECM, but don’t fall for some of the scams or unwise strategies being peddled. Don’t use a HECM to buy an annuity or life insurance or to finance a vacation.
A reverse mortgage can be an important income management tool. Always keep in mind, however, that it isn’t free money. Interest is compounding on the loan, and you incur expenses to take out the loan. To the extent you have an outstanding reverse mortgage on your passing, there won’t be equity in your home for your heirs to inherit.