Reverse Mortgages Can Reduce Key Retirement Risks

Strategic use of a reverse mortgage can reduce the risks of running out of money due to longevity and market volatility. A reverse mortgage also can free up what was an illiquid asset, and it’s tax free. Reverse mortgages once were the domain of hucksters and shady financial salespeople. There’s still some of that element around, so you need to be careful. But tighter regulations, plus acceptance by many financial advisors and researchers, turned the reverse mortgage into a valuable financial tool in many circumstances.

A reverse mortgage is also known as a home equity conversion mortgage, or HECM. Most HECMs are federally insured by the Department of Housing and Urban Development (HUD) through its Federal Housing Administration (FHA). In this discussion, I assume you’re looking at a federally insured HECM. A HECM is potentially available to anyone age 62 or older who has substantial home equity. You must have at most a mortgage balance of less than 50% of the home’s value, but little or no mortgage is best. There are several forms of HECMs.

You can receive a lump sum, an annuity- like stream of payments that lasts for years or life, or a line of credit that you tap when money is needed, also known as a HELOC. A HECM is obtained from a lender that participates in HUD’s program. To obtain a HECM you must have a session with a HUD-approved counselor, which usually lasts 90 minutes or more, to ensure you understand and qualify for a reverse mortgage.

It is called a reverse mortgage because after taking the loan, you don’t make interest or principal payments as long as the home remains your principal residence. Repayment occurs after you pass away or move out of the house for more than one year, whether to another home or something like an assisted living residence.

The interest and principal compound until then, and proceeds from selling the home are used to pay the loan. If the amount due exceeds the equity in the home, the federal insurance kicks in and pays the lender the difference. You, your family, and estate have no further obligations. There are some protections for a surviving spouse who isn’t a borrower on the HECM and wants to live in the house after the borrowing spouse passes away or moves out of the home.

After taking out the HECM, you remain owner of the home and are required to pay taxes, insurance, and maintenance while living there. Part of the application process is to ensure you have adequate cash flow to do that. Of course, the more you borrow on a HECM, the less home equity is available for your children or other heirs to inherit. The amount you’re allowed to borrow depends on current interest rates, your age, the home’s appraised value and any current mortgages. Any appraised value above $1,089,300 million in 2023 isn’t considered when determining the amount that you can borrow. The older you are, the higher the percentage of the home’s equity you can borrow.

The lower interest rates are, the more you can borrow. There are both upfront and continuing costs to a HECM. There is an FHA mortgage insurance premium, which costs 2% of the appraised value up to $300,000, or a maximum of $6,000. You can include this fee in the amount of the loan so there’s no upfront cash outlay for it. There’s also an annual mortgage insurance premium of 0.5% of the amount borrowed.

If you have a HELOC, for example, this fee is charged only on the amount you’ve borrowed, not on the appraised value or the amount you’re eligible to borrow. This premium also can be part of the loan. You’ll incur typical mortgage costs such as appraisal, title search, surveys, inspections, recording fees, credit checks and whatever else is common in your area or required by the lender. The lender can charge an origination fee for processing the loan application. The maximum origination fee is $6,000. The origination fee can be charged as either the greater of $2,500, or 2% of the first $200,000 of appraised value plus 1% of the value over $200,000.

A regular servicing fee also can be charged by the lender and can be no more than $30 per month on a fixed interest loan and $35 per month on a variable interest rate loan. The fee can be deducted from your funds available to borrow or factored into the interest rate. You also must pay for the counseling session. One valuable way to use the HELOC version of a HECM is as what’s called a buffer asset that’s used to smooth the effects of stock market fluctuations. Suppose the main source of Max Profits’ retirement cash flow is his investment portfolio.

The markets tumble, and Max’s portfolio value declines by 30%. Max doesn’t want to continue distributing the same amount from the portfolio, because now he’d be distributing9 principal. He wants to keep the portfolio intact so it will regain value faster when the markets recover. If Max lined up a HELOC in advance, he can start writing checks against the HELOC to pay some of his monthly expenses, deferring distributions from the portfolio.

The HELOC lets Max use his home equity to ride out bad markets without depleting his portfolio or slashing his spending. In addition, after the portfolio recovers, if Max wants to, he can repay some or all the money he borrowed on the HELOC. That restores the amount Max can borrow through the HELOC in the next market downturn. There are other buffer assets, such as conventional home equity lines of credit and margin loans against investment accounts. But for most people, the HELOC is the cheapest and easiest source of cash.

Most important is that it doesn’t require any payments as long as you live in the home. A number of retirement finance researchers have run the numbers under different scenarios and concluded that using a HELOC as a buffer asset makes a portfolio last longer and reduces the probability of running out of money during retirement. Even if the HELOC is used to skip only one or two years of distributions from the retirement portfolio, it can extend the life of the portfolio significantly.

An interesting feature of the HELOC is that to the extent you have an unused line of credit, the amount you can borrow increases over time. How that occurs is technical, but it’s another reason to consider setting up a HELOC early in retirement before you need it. Another use of a HECM is to help purchase a new principal residence in retirement.

Using a HECM this way lets you keep more of the sale proceeds from your old home invested, plus you don’t have to make mortgage payments during your lifetime. You can’t use a HECM to finance the full purchase price of the new home, but depending on your age and interest rates, you can finance a significant portion. Plus, unlike a conventional mortgage, no payments are due if it remains your principal residence.

There are two ways to use a HECM to provide guaranteed regular income for life, or while you live in the home. You can set up a HECM that makes equal monthly payments to you, known as a tenure plan. Or you can borrow a lump sum through the HECM and use that money to purchase a commercial annuity. You can compare payments, and you’ll probably find the commercial annuity pays more than the tenure plan.

The caution, however, is that federal regulations prohibit using a reverse mortgage explicitly to buy an annuity. This rule was created because some insurance agents were persuading people to maximize their reverse mortgage borrowing to buy high-fee annuities that didn’t provide them much value.

Because of the regulations, to execute this plan you must show that you have enough money from other sources to buy the annuity and didn’t need the HECM to do so. Some people use the HELOC version of the HECM as their long-term care insurance. They plan to receive any LTC they need at home and write checks against the HELOC to pay for whatever that care costs.

To use a HELOC this way, you must be reasonably sure that the HELOC borrowing limit will be enough to cover likely home care costs and that the type of care you’ll need can be provided at home. A HECM also can be used to pay for needed home repairs or improvements. That maintains the home’s value without taking money from an investment portfolio or reducing other spending.

You can find a list of FHA-approved HECM lenders and the approved counselors on the HUD website. Also, check out the Kosher Reverse Mortgage ® lenders on the website of the Mortgage Professor, at www.mtgprofessor.com.