Like most financial planners, I recommend not thinking of your home as a part of your investment portfolio or a source of retirement income. One possible exception to this rule is a reverse mortgage.
Lenders which are FHA-approved can offer Home Equity Conversion Mortgages, or HECM‘s. These are insured by the U.S. government and allow homeowners age 62 and older to borrow against the equity in their homes. When the homeowner dies or moves out, the property is sold to repay the loan. Any equity left over belongs to the owners or their heirs. Any outstanding loan balance must be forgiven by the lender.
Reverse mortgages may be useful for elderly people in good health who have limited income or assets but who are living in paid-for homes. Until now, I have viewed them as options of last resort. A report by financial planner Michael Kitces has given me some cause to re-evaluate that position.
One major disadvantage of reverse mortgages is that the income uses up the equity in the house. Seniors who take out reverse mortgages too early risk spending most of their home equity to cover living expenses. As long as they can stay in the house, that’s no problem. If they have to move, however, they will have to pay rent or long-term care costs. Without income from the sale of their house, they may be left with little except Social Security to pay their bills.
A second disadvantage has been high upfront fees. A new option described by Kitces, however, significantly lowers those costs. The HECM Saver option eliminates the upfront mortgage insurance premium of 2%. This would drop the costs of a reverse mortgage on a $500,000 home from $17,000 to $7,000. The tradeoff is a lower lump-sum or monthly payment.
The most typical use of a reverse mortgage is to tap into home equity to pay the bills when all other means of support become exhausted. Instead of selling or refinancing, the homeowners can choose to stay in the home and receive monthly payments for life. They don’t have to sell the property until they can no longer continue to live in it.
Another way to use a reverse mortgage is to refinance an existing mortgage. This can not only eliminate the monthly payment, but if there is enough equity in the home it can also provide a monthly income or a lump sum payment.
Kitces uses the example of a 70-year old couple paying $1000 a month for a $175,000 traditional mortgage on a $450,000 property. A $175,000 reverse mortgage would eliminate the $1,000 payment. Assuming the net principal limit for the borrower was $250,000 on the property, they could use the reverse mortgage to extract an additional $75,000 of equity. They could receive this in a lump sum payment, create a $75,000 line of credit, or receive lifetime monthly payments based on the $75,000.
Let’s assume this couple’s monthly expenses, including the mortgage payment, are $5,000. They receive $1,500 a month from Social Security and withdraw $3,500 a month from their $600,000 investments. The total $42,000 annual withdrawal is an unsustainably high 7% of their portfolio.
The reverse mortgage would eliminate the $1,000 mortgage payment and reduce the investment withdrawal to $2,500 a month. This totals $30,000 annually, a more sustainable withdrawal rate of 5%. Investing the $75,000 of excess proceeds would produce additional monthly income and reduce the withdrawal rate even further. Using a reverse mortgage in this way makes sense if the lost home equity is offset by an increase in investment assets.
We’ll look at other reverse mortgage options in next week’s column.