You might not have heard much about reverse mortgages outside of AARP or daytime tv commercials. They mostly fly under the radar for three main reasons; they're not heavily promoted, they suffer from social stigma, and most financial advisors aren't familiar with their financial planning utility.
However, reverse mortgages have evolved in recent years, so much so that most investors should at least consider looking into them as part of an overall retirement income strategy.
HOW THEY WORK
At the most basic level, a reverse mortgage allows a borrower to use home equity to supplement retirement income. The premise is that distributions augment retirement income sources already in place.
Reverse mortgages are issued by a bank to a home owner age 62 or older. The bank provides the borrower with cash flow. There are no specific stipulations regarding how the distributions should be spent. As the borrower receives distributions, a loan balance accrues against the home's equity.
When the borrower sells the home & moves, transitions to assisted living, or passes away, the bank gets their money back via sale of the home. Alternatively, if the kids want to keep the house, any reverse mortgage balance can be paid with life insurance death benefits, bank accounts, leftover investment assets, or any combination of those. If the home sells for more than what's owed, the borrower, or the beneficiaries managing their estate, keep any difference.
FACTS
- Youngest borrower must be at least 62.
- Enrollees keep the deed to their house.
- There are caps on how much the enrollee can initially borrow based on age, home value, and rate.
- Rates are similar, but usually a tad higher, than a conventional mortgage.
- Distributions are considered loan advances and therefore not treated as taxable income.
- Distributions do not impact Medicare premiums or the taxation of Social Security benefits.
- Repayments are not required, but can be made voluntarily or at any time during the loan with no prepayment penalty if the borrower chooses.
- Reverse mortgages come with government insurance designed to protect the borrower if the home doesn't sell for as much as what was borrowed.
- Loan interest is deductible in the year repayments are made as long as the borrower itemizes on their tax return.
- Special reverse mortgage programs exist for condo owners & high value homes, usually worth > $1M.
- Borrowers do not need a fully paid off home to initiate a reverse mortgage.
MISCONCEPTIONS
Reverse mortgages underwent significant evolutions in 2013, 2014, and 2015, making them more affordable, cost effective, and flexible*. However, myths persist from years of negative publicity and lingering social stigma.
Here are a few general types of misconceptions**:
The Bank Gets Your House. False. You and/or your estate retain ownership, deed, and title. The bank's role is limited to any outstanding loan balance.
You Must Make Monthly Repayments. No. The whole point of a reverse mortgage is to create an income stream you don't have to repay until you move or pass away.
Your Kids Don't Get The Home. Not so! However, your kids don't want your home. They already live where they want to live. Second, your kids can use your bank & brokerage assets or life insurance death benefits to pay off the loan and move into your house if that's what they really want.
You Need To Own Your Home Outright. Not true. You can convert your mortgage to a reverse mortgage at retirement. Goodbye monthly payments. Hello newfound money for a more sustainable retirement!
A High Level Of Income Is Required. No. You must demonstrate an ability to cover normal home related expenses such as insurance and property taxes. You've been doing this for years anyway.
Reverse Mortgages Are Only A Last Resort. Historically, sure, but quite the opposite today. Reverse mortgages create additional retirement income helping you achieve financial goals such as retiring earlier than anticipated, reducing taxable income, delaying Social Security payments, and reducing stress on your investment portfolio.
You Could Owe More Than Your Home Sells For. This could happen, which would normally be a risk if it weren't for government insurance built into all reverse mortgages. A small portion of your loan expenses cover this cost to bridge any potential gaps when the home is ultimately sold.
Your Friends Will Judge You. Maybe, but not after you explain the benefits. Besides, no one but your kids even need to know until you die. You probably won't care what people think at that point anyway.
It Just Seems Weird After Spending All Those Years Paying Your Mortgage Off. Nah. This is just your own mental constraint. Get over it. Start thinking of your house as a potential income producing asset as well as a familiar place to call home.
COMMON USES
There are three main ways to use reverse mortgages; taking a lump sum distribution at the onset, periodic payments either scheduled annually (Tenure) or ad hoc (Coordinated), and taking distributions near the end after significant portfolio assets have been depleted. The two options I believe to be most palatable to consumers are the Coordinated and Tenure strategies.
Research suggests establishing the line of credit early paired with ad hoc distributions results in the highest likelihood of maintaining retirement cash flow***. This is the coordinated strategy. Assuming a withdrawal rate of 6% based on portfolio assets and current rates, the coordinated strategy ranks highest.
The research also suggests similar results when evaluating 4%, 5%, and 6.5% withdrawal rates***.
Essentially, the higher the assumed withdrawal rate, the higher the probability of maintaining expected cash flow in retirement.
As a best practice with the coordinated strategy, the borrower(s) establish the line of credit as early as possible. The more time the line of credit is open, the more opportunity the line of credit grows via compounding. The benefit is a larger pool of money to extract distributions from over time.
To illustrate the coordinated strategy, let's take a 67 year old with a $500,000 home initially starting their line up credit at a 5.144% growth rate. Based on these hypothetical parameters, they would qualify for an initial line of credit of $217,563. After 5 years, the line of credit would be $263,662. After 10 years, the line of credit has grown to $325,566. And after 15 years the line of credit reaches $405,143. Start early!
The other type of strategy I think investors will appreciate is the tenure strategy. This strategy refers to scheduled payments that are consistent over time.
Using the same assumptions as above, the borrower can schedule distributions in the amount of $1,278/month, ending after 25 years. After 5, 10, and 15 years, that's $76,680, $153,360, and $230,040 in respective distributions received.
Note that tenure payments can be scheduled for a variety of terms depending on the borrows current age, health status, income requirements, etc.
FINANCIAL PLANNING IMPLICATIONS
Thinking of a reverse mortgage as a tax-free income producing asset, we can quickly see how increased cash flow can positively impact a financial plan. Applying a tenure strategy method (fixed payments), we can model the overall impact on a financial plan.
First, we model an investor not using a reverse mortgage of any kind. Using the same initial assumptions as before and adding $7,500 in monthly expenses, that 67-year old's financial plan looks like this:
79% Probability of Success & $3,956,285 Net Worth @ Age 92.
However, when that investor utilizes a reverse mortgage tenure strategy equaling payments of $1,278/month, look at what happens to their financial plan: 85% Probability of Success & $3,079,039 Net Worth @ Age 92.
Note that in this hypothetical example the net worth at the assumed age of death (92) was still over $3M!
What's also worth noting is that this investor enjoyed an extra $15,336 in tax free income to spend each year. Plus, assuming a 4% appreciation factor on the home, the investor still had $314,092 in net home equity (after the reverse mortgage loan balance) at age 92!
For my own research, I used the tenure strategy because it was relatively easy to model. However, more advanced types of strategies can be deployed, such as a coordinated strategy. This is especially useful when we're focused on increasing the Probability of Success metric.
Here, the investor only taps into the reverse mortgage line of credit during down stock markets (both coordinated methods seen below).
The main benefit of the coordinated strategy is portfolio distributions are minimized. This is highly advantageous during down markets because the investor isn't forced to liquidate assets and lock in portfolio losses above what's needed for required minimum distributions (RMDs).
Note that using home equity last generated the highest overall Probability of Success outcome (graph above). Although it may academically model the best, my bet is that investors might not want to go all in on waiting until portfolio assets are exhausted before tapping home equity. But that's just my educated guess.
What about investors who want to use a reverse mortgage to increase cash flow in retirement as well as maximize assets passed on to their heirs? There is some research that concludes this is a likely outcome when using the tenure reverse mortgage strategy (fixed payments).
Although the paper used different assumptions than I did in my own research, the result was compelling none the less:
TAKEAWAY & FURTHER READING
Whether you're approaching retirement or already enjoying your retirement, you owe it to yourself to ask yourself if you can benefit from a reverse mortgage. Generally, you are probably a good reverse mortgage candidate if you want to increase retirement income, reduce taxation, retire earlier, and in some cases, pass on even greater wealth than anticipated to your heirs. So, most people.
You can start exploring reverse mortgages by asking us if it could fit into your overall retirement plan. If your goals align with any of the reverse mortgage strategies, we'll help you choose an option and show you the results in your financial plan. Once the reverse mortgage strategy is established and the expectations are agreed upon, we can refer you to a number of reverse mortgage professionals for current rates and cost quotes.
If you'd like to do your own homework, here is a list of resources to sift through.
Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, Sacks & Sacks.
Lastly, I'd like to acknowledge the work Shana Judd at Retirement Funding Solutions put into this post. Shana graciously allowed me access to her reverse mortgage planning software which provided many of the facts and figures I presented. You can explore more about reverse mortgages on her website found HERE.
*Reverse Mortgages, How To Use Reverse Mortgages to Secure Your Retirement, Pfau, 2016.
** Some of these were adopted from Myths and Misconceptions about Reverse Mortgages, MAC5 Mortgage Inc, courtesy Rod Cameron (rod@cameron-financialservices.com).
*** Understanding the Line of Credit Growth for a Reverse Mortgage, Pfau, Journal of Financial Planning, March 2016.