Reverse Mortgages: Take the Longevity View

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Photograph: Getty Images

It's a reversal in reverse mortgages. And that may mean a boon for boomers.

The reverse mortgage, long a pariah in financial planning circles, lets homeowners tap home equity and defer repayment until they sell, move or pass away. As interest on the loan builds, home equity shrinks. Leading up to the financial crisis, many senior homeowners cashed out big chunks of home equity as lump sums, often to pay other debts. Whether borrowers had the cash flow to afford the home's ongoing costs -- property tax, insurance, maintenance -- was another question. By 2010, nearly 10 percent of reverse mortgages were in technical default after falling behind in tax and insurance payments.

The stigma has been so bad that reverse mortgages were left off the financial planning curriculum at Texas Tech University until a few years ago. They graduated to a brief mention as a last resort. Now, strategies for using reverse mortgages in retirement get a full day, says John Salter, assistant professor of financial planning at the university and a planner at wealth management firm Evensky & Katz.

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Why the sudden respect? A combination of new research that makes a compelling case for reverse mortgages as a viable planning tool when used responsibly, and a fall 2013 overhaul of the government program that insures more than 90 percent of the mortgages. The latest tweaks to the Home Equity Conversion Mortgage Program (HECM) -- the official name of the Federal Housing Administration's reverse mortgage program -- reduce the amount of home equity that can be converted. They also discourage tapping loans heavily early on. The mortgage insurance premium (MIP) jumps from 0.50 percent to 2.5 percent for borrowers who qualify to tap 60 percent-plus of the loan in year one.

'Standby' Strategy

Salter and two colleagues set out to determine if there was a place for reverse mortgages in responsible long-term financial plans. They started by looking at the prospect for a 62-year-old relying on a $500,000 investment portfolio to fund retirement. To reach a 90 percent probability that the money will last 30 years, the retiree could take out just under 3.25 percent of the portfolio's value annually. (The portfolio is 60 percent stocks, 40 percent bonds.)

The outlook brightened after the planners used what they dub a 'standby reverse mortgage' strategy, based on a home valued at $250,000. In a falling market, the reverse was tapped, rather than the portfolio. The retiree repays the money when the market recovers. That supports a 5 percent withdrawal rate, with a 90 percent probability of the money lasting 30 years, Salter says.

Reverses can also be used to create monthly income. Gerald Wagner, CEO of Ibis Software, which does reverse mortgage analysis, crunched some scenarios to test that out. He started with a base assumption of $450,000 in home equity and an $800,000 investment portfolio with a 60/40 allocation. In general, adding the reverse to the mix supported a sustainable withdrawal rate between 5 percent and 6 percent.

Also in reverse mortgages' favor is tax treatment. The money pulled out is tax-free income and doesn't count when computing taxes on Social Security income. And a reverse line of credit can help delay taking Social Security until age 70, when retirees get the largest payout.

Nuts and Bolts

Reverse mortgages don't come cheap. Upfront fees can top $10,000 on a $250,000 mortgage. For that to make sense, you need to be sure you can stay in your home at least seven to 10 years. That said, a reverse is a better planning tool than a lower-cost home equity line of credit. During the financial crisis, Helocs were yanked by stressed financial institutions. Lenders can’t touch the terms of a reverse once the loan is made.

How much you can borrow depends on your age, home value and interest rates. You must be at least 62, and the maximum value eligible for the federal HECM program is $625,500. The younger you are, the less you can borrow. Beware sketchy lenders who recommend leaving younger spouses off the loan. If that spouse isn’t on the loan, she -- most survivors are women -- must pay back the loan or move out.

The lower interest rates are, the more you can borrow. At today’s 5.5 percent rate, a 65-year-old can get a reverse equal to 48 percent of a home’s value. If rates rise to a more normal 7 percent, that drops to 36 percent. Expectations of rising rates argue for doing a reverse sooner rather than later, says Salter.

One wrinkle: If you’ve still got a mortgage or an open Heloc, you’ll need to pay it off. (You can use the reverse for that, though that makes it less useful as a long-term planning tool.) Repayment isn't due until the last person named on the loan has died or hasn't lived in the home for at least 12 consecutive months. Even if you're technically underwater at that point, with the loan balance more than the current home value, you or your heirs aren't required to make up the difference.

If you use the “standby” strategy that repays used equity, your heirs will still have a house to inherit. But even if you do start depleting your home equity, your kids will likely be happier knowing you have a secure retirement.

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