Reverse mortgages, once maligned as the “loan of last resort,” have resurfaced as a topic of conversation between financial advisors and their clients. While these financial products are not appropriate for all investors, they can play a strategic role for investors who want to “age in place,” or who want to take only modest withdrawals from traditional retirement accounts so as to preserve capital for themselves or heirs.
John Flavin, CFP at Synergy Financial Management in Seattle, says that he has two clients using reverse mortgages. One client owns a home valued at over $2 million but has only $500,000 in retirement accounts. If she needs $60,000 per year to live in retirement, her retirement account balance would swiftly dwindle based on the size of withdrawals she would need to make from retirement accounts.
The problem would accelerate as she reached the age at which she’d be required by law to withdraw “required minimum distributions” (a percentage of the total balance) from her accounts. By using a reverse mortgage to withdraw funds from her home’s equity, she can take minimal withdrawals from her retirement accounts for as long as possible and thus preserve that capital longer. This also allows her to wait to elect (and thus maximize) Social Security benefits.
“Advisors as fiduciaries have to look at all options for their clients,” says Rita Cheng, CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland, who says reverse mortgages are often brought up by adult children of seniors who want to assure that their parents can age in place. “Reverse mortgages can help create a source of tax-free sustainable retirement income.”
How does a reverse mortgage work?
So how does a reverse mortgage work? Adults 62 or over who own their home outright (or who have substantial equity) can elect to withdraw that equity through a financial agreement with a lending institution, allowing them to use a portion of their home’s accumulated value as tax-free income and live mortgage-free there until their death. The Federal Housing Administration calls a reverse mortgage a Home Equity Conversion Mortgage (HECM).
These loans do have fees, and they don’t return 100% of the equity a borrower paid into a home. Generally, reverse mortgage payments are calculated from an amount that is built off around 50% (for a 62 year old or younger borrower) to 75% (for an older borrower) of a home’s value, with a maximum home value set by the Federal Housing Administration at $636,150, notes Shelley Giordano, chair of the Funding Longevity Task Force at the American College of Financial Services in Washington D.C., who notes that reverse mortgage practices were revised in 2013 in the aftermath of the “Great Recession.”
Those who take a reverse mortgage may withdraw funds in the form of a lump sum (one-time payment), in the form of an annuity-like flat monthly payment (known as a “tenure payment”), or in the form of a home equity line of credit (HELOC). Giordano notes that HELOC-style reverse mortgages are popular because the homeowner can establish the line of credit and then wait to withdraw on it.
Waiting increases the amount of equity available, which is a benefit for seniors who know that their medical costs may increase as they age and can wait to tap the line. Unlike a regular home equity line of credit, which can be frozen or canceled in adverse market conditions (as happened in the Great Recession), a HELOC on a reverse mortgage cannot be rescinded. Reverse mortgage applicants do need to demonstrate the ability to pay expenses such as home maintenance and utilities.
They also need to live in their home for at least 13 months after the reverse mortgage is initiated. If the retiree has to eventually move into a care facility, they can continue collecting the reverse mortgage payments if they’ve lived in the reverse-mortgaged home for the minimum 13 months for as long as they’re alive.
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When to use reverse mortgages, when to avoid them
Reverse mortgages are popular for adults who want to age at home and who own outright or have a high percentage of home equity. However, Ms. Cheng notes, before initiating a reverse mortgage, homeowners need to ask if they’re actually living in an appropriate home where they can age in place— both physically and financially speaking.
“If you’re not staying for at least three to five years, this doesn’t make sense,” she notes. “And if the current home is too expensive to maintain or too big or not safe for a future senior, it may not make sense.”
Those homeowners might want to turn to another property, and initiate a reverse mortgage there—if indeed they need to use one.
Reverse mortgages can provide tax-free supplementary income to help an adult postpone taking Social Security payments, and they can provide supplementary income for medical expenses. They can also provide flat, regular payments that can help in the event of a stock market slump or if a portfolio’s total value is down—a time when smaller percentage withdrawals may be advised for capital preservation.
While reverse mortgages mean that a homeowner or homeowner couple won’t have a home to leave to heirs—although heirs can purchase the home from the lender, if desired—that isn’t a common concern, Ms. Cheng says: “Some adult children see their parents’ resources as ‘their’ future money, but many would rather see their parents living in a financially secure arrangement.”
Giordano seconds this notion, “The kids don’t want to inherit and have to sell your house. They want to inherit and liquidate your portfolio.”
Before pulling equity out of your home, FHA requires that prospective reverse mortgage users attend an independent counseling session to make sure they understand the particulars of this financial product. Giordano also advises that expenses tied to reverse mortgages, just like those tied to regular mortgages, are flexible–and borrowers are advised to tap at least three lenders to negotiate terms.
Of course, the decision to turn a home’s equity into cash is ultimately tied to a retiree’s income needs. And for those with robust portfolios, pensions, access to Social Security, or other passive income streams in retirement, going this route isn’t always advisable.
“For me, it’s all about whether the client needs the extra income,” says John Flavin. “I only want to use this tool if it’s appropriate. You’re basically annuitizing your house in exchange for fees.”
While reverse mortgages do carry consequences for the next generation in a family and don’t pay out 100% of the equity a homeowner has paid into a property, advisors say these products do merit analysis for many near-retirees or those approaching 62. For adults whose home is among their larger assets, the newer product offerings and types of reverse mortgages available may provide a practical source of income during retirement.
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