Aging in place. It’s a relatively new term for a very old concept: remaining in your own home as you grow older. Once upon a time, this wasn’t an issue. Extended families ensured that someone would be available to look after Grandma or Grandpa should the time come when they needed assistance.
If, after considering other housing options, you have decided to remain in an eligible home or to move into a new home, you may want to consider a Home Equity Conversion Mortgage (HECM) – more commonly known as a reverse mortgage – as a source of retirement income.
The vast majority of reverse mortgages in the United States are HECM reverse mortgages, which are regulated and insured through the federal government by the Department of Housing and Urban Development (HUD) and the Federal Housing Authority (FHA). Other options outside of the federal program pop up occasionally, like jumbo reverse mortgages that exceed federal limits.
The HECM program includes both fixed rate and variable rate loans, though fixed rate loans are uncommon and require the entire allowed credit to be taken as an initial lump-sum amount. We will not concern ourselves with fixed rate loans, only variable rate.
Any discussion of reverse mortgages as a retirement income tool has typically focused on real or perceived negatives related to traditionally high costs and potentially inappropriate uses for these funds. These conversations often include misguided ideas about the homeowner losing the title to their home and hyperbole about the American Dream becoming the American Nightmare.
Any acceptance of reverse mortgages in financial and retirement planning was as a last resort after all other possibilities had failed. Reverse mortgages continue to carry a negative connotation thanks to late-night television commercials that leave many suspicious of their viability as a retirement income tool.
However, developments of the past decade have made reverse mortgages harder to dismiss outright. The federal government has been refining regulations for its HECM program since 2013 in order to:
• improve the sustainability of the underlying mortgage insurance fund;
• better protect eligible non-borrowing spouses,
• ensure borrowers have sufficient financial resources to continue paying their property taxes, homeowner’s insurance, and home maintenance expenses.
The thrust of these changes has been to ensure reverse mortgages are used responsibly as part of an overall retirement income strategy, rather than to simply fritter away assets.
On the academic side, several recent research articles have demonstrated how responsible use of a reverse mortgage can enhance an overall retirement income plan. Importantly, this research incorporates realistic costs for reverse mortgages, both in relation to their initial upfront costs and the ongoing growth of any outstanding loan balance. Any quantified benefits are understood to exist after netting out the costs associated with reverse mortgages.
In short, well-handled reverse mortgages have been suffering from the bad press surrounding irresponsible reverse mortgages for too long. Reverse mortgages give responsible retirees the option to create liquidity for an otherwise illiquid asset, which in turn can potentially support a more efficient retirement income strategy (more spending and/or more legacy). This liquidity is created by allowing homeowners to borrow against the value of the home with the flexibility to defer repayment until they have permanently left the home.
With so much bias, it can be hard to view reverse mortgages objectively without a clear understanding of how the benefits can exceed the costs. To understand their role, it is worth stepping back to clarify the retirement income problems we seek to solve.
Retirees must support a series of expenses – overall lifestyle spending goals, unexpected contingencies, legacy goals – in order to enjoy a successful retirement. Suppose retirees only have two assets – beyond Social Security and any pensions – to meet their spending obligations: an investment portfolio and home equity. The task is to link these assets to spending obligations efficiently while also mitigating retirement risks like longevity, market volatility, and spending surprises that can impact the plan.
The fundamental question is this: How can these two assets meet spending goals while simultaneously preserving remaining assets to cover contingencies and support a legacy? Spending from either asset today has implications for future spending and legacy.
Spending a portion of financial assets today surrenders future market gains (or losses). Spending home equity today reduces future spending potential or legacy and increases the loan balance due on this spending.
When a household has an investment portfolio and home equity, the “default” strategy tends to be to spend down investment assets first and preserve home equity as long as possible, with the goal of supporting a legacy through a debt-free home. A reverse mortgage is only used as an absolute last resort option once the investment portfolio has been depleted and vital spending needs are threatened.
The research of the last few years has generally found this conventional wisdom constraining and counterproductive. Initiating the reverse mortgage earlier and coordinating spending from home equity throughout retirement can help meet spending goals while also providing a larger legacy. That is the nature of retirement income efficiency: using assets in a way that allows for more income and/or more legacy.
For heirs wishing to keep the home, a larger legacy offers an extra bonus of additional financial assets after the loan balance has been repaid. The home is not lost.
Legacy wealth is the combined value of any remaining financial assets plus any remaining home equity after repaying the reverse mortgage. Money is fungible and the specific ratio of financial assets and remaining home equity is not important. In the final analysis, only the sum of these two components matters.
While taking money from the reverse mortgage reduces the home equity component, it does not necessarily reduce the overall net worth or legacy value of assets. Wanting to specifically preserve the home may be a psychological constraint which leads to a less efficient retirement. A reverse mortgage allows a retiree to gift the value of the house, rather than the house itself. Should the heir wish to keep the house, the value of the house they have received as an inheritance can be redeployed for this purpose, as long as net legacy is large enough to do so.
The Underlying Mechanisms of Why Reverse Mortgages Can Help
Two factors give opening a reverse mortgage earlier in retirement the potential to improve retirement efficiencies in spite of the loan costs. First, coordinating draws from a reverse mortgage reduces strain on portfolio withdrawals, which helps manage sequence of returns risk.
Investment volatility is amplified by sequence of returns risk and can be more harmful to those who are withdrawing from, rather than contributing to their portfolio – namely, retirees. Reverse mortgages provide a buffer asset to sidestep this sequence risk by providing an alternative source of spending after market declines.
The second potential benefit of opening the reverse mortgage early, especially when interest rates are low, is that the principal limit which can be borrowed from will continue to grow throughout retirement. Reverse mortgages are non-recourse loans. Sufficiently long retirements carry a reasonable possibility that the available credit may eventually exceed the value of the home. In these cases, mortgage insurance premiums paid to the government on the loan balance are used to make sure the lender does not experience a loss. In addition, the borrower and/or estate will not be on the hook for repaying more than the value of the home when the loan becomes due. This line of credit growth is one of the most important and confusing aspects of reverse mortgages. I will return to this for a deeper explanation later.
As the government continues to strengthen the rules and regulations for reverse mortgages and new research continues to pave the way with an agnostic view for their role, reverse mortgages may become much more common in the coming years. Many Americans rely on home equity and Social Security as the two primary available retirement assets.
As gerontologist and visiting professor at the American College, Dr. Sandra Timmerman, said, “The transition to retirement is a wake-up call for many middle income Baby Boomers who haven’t saved enough money to last a lifetime and want to age in place. With their homes as a major untapped financial resource, the smart use of reverse mortgages will be their saving grace.”
By Wade Pfau, Ph.D., CFA
This article recently appeared on Retirement Researcher.