U.S. and global economic volatility due to the COVID-19 pandemic have many retirees (and those close to retirement) worrying how to survive these turbulent times.
Will you have enough assets to maintain your lifestyle and meet retirement spending goals in the face of a possibly long-term bear market?
Traditionally, older adults fund retirement with a mixture of Social Security, pensions, 401(k)s and other retirement and saving accounts.
However, many could be sitting on (or rather, in) hundreds of thousands or even millions of dollars they haven’t considered using: home equity. This source of wealth is often ignored in retirement income planning.
One of the most sensible ways of leveraging home equity in retirement age is through Home Equity Conversion Mortgages (HECM), also known as reverse mortgages. With increased safeguards to protect consumers and lower costs than in the past, reverse mortgages are becoming mainstream financial instruments.
How Does It Work?
Simply put, reverse mortgages enable homeowners age 60+ to borrow up to roughly 50% of their home’s value, depending on their age and that of any spouse also on the loan. Borrowers are guaranteed the right to continue living in their home for the rest of their lives (or until they permanently move out).
Furthermore, while any funds borrowed against home equity continue to accrue interest, all reverse mortgage are non-recourse loans. That means borrowers can never owe more on the loan than what the house is worth when the loan is repaid. If the house has declined in value, the FHA or the lender bears the risk (in part with the help of mandatory mortgage insurance. See below).
On the other hand, if the home should increase in value by the time the owners move out, all remaining equity after paying off the loan belongs to the borrower or their heirs.
In addition, homeowners may pay back the loan without penalty or sell the home at any time (at which point the reverse mortgage lender will be fully repaid).
Higher net worth individuals and families often choose to use reverse mortgages as part of their overall retirement income strategy. It’s not uncommon for these borrowers to make regular payments on their reverse mortgage.
Some choose to make interest-only payments, so their balance doesn’t increase at the rate it ordinarily would.
Others treat a reverse mortgage similar to a traditional loan and make regular monthly payments. With rates on par with traditional mortgages, they are able to borrow money at a low rate of interest and pay it back on their terms, as opposed to the structure of a fixed 15-, 20- or 30-year term.
And some may choose to defer payback until the last remaining borrower leaves the home.
Ways To Make Use Of One
Pay off an existing mortgage: A reverse mortgage can pay off and replace a traditional mortgage loan, reducing the burden of a mandatory monthly payment and resulting in immediate savings — especially helpful in today’s uncertain times.
Standby line of credit: Unlike traditional credit lines, reverse mortgage credit lines are federally insured and cannot be frozen or called due. The unused portion has a guaranteed growth rate of .5% over the current interest rate on the loan, allowing more funds to be borrowed over time. Even if the home decreases in value, the line of credit remains and continues to grow.
This offers an excellent insurance policy against market fluctuation, and a tax-free source of money that can be used as a buffer in a down market.
The strategy in turbulent times would be to draw funds from the credit line instead of drawing on other assets (such as selling stocks when they’re down). Thus, a reverse mortgage credit line can limit the need to make portfolio withdrawals, protecting and preserving retirement accounts.
Multiple payout options: Reverse mortgage proceeds may be accessed in a lump sum, in the form of an annuity (a lifetime payout known as “tenure”), through equal payments over a fixed period of time (known as “term”), or through a combination of these options.
While reverse mortgages can be based on fixed interest rates, the line of credit, tenure and term payouts are available only on adjustable interest rate options.
Interest rates on reverse mortgages are on par with traditional mortgage interest rates. Rates are negotiable and vary from lender to lender.
The “index rate” is the standard rate that varies depending on market interest rates. It is not controlled by the lender. The rate charged on your loan can increase or decrease depending on whether the index increases or decreases.
The margin rate is the interest percentage that is added to the index by the lender. This rate is not adjustable, meaning that after loan origination, the margin stays the same throughout the loan term, regardless of what the index may change to. It is also negotiable.
Cost Of A Reverse Mortgage
HUD counseling: To obtain reverse mortgages, borrowers must undergo mandatory counseling with a third-party HECM counselor approved by the U.S. Department of Housing and Urban Development. Typically charged at $125, this counseling addresses the lending process, benefits, drawbacks and eligibility requirements.
Home appraisal: Appraisals run on average $450 to $550 and can vary depending on the size, age and condition of your home. They are ordered through an independent appraisal management company.
Third-party closing costs: Expect to pay typical mortgage fees for loan recording, credit report and title insurance. These fees could vary and are negotiable. Ask for an itemized fee breakdown.
Mortgage Insurance Premium (MIP): There is an initial mortgage insurance premium of 2% of the home’s appraised value. Over the life of the loan, you’ll also pay an annual MIP that equals 0.5% of the outstanding mortgage balance. (This federally-backed insurance helps protect lenders in the event the value of the home drops over the life of the mortgage.)
Loan origination fee: Lenders may change a loan origination fee ranging from zero to $6,000 depending on your home value. This fee is negotiable and can vary among lenders. Most costs may be financed into the loan.
An important note on costs: Reverse mortgage borrowers must also continue to pay their property taxes, insurance and maintain the home to comply with loan guidelines.
As with any financial product or service, education is paramount. Discuss the options with a knowledgeable professional before committing.
This article originally appeared in the April 2020 Edition of The Beacon Newspaper
We wanted to provide a glossary to help you understand the terminology used in education materials and literature on Reverse Mortgages.
Home Equity Conversion Mortgage. This is the industry term for Reverse Mortgage.
A report that states an opinion on the value of a property based on its characteristics and the selling prices of similar properties in the area.
A service provided by an independent third-party, typically approved by the U.S. Department of Housing and Urban Development, to make sure the borrower fully understands the reverse mortgage and reviews alternative options, prior to application. Mandatory for the HECM program and in certain states for all types of reverse mortgages.
Initial Principal Limit:
Amount of funds you are eligible to receive from a reverse mortgage before closing costs are deducted.
Expected Interest Rate: The interest rate used to calculate the principal limit. It equals either the 10-year CMT or the 10-year LIBOR rate plus a margin.
Actual Interest Rate: The interest rate first charged on the loan beginning at closing; it equals one of the HUD-approved interest rate indices (1-month CMT, 1-year CMT, or 1-month LIBOR) plus a margin. Also called Initial Interest Rate.
Interest Rate Structure:
Index: Reverse mortgage interest rates are tied to one of two indexes, the Constant Maturity Treasury rate (CMT) or the London Interbank Offered Rate (LIBOR).
Margin: An amount added to the Index (CMT or LIBOR) to determine both the Expected and Actual interest rates. The margin is determined by the loan investor.
Variable Rate: An interest rate that adjusts monthly or annually.
Fixed Rate: An interest rate that remains constant over the life of the loan.
Lifetime Expectancy Set-Aside (LESA):
A Reverse Mortgage LESA, which stands for life expectancy set aside, was introduced as part of the new financial assessment guidelines rolled out by the Federal Housing Administration (FHA) in 2014. The idea behind the LESA is to help reverse mortgage borrowers with credit challenges or limited income to stay current with payments for property taxes and insurance (which is an important requirement of the reverse mortgage program).
Setting up a LESA involves carving out a portion of the principal limit (the total pool of funds available) into a set aside account that is preserved solely for the payment of property charges. The exact amount of the carve out varies widely from borrower to borrower because it is based on age and how much property taxes and insurance cost.
If property charges are low, the total reverse mortgage LESA carve out tends to be low. If property charges are high (such as in areas where property taxes are high), then the LESA can be a pretty substantial portion of the loan proceeds.
It’s possible that a LESA can make a reverse mortgage completely unworkable. If the home has a high mortgage balance, its possible there isn’t enough left in the principal limit to create the LESA. In such a case the loan would be short to close, which means the borrower would have to come up with cash to make the numbers work.
Line of Credit Growth Feature:
In some cases, the available line of credit increases over time according to the terms of the loan agreement.
Loan Closing Date:
Date on which your reverse mortgage is scheduled to close.
Maximum Claim Amount:
The lesser of a home’s appraised value or the maximum loan limit that can be insured by FHA. Used in determining the principal limit.
MIP (Mortgage Insurance Premium):
Under the HECM program, a fee charged to borrowers that is equal to a small percentage of the maximum claim amount, plus an annual premium thereafter on the loan balance. The MIP guarantees that if the lender goes out of business, FHA will step in and ensure the borrower has continued access to his or her loan funds. The MIP further guarantees that when the property is sold to pay back the reverse mortgage, the borrower will never owe more than the value of the home.
Net Principal Limit:
Amount of funds you are eligible to receive at closing after loan costs have been deducted.
A feature that limits the amount owed by the borrower, heirs or estate when the loan becomes due and payable to the appraised home value. For the HECM program, non-recourse only applies when the home is sold.
Open End Line of Credit:
A line of credit that allows the borrower to withdrawal funds, make payments back to the lender, and then have the ability to make subsequent withdrawals.
A fee charged by the lender to cover its expenses for originating the loan. A lender can charge the greater of $2,500 or 2% of the first $200,000 of your home’s value plus 1% of the amount over $200,000. HECM origination fees are capped at $6,000. Some lenders waive or reduce the origination fees on certain products.
Paying off a reverse mortgage early (that is, before the borrower permanently vacates the property). Under the HECM program, there is no penalty for paying all, or a portion, of the loan prematurely.
The total loan proceeds available at closing.
A type of insurance policy that protects a homeowner or lender against financial loss from defects in title to real property and from the invalidity or unenforceability of mortgage liens. The cost for the policy is typically paid at closing by the borrower.
How Does A Reverse Mortgage Work
If you’re like many older Americans, you’ve worked hard and saved money, but you may still have concerns about having enough to live comfortably throughout your entire retirement. If you’re retired, or close to retirement, the wealth amassed in your home equity likely represents a large portion of your net worth.
Understanding how to strategically and tax efficiently incorporate this wealth into your retirement plan may be the key to prolonging and protecting your overall portfolio. How we plan to fund our longevity is very different today than in decades past. Historically, many companies provided lifetime pensions, which provided retirees with certainty and peace of mind. Today, medical expenses, longer life-spans, long-term care needs and other issues have left many older Americans in Baltimore worried about the possibility of outliving their money.
Yet, older homeowners have amassed an unprecedented $7.14 trillion in untapped home equity as of the first quarter of 2019. (Source: National Reverse Mortgage Lenders Association and Risk Span) This begs the question: Is it reasonable to ignore your largest asset when developing a financial plan?
Simply put, a reverse mortgage loan enables homeowners age 62 or above the ability to borrow up to roughly 50 percent of their home’s value. Payouts can be made to the borrower in the form of a lump sum payment, line of credit with a guaranteed growth rate, monthly payouts or a combination of all three. (We’ll touch on how the line of credit grows in a future article.)
A reverse mortgage may also be used to purchase a home. The HECM for purchase loan combines a reverse mortgage with the equity from the sale of your previous home - or from other savings and assets - to buy your next primary home in a single transaction. Regardless of how long you live in the home or what happens to your home’s value, you only make one initial down payment towards the purchase, provided that you pay property taxes and homeowner’s insurance, and maintain the property.
Reverse Mortgage Misconceptions
A common misconception about reverse mortgages is that bank owns the home. This is not the case. The homeowners retain ownership of the home, just like they would with a traditional mortgage. Unlike traditional mortgages, there is no monthly payment requirement as long as the home remains the primary residence.
Another common misconception is that rates on reverse mortgages are higher than traditional home loans. This is also false. Reverse mortgage interest rates are in line with traditional mortgage rates. Borrowers have the option to make monthly payments or to defer payback until the last remaining borrower leaves the home.
The key here is flexibility. Reverse mortgage borrowers may access their home equity on demand. The flexible payment option is designed to provide homeowners, especially those on a fixed income with additional cash flow later in life when a mortgage payment can often be burdensome. They may also pay back the loan without penalty, or sell the home at any time. Borrowers must pay their property taxes, insurance and maintain the home to comply with loan guidelines.
Reverse Mortgage Pros
Reverse Mortgage Cons
The Bottom Line
As with any product or service, education is paramount. The reality is that the home is too large an asset to be ignored. Today’s reverse mortgages are not meant to be a Band-Aid or short-term fix to larger financial issues. In some cases, someone in financial distress may be better off selling the home to access more of equity, downsizing or moving to a care facility.
In other cases, a reverse mortgage is a powerful tool that can provide a more stable, comfortable and fulfilling retirement. If you’re considering a reverse mortgage, reach out to a specialist who has expertise in this specific program and who will take the time to understand your unique needs and situation.
Steven J. Sless (NMLS: # 298581 MLO: # 49963) is the reverse mortgage division manager with PRMI. He also oversees PRMI’s office in Owings Mills – one of the nation’s only consumer-direct retail branches that deals exclusively with reverse mortgages. For more information, Contact Us, call 410-814-7575 or follow morewithsless on Facebook, Twitter, LinkedIn and Instagram.