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April 29, 2018
If used strategically, reverse mortgages can be valuable financial planning tools to help retirees cover a variety of lifestyle expenses and can also strengthen the spending power of their retirement portfolios.
Conventional wisdom has suggested getting a reverse mortgage later in life, to maximize borrowing power. In the past, this made sense. The majority of reverse mortgages were fixed rate loans in which the older the borrower was, the larger the portion of their equity that could be accessed. Waiting made sense then.
But reverse mortgages have changed a lot in recent years, and so has the wisdom around how they can help retirees. Rather than taking a reverse mortgage at the last possible moment, many financial advisors are now suggesting the opposite: to take a reverse mortgage at the first possible opportunity.
It is a striking turnaround when compared to what you may have heard in the past — reverse mortgages have now become safer financial products. This is thanks to a series of rule changes in recent years that ensure borrowers have the resources needed to support the loan, and themselves, during retirement.
New safeguards have even caught the attention of financial planners, many of whom have researched extensively the financial benefits of incorporating home equity into a retirement income plan.
“The assumption in financial and retirement planning was that reverse mortgages should only be considered as a last resort, once all other resources and possibilities had failed,” wrote Wade Pfau, professor of retirement income at The American College in Bryn Mawr, Pa., in an article published by The Wall Street Journal. “Well, a lot has changed in the past several years, and the result is that reverse mortgages have an undeserved bad reputation.”
“Well, a lot has changed in the past several years, and the result is that reverse mortgages have an undeserved bad reputation.”
Since 2013, the federal government has increased borrower protections for reverse mortgages. Under the new rules, borrowers are now required to undergo a financial assessment to ensure they have the resources needed to maintain the reverse mortgage, including the ability to afford property taxes and homeowners insurance payments.
In the past, some borrowers found themselves in financial trouble after taking their home equity in single lump-sum payment, and then running through all of the proceeds, leaving little to nothing left to cover mandatory obligations like property taxes and insurance. To make sure this does not happen again, recent rules now limit the amount of loan proceeds borrowers can access during the first year of their reverse mortgage.
Not only have these new rules made reverse mortgages safer for borrowers, but they’ve also laid the foundation for how these products can be effectively leveraged in retirement planning. Just how effective a reverse mortgage can be, however, depends on how it is used.
“Intuitively, there are two reasons why opening a reverse mortgage earlier in retirement has the potential to improve retirement efficiencies despite the reverse mortgage costs for those wishing to remain in their homes,” Pfau writes.
Reverse mortgages allow borrowers to access a portion of their home equity in a variety of payment options, including a lump sum, monthly installments or through a line of credit. Of all the different options, the line of credit strategy has been gaining considerable attention from financial planners largely due to its unique “growth feature.”
Similar to a traditional Home Equity Line of Credit (HELOC), a reverse mortgage line of credit accrues interest only on the amount that is borrowed. An advantage of the reverse mortgage credit line, however, is that borrowers are not required to make monthly payments to the lender (although you must still pay your property taxes and insurance). Unlike a traditional HELOC, a reverse mortgage line of credit cannot be cancelled or frozen by the lender, enabling borrowers to draw on the credit line as needed for as long as they live in the home.
If taken early in retirement and left to “grow” for several years, a reverse mortgage line of credit can serve as a buffer . . . when they face market turmoil and negative returns.
If taken early in retirement and left to “grow” for several years, a reverse mortgage line of credit can serve as a buffer that prevents retirees from drawing on their investment portfolios in years when they face market turmoil and negative returns.
Coordinating draws from a reverse mortgage line of credit reduces the strain on investment portfolio withdrawals, writes Pfau, who published an extensive research paper detailing the various strategies in which a reverse mortgage can be used in retirement income planning.
“Retirees are more exposed to investment volatility because volatility has a bigger impact on financial outcomes when taking distributions from the portfolio as compared with when adding new funds to the portfolio,” Pfau says. “Reverse mortgages provide a buffer asset to sidestep the sequence risk by providing an alternative source of spending after market declines.”
A reverse mortgage line of credit can also provide other potential benefits for borrowers if obtained early in retirement.
The second potential benefit for opening a reverse mortgage early, especially when interest rates are low, is that the principal limit a borrower can draw from will continue to grow throughout retirement, according to Pfau.
Most of the reverse mortgages found on the market today are insured by the Federal Housing Administration. Known as Home Equity Conversion Mortgages (HECMs), the government backing makes reverse mortgages non-recourse loans. This means that if the reverse mortgage loan balance grows to be larger than your home value, you will never be required to pay more than the home is worth at the time of sale.
Because you will never be on the hook for more than your house is worth, this non-recourse provision can benefit borrowers who end up living longer lifetimes, granted they continue to live in the home as their principal residence. Vacating the home for any reason for longer than 12 months triggers the reverse mortgage to become due and payable.
Borrowers may particularly benefit from the non-recourse provision if they obtain a line of credit and manage to live long enough where the balance in the credit line has grown to exceed the value of their home.
“. . . for sufficiently long retirements, there is a reasonable possibility that the line of credit may grow to be larger than the value of the home . . . .”
“Reverse mortgages are non-recourse loans, and for sufficiently long retirements, there is a reasonable possibility that the line of credit may grow to be larger than the value of the home,” Pfau writes.
Although reverse mortgages can provide a number of benefits for borrowers when obtained at the start of retirement, as opposed to later in life, these complex financial products are not a one-size-fits-all solution to every retiree’s financial plans.
If you would like to know more about how a reverse mortgage might fit into your particular financial plan, contact reverse mortgage professional today.
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