Home equity can become your safety net
[Introductory note: A reverse mortgage allows homeowners 62 and over to borrow against the equity in their home while retaining the right to remain in the home as long as they live.
The money can be made available in the form of a lump sum, an annuity or a line of credit with a guaranteed rate of growth, and never needs to be paid back by the homeowner.
The lender will recoup the loan when the homeowner leaves or dies and the home is sold, or the loan can be paid off by heirs if they want to retain the home.]
Reverse mortgages have often been branded as a way for older retirees to raise money only when other sources of retirement income have dried up.
But a growing group of financial planners and academics say that taking out a reverse mortgage early in retirement could help protect your retirement income from stock market volatility and significantly reduce the risk that you’ll run out of money.
Here’s how the strategy, known as a standby reverse mortgage, works: Take out a reverse mortgage line of credit as early as possible — homeowners are eligible at age 62 — and set it aside. If the stock market turns bearish, draw from the line of credit to pay expenses until your portfolio recovers.
Retirees who adopt this strategy should be able to avoid the pitfalls of the Great Recession, when many seniors were forced to sell stock from severely depressed portfolios to pay the bills.
The standby reverse mortgage strategy can be effective “both from a practical and a behavioral perspective,” said Harold Evensky, a certified financial planner. “If people know they’ve got resources when the market collapses, they don’t panic and sell.”
A traditional home-equity line of credit could also provide a source of emergency cash, but you can’t count on the money being there when you need it, said Shelley Giordano, founder of the Academy for Home Equity in Financial Planning at the University of Illinois at Urbana Champaign.
During the 2008-09 market downturn and credit crunch, many banks froze or closed borrowers’ home-equity lines. “Just when people needed money and liquidity, the banks needed liquidity, too,” Giordano said.
That won’t happen if you have a reverse mortgage line of credit. As long as you meet the terms of the reverse mortgage — you must maintain your home and pay taxes and insurance — your line of credit is guaranteed.
Favorable interest rates now
Several factors make a standby reverse mortgage particularly attractive now. Homeowners age 62 and older have seen the amount of equity in their homes increase sharply in recent years, to a record $7.14 trillion in the first quarter of 2019, according to the National Reverse Mortgage Lenders Association.
Low interest rates are another plus. Under the terms of the government-insured Home Equity Conversion Mortgage (or HECM, the most popular kind of reverse mortgage), the lower the interest rate, the more home equity you’re allowed to borrow.
Which leads us to one of the most counterintuitive — and potentially lucrative — features of reverse mortgages. Your untapped credit line will increase as if you were paying interest on the balance, even though you don’t have to pay interest on money you don’t tap.
If interest rates increase — and given current low rates, they are almost guaranteed to move higher eventually — your line of credit will grow even faster, Giordano said.
You won’t have to pay back money you tap as long as you remain in your home — a comforting thought if you take money during a bear market. A HECM reverse mortgage is a “non-recourse” loan, which means the amount you or your heirs owe when the home is sold will never exceed the value of the home.
For example, if your loan balance grows to $300,000 and your home is sold for $220,000, you (or your heirs) will never owe more than $220,000. The Federal Housing Administration insurance will reimburse the lender for the difference.
If you have an existing mortgage, you’ll have to use the proceeds from your reverse mortgage to pay that off first.
You have plenty of flexibility: Funds left over can be taken as a line of credit, a lump sum, monthly payments or a combination of those options.
Even if there’s not a lot of money left over, paying off your first mortgage means you won’t have to withdraw money to make mortgage payments during a market downturn, Giordano noted. “A regular mortgage that requires a monthly principal and interest payment can be a real burden, especially when the value of your portfolio is under stress,” she said.
One of the biggest downsides to reverse mortgages is the up-front cost, which is significantly higher than the cost of a traditional home-equity line of credit.
The FHA allows lenders to charge an origination fee equal to the greater of $2,500 or 2% of your home’s value (up to the first $200,000), plus 1% of the amount over $200,000, up to a cap of $6,000.
You’ll also be charged an up-front mortgage insurance premium equal to 2% of your home’s appraised value or the FHA lending limit of $726,525, whichever is less.
And you’ll have to pay third parties for an appraisal, title search and other services. You can pay for some of these costs with the proceeds from your loan, but that will reduce the loan balance. Costs vary, so talk to at least three lenders that offer reverse mortgages, Giordano said.
Because of the up-front costs, it’s rarely a good idea to take out a reverse mortgage unless you expect to stay in your home for at least five years.
Remember, too, that the loan will come due when the last surviving borrower sells, leaves for more than 12 months due to illness, or dies.
If your heirs want to keep the home, they’ll need to pay off the loan first. That may not sit well with children who expect to inherit the family homestead, so it’s a good idea to discuss your plans with them in advance.
Giordano doesn’t see this as a big barrier to a standby reverse mortgage — especially if it helps you preserve other, more liquid assets. “Kids would much rather split up a big fat portfolio than try to decide how to split up the house,” she said.
Yes, this new phase of life comes with a lot of uncertainties. And financial advisers say that many new retirees often hold back on spending because of all the unknown bills that may await years down the line.
But Keith Bernhardt, vice president of retirement income at Fidelity, said these retirees often discover a happy surprise.
“They actually find out that they are in a pretty good spot. They are able to be happy and enjoy retirement,” he said. “It’s not quite as expensive as they thought it was going to be.”
© 2019 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.