February 23, 2017
Clients often ask us how their parents can remain financially independent and continue to live in their own homes. One way they can do this, if they have substantial equity in their home, is through a reverse mortgage.
The idea of using a reverse mortgage to supplement a retirement portfolio is seen by many people as a last resort. However, research shows that coordinating withdrawals from IRAs and other accounts with a reverse mortgage line of credit reduces the risk of running out of money too soon.
Although a reverse mortgage is not appropriate for everyone, it is worthwhile to consider for relatively healthy older homeowners who seek additional income in retirement. A reverse mortgage can help them remain in their own homes and stretch out their retirement portfolios.
A reverse mortgage allows homeowners age 62 or older to borrow equity from their homes. But unlike a traditional mortgage, they do not need to pay back the money or interest until they move out of the property or die. The most common reverse mortgage is offered through the Federal Housing Administration’s Home Equity Conversion Mortgage (HECM) program. One benefit of a HECM is that it is a non-recourse loan, meaning the balance due cannot exceed 95% of the value of the home.
Keep in mind the home must be the owner’s primary residence. The borrower must also receive special, HUD-approved counseling before taking out the mortgage and demonstrate financial capacity to pay property taxes and insurance for their life expectancy. Property insurance and taxes must be paid on time, otherwise the loan could become due and payable. If money isn’t available to pay the balance due, the home could be foreclosed upon. Other terms and fees apply to take out the mortgage.
One way a reverse mortgage can be set up is as a line of credit. The credit line grows as long as the borrower remains in the home. The initial size of the line is determined by several factors, primarily the equity value in the home (up to $625,500) and the age of the oldest borrower, if a couple. The rate of growth is predicated on the interest rate and mortgage insurance premium rate.
Research studies have shown that reserve mortgages can help augment retirement investment income.
Wade Pfau, Professor of Retirement Income at the American College, demonstrated in a study published by the Journal of Financial Planning that the optimal downside protection for income in retirement is to open a reverse mortgage line of credit early in retirement and then delay using it until after the investment portfolio is depleted. This strategy allows the credit line to grow over a longer period of time before it is ultimately used, providing for more income. Remember, however, that the reverse mortgage cannot be used, or must be repaid, if the person needs to move out of the home in the later years.
Another, more active, strategy can help prolong retirement savings. In another study in the Journal of Financial Planning, researchers Barry H. Sacks, J.D., Ph.D., and Stephen R. Sacks, Ph.D., found that coordinating a reverse mortgage with spending down liquid assets was an alternative to taking out the reverse mortgage after other assets have been depleted. They found that accessing the line of credit in years when the market has a negative return is a better option than selling assets during a market decline to meet living expenses.
These examples show there are different ways to use a reverse mortgage to extend retirement income. For people who may live into their 80s and 90s, the HECM also provides the security that they, and their heirs, will never owe more than the value of their home.
With property values increasing in many areas of the country, this is an option we encourage clients to discuss with their parents. An independent financial advisor with a duty to act in their clients’ best interests can help determine whether a reverse mortgage is right for the family and which strategy would be most beneficial.
Cliff Loh and Kaleb Paddock, senior associates of Wealth Management in our Silicon Valley office, contributed to this post.
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