Serving Santa Cruz and Santa Clara Counties

Reverse Mortgages: What Advisors Should Know

If you think that reverse mortgages are only for cash-strapped retirees without any other financial options, think again. The features of reverse mortgage loans have been evolving over the years and a growing body of research suggests that these loans can help older adults manage a dependable stream on income during their retirement years.

Today almost all reverse mortgages are home equity conversion mortgages. These are issued by a variety of lenders but all are insured and regulated by the Federal Housing Administration, a branch of the U.S. Department of Housing and Urban Development (HUD).  As the program has evolved over the years, it has developed new rules to make the home equity conversion mortgage more dependable and sustainable for most borrowers.  Many problems with earlier versions have been addressed. There are now more practical safeguards, better consumer protections and, importantly, some attractive new features.

In September 2013, HUD made a number of important changes to remove some of the risks of these loans.  First they limited the amount of the home value which could be borrowed so that borrowers don’t overextend themselves.  Second, HUD found that excessive first-year payouts strongly correlated to problem loans.   In response, they instituted strong incentives that encourage borrowers to limit the first-year maximum payouts to 60% of the maximum loan value by mandating much higher insurance cost if these payouts exceed 60%.

Finally, in early 2014, HUD instituted a requirement that all potential borrowers must go through financial counseling with a third party before applying for the loan in order to establish their ability to manage the loan.  If the lenders determine that the borrower’s income may be insufficient to manage their cash flow, the lender will set aside a portion of the loan funds to pay ongoing obligations.

Research at Texas Tech University, home of a leading financial planning program, and by others suggests that the current structure of reverse mortgages offer important benefits to the right borrower who needs to balance their household budget and stabilize retirement income. One powerful application is using the reverse mortgage line of credit option as a Bear Market Standby Account.

Many people depend upon retirement savings in IRAs, 401(k)s and even taxable investment accounts to provide ongoing retirement income. The inevitable bear markets, however, present unique and potentially serious risks when the financial markets drop significantly.

The problem arises because the need for withdrawals from accounts does not change.  If a person needed $30,000 per year from these accounts before the recession they would still need $30,000 per year except now $30,000 is a much larger percentage of their portfolio. If the withdrawals are too large, and the bear market and recession is too prolonged, their account value can spin into a death spiral and run out of funds much earlier than anticipated. This is a major challenge in many retirement income plans.

There are a number of ways to deal with this risk that have been widely reported including keeping annual withdrawals very modest (3%-5%) or planning to curtail withdrawals during deep bear markets.  Another option is using a reverse mortgage line of credit.

A reverse mortgage line of credit can neatly safeguard your long-term retirement income plan against this scenario by serving as a Bear Market Standby Account. Basically the reverse mortgage line of credit is secured and maintained primarily for the eventuality of a bear market.  In either case, you then simply maintain the line of credit only to be used when needed.

In years of the inevitable and periodic steep market declines, one takes payouts out of the line of credit to fill retirement income needs instead of taking it out of one’s investment portfolio. This allows the investments to weather the market declines and have time to recover without the compounded stress of withdrawals. The borrower might use the line of credit for income for six months or a year until the markets have recovered sufficiently.

This prevents having to sell stocks or mutual funds at depressed values and allows the person to more predictably manage investments for consistent income. Research suggests that using this strategy can boost the potential withdrawal rate from your investment portfolios by as much as 1.5% to 3.5% per  year, a huge amount over your projected retirement.

One applies for a reverse mortgage with a line of credit option, pays closing costs, but initially does not borrow any funds except for closing costs, which will be around $8,000 – $10,000 depending on the home value, state and other requirements.  Most people roll this into the line of credit but some pay this out-of-pocket.

An interesting additional feature is that the line of credit grows over time.  The line of credit amount available to borrow grows year in, year out at the same interest rate as the loan regardless of whether you are currently borrowing funds.  This allows this standby account to keep pace with inflation.  Even if your house value drops, the line of credit still grows.

Lastly, the current low-interest rate environment, while terrible for savers, is a great time to borrow. Reverse mortgage strategies are especially attractive with current interest rates since it allows for higher loan amounts and higher lines of credit.

There are many other features and variables to consider with reverse mortgages. Any prospective borrower should thoroughly review all the features of a proposed reverse mortgage just as they would for any other financial transaction.  The assistance of a third-party advisor such as a financial planner is especially recommended to help review the pros and cons of the mortgage for the borrower’s specific circumstances.

There is no one perfect solution for retirement income planning that works for all people. Rather there is a range of solutions and strategies that should be evaluated in light of your specific needs.  Current reverse mortgages deserve to be one of those options.