Nested Interest

OK, I’m sure you’re skeptical about any product that is pitched through paid advertising on late night cable television, especially something from the financial services industry.  I, too, was a bit skeptical when I first heard about reverse mortgages, but the closer I looked at them the more I began to appreciate how truly unique they are and the great value that they can offer many retirees.

This blog is not going to be a “Reverse Mortgage 101” write-up – there are already many of those available on various websites (and, by all means, please read up on them).  Instead, I am going to hone in on some of the properties of reverse mortgages that I believe are particularly valuable, and that are somewhat less recognized.  Once you get your arms around some of these facts, I believe that you will see that this can be an extremely valuable component of a comprehensive retirement income plan.

In short, if you are approaching retirement (or are already retired), and your home equity is a significant portion of your retirement savings, you should take a close look at a reverse mortgage.

Here are my seven reasons to give a reverse mortgage serious consideration:

1. Insured by the US Government

This is probably one of the most important things to understand about a reverse mortgage, that all promises that are made through this product are fully backed by the US federal government (through the Department of Housing and Urban Development a.k.a. “HUD”).  Any promise made through a financial product is only as good as the party standing behind it.  Is there any party in the world stronger than US government?

2. “Tails” HUD Loses…

This is perhaps the most compelling reason to consider a reverse mortgages, so it is probably the most important one to understand.  Suppose you have a reverse mortgage and the total outstanding amount of the loan that has accrued under the reverse mortgage is $300,000.  Now, suppose you have to sell your home and must repay the loan, but, with it being a bad housing market, you can only sell your home for $250,000.  What happens to the $50,000 that of debt that cannot be repaid through the sale of your home?

Well, in this scenario, the $50,000 of debt that cannot be recovered is covered by HUD.  Therefore, one feature of a reverse mortgage is that it is a guaranteed minimum amount at which your home can be monetized.  To further illustrate this point, suppose in our example you had never drawn down any amount against your reverse mortgage and had an open line of credit of $300,000; in this situation, you could take out a loan of $300,000 under your reverse mortgage just before you sold your home for $250,000, leaving HUD on the hook for the $50,000 deficiency.  This would be economically similar to having sold your house for $300,000 instead of $250,000. You owe nothing more than whatever the sale of your home can repay.  Not too bad!

I should point out that this insurance feature is why HUD limits the amount that you can borrow against your home to something less than 100% of its appraised value when you first enter into the reverse mortgage.  It provides HUD a safety margin in case the value of your home declines (similar to why banks require that you provide a down payment on a home when you take out a mortgage).

 3.  …and “Heads” You Win.

After understanding that HUD is on the hook if your home value is less than the loan, you’re probably wondering “what’s the catch?”  There are a few: for example, the amount of loan that you can take out on your home when you first purchase a reserve mortgage is limited, and you also must purchase mortgage insurance.  However, one thing that you do not have to sacrifice is your right to any appreciation in value of your home.  If, under my previous example, you were able to sell your home for $500,000 when the outstanding amount of debt under the reverse mortgage was $300,000 you keep the full $200,000 gain.

If the value of your home appreciates considerably, it may be possible to refinance your reverse mortgage to increase the available line of credit.  This will mean that you will have to incur some closing costs, but it may be a valuable option in certain circumstances.

4.  Irrevocable Line of Credit

Once a reverse mortgage is provided, it cannot be arbitrarily revoked.  A reverse mortgage can be terminated if you do not pay property taxes on your home, if you fail to maintain homeowners insurance, or it you must move out of your home or sell it.  So long as you adhere to these types of basic requirements, any line of credit or income benefit promised to you under a reverse mortgage cannot be revoked.  It cannot be altered because of a change in the value of your home or a change in your credit rating, unlike other types of debt.  This provides retirees with much needed peace of mind.

5. Guaranteed LOC Increases; Only Goes Up…Never Goes Down

Some reverse mortgage programs provide a line of credit that has guaranteed increases linked to an external index.  This happens automatically, without a need to reapply or pay an additional fee.  An increasing capacity to borrow can be useful when considering the impact of inflation or rising healthcare costs during retirement.  I am not aware of any other type of debt has such a feature.

6. No Risk of Foreclose for Failure to Make Payments

Unlike a conventional home equity line of credit (which typically require monthly repayments), there is no requirement to make periodic repayments of the loan.  Outstanding loan balances grow with interest, and you will generally not be obligated to repay the loan until you sell it or move out.  Under a home equity line of credit, if you fail to make your required payments the issuing bank will typically have the right to foreclose upon your home.  However, because there is no obligation to make periodic repayments under a reverse mortgage, you are not subject to this risk of foreclosure due to a failure to meet required repayments (but you must remain current on property taxes and homeowners insurance).  This provides retirees with much greater cash flow flexibility than other types of debt, and reduces the downside risk of borrowing against your home.

7. Guaranteed Lifetime Income…With a Clawback

When you take out a reverse mortgage, you are offered two ways in which to receive payments.  One option is to open up a line of credit, which gives you the flexibility to take out however much cash you want, when you want, up to a specified limit.  The other option is what is called the “tenure option”, which provides a fixed income benefit that is payable for the rest of your life (so long as you live in your home), similar to an annuity.  Interestingly, reverse mortgages do not force you to commit to one of these two options for the duration of the agreement; rather, you have the right to switch between the line of credit option and the tenure option.  This can be an extremely valuable option, particularly when you compare the tenure option to an immediate annuity.  Under an immediate annuity, you must pay a single premium to the insurance company and, once you make the premium payment, you cannot redeem any equity (you can only receive the income benefits); however, under the tenure option of a reverse mortgage, you can switch out of the tenure option and into the line of credit option, giving you access to some of the equity income your home.  This can be extremely valuable if you have sudden, unforeseen need for additional cash.

Further, upon your death any remaining home equity (equal to the selling price of the home over the cumulative amount of tenure payments accrued under the reverse mortgage) will remain in your estate, while at the same time providing longevity protection.  This is quite different than an immediate annuity, which generally does not repay outstanding principal to heirs (instead, insurance companies use outstanding principal to fund the benefits for annuitants that live beyond their life expediencies).

Concluding Thoughts

I hope that this information is helpful, perhaps bringing some important features of reserve mortgages to your attention that you may not have otherwise fully appreciated.

One final point – it can still make good sense to secure a reverse mortgage today, even if you do not intend to draw income from it for a number of years.  The guarantees associated with reserve mortgages can serve as an important safeguard to an important part of your future retirement income.

A reverse mortgage is not necessarily appropriate for everyone – you should consult with a financial adviser or an approved reserves mortgage counselor to help make this determination.  For more information about reverse mortgages, check out the HUD website (click here for link).