Recent research suggests the potential benefits of reverse mortgages may be underappreciated.
• Home equity is the largest asset for many Americans. Although it is typically a lower percentage of net worth for wealthier persons, it still represents an illiquid, largely untapped resource.
• Some researchers maintain that home equity conversion mortgages (HECMs) can improve retirees’ income and financial well-being. However, use of reverse mortgages has been modest.
• Recent changes to HUD regulations increased upfront costs for most HECM applicants but lowered annual fees on outstanding balances.
Suppose a private client’s largest asset was illiquid and costly to maintain. Its long-term price performance was mediocre, and its value was subject to wide swings. You probably would recommend reducing exposure to this asset, either by hedging or sale, with a goal of increasing overall portfolio diversification.
For many older Americans, home equity represents that type of concentrated position. According to a 2017 study by Kaul and Goodman, the national aggregate value of primary residential equity in the US exceeds $11 trillion and homeowners age 65 and older have 40% of that equity value.
An ability to monetize home equity would benefit many retirees, particularly the less affluent.
Kaul and Goodman note that “owner-occupied households age 65 and older could increase their incomes 45 percent among those in the lowest income group and 56 percent among those without high school diplomas.” Access to home equity would also benefit wealthier retirees. However, they add, “In contrast, those in the highest income group could increase their incomes 17 percent, and those with college degrees, 32 percent.”
Methods for Using Home Equity
The property must be the borrower’s primary residence, and the borrower must be able to pay for home maintenance, insurance, and property taxes. Most reverse mortgages are home equity conversion mortgages (HECMs) that are insured by the Federal Housing Administration (FHA) but originated by private lenders. Non-HECM, privately issued reverse mortgages make up a very small segment of the market. Prospective HECM borrowers must receive counseling from an approved counselor before the mortgage is approved.
Few Takers (So Far)
Should the mortgage debt exceed the home’s value at sale, the FHA insurance makes up the difference so lenders don’t incur a loss. If the sales price exceeds the loan balance, the owner or heirs receive the remaining equity. It sounds like a good deal, but after reaching a peak of about 115,000 new HECMs in 2009 (fiscal year ending in September), the annual pace dropped to roughly 49,000 for 2016. That reduced activity doesn’t seem likely to increase soon: A Fannie Mae survey in early 2016 found that 90% of older homeowners were not interested in tapping into their home equity.
Several reasons could explain the reluctance. Establishing an HECM incurs significant upfront costs, even if the homeowner sets up a line of credit but does not use it immediately. HECMs also still suffer from negative publicity, with reports of indebted seniors facing the loss of their homes, frequently because of an inability to pay property taxes, insurance, or required maintenance. Kaul and Goodman cite longer careers and a desire to avoid debt in old age as other important considerations; viewing the home as a bequest for heirs is another factor.
Private wealth advisers have considered HECMs as too expensive and viewed them as the loan of last recourse. Some advisers’ negative views of HECMS changed during the stock market’s 2008–09 collapse, however. Retired clients whose income relied on distributions from portfolios managed for total return faced a difficult decision. Should they cut their spending in line with their portfolios’ negative returns or sell stocks at a loss to maintain distributions? A few advisers with whom I spoke at that time had clients set up HECM lines of credit as an alternative solution. Instead of selling into a bear market, clients tapped their lines of credit (which didn’t require immediate repayment) and kept their portfolios intact. This approach paid off after the market rebounded. The costs incurred with the line of credit were relatively modest in comparison to the losses clients would have incurred by selling, and clients used subsequent capital gains to pay off their lines of credit.
Research into reverse mortgages’ potential applications accelerated in 2012. That year, the Denver-based Financial Planning Association’s Journal of Financial Planningbegan to publish what became a series of articles arguing that reverse mortgages could enhance retirees’ finances. Wade Pfau, CFA, professor of retirement income at the American College of Financial Services in Bryn Mawr, Pennsylvania, published multiple articles on this theme, and in 2016, he wrote Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (Retirement Researcher Media).
Pfau identified multiple potential uses for HECMs. One is to pay off an existing mortgage or to purchase a new home. The second, which is where most research has focused, is to coordinate the reverse mortgage and investment portfolio to help manage sequence-of-returns risk. Another category is what Pfau calls “retirement efficiency improvements.” These actions require current payment for long-term benefits, such as delaying Social Security retirement benefits or paying the income taxes due from a Roth IRA conversion.
The final use is a longer-term strategy in which the borrower opens an HECM line of credit but doesn’t use it immediately. Maximum loan values on HECM lines of credit are tied to a formula that generates annual increases in the loan limit, regardless of the home’s market value. As a result, borrowers who set up their lines of credit at age 62 will be able to access more of their home equity at, say, age 75 than those who establish the credit line at age 75 on a similarly valued home. Those increases can provide additional funds for major later-life expenses, such as long-term care.
An HECM line of credit isn’t correlated with the home’s market value, says Jamie Hopkins, professor of retirement income at the American College. Unlike a traditional HELOC, where the credit amount is based on the house’s value at any given time, a reverse mortgage line of credit continues to grow, even if the home’s value falls below the line of credit’s maximum borrowing limit. Although it’s not the program’s intent, this structure creates downside protection for the homeowner. “Setting up a line of credit that’s not related to the housing value anymore, once it’s set up, really creates a new asset,” says Hopkins. “It’s like reallocating your assets between a line of credit and your house so you can better utilize those assets in a comprehensive planning portfolio and draw from that when it’s most impactful for the retiree, typically when markets are down.”
HECM lines of credit likely became less attractive, at least marginally, after 2 October 2017. On that date, Housing and Urban Development (HUD) raised the upfront premiums for HECMs to 2% of the home’s value (most borrowers paid 0.5% upfront before the change), although the annual fee on outstanding loan balances will drop from 1.25% to 0.5%. These changes will reduce the maximum loan amounts and slow growth rates for lines of credit maximum limits. Hopkins and Pfau believe the number of new HECM line of credit applications will fall, although they caution that they have just started analyzing the changes’ impact.
The research has increased advisers’ willingness to consider reverse mortgages, but there are still hurdles, says Hopkins. Some financial services firms prohibit affiliated advisers from discussing HECMs and their potential uses. The advisory business model’s emphasis on investable assets is another stumbling block. An adviser might agree that home equity is an important asset, but most advisers “don’t think about the home as part of the client’s asset pool and don’t think about the ways to effectively utilize that reverse mortgage, standby line of credit, downsizing, or the like,” says Hopkins. Still, HECMs’ complexity warrants the adviser’s analysis, he adds: “If we say it’s a complicated product with fees and somebody’s borrowing and there’s risk, of course I want the financial advisor involved.”
Christopher Cordaro, CFA, with RegentAtlantic in Morristown, New Jersey, has discussed reverse mortgages with many clients, although only a few have applied for HECMs. But the conversation about potentially using home equity helps clients see how that equity could play a role in their retirement income plans. Once they understand that potential benefit, the next step is to determine how to best access home equity if it’s needed. The resulting analysis often leads to other products, such as traditional HELOCs, says Cordaro.
Marguerita Cheng, with Blue Ocean Global Wealth in Gaithersburg, Maryland, notes that most retirees want to age in place, but that doesn’t mean their current home is ideal for an aging resident. In those instances when the client might have to move in the near term, HECMs don’t make sense. In cases where the client is likely to remain in the home for the foreseeable future, a reverse mortgage can meet the client’s needs. Cheng cites her work with a widow who received Social Security and a pension benefit from her late husband. The client owned long-term care insurance, and her suburban Washington, DC, home had a senior-friendly rambler (ranch house) design that was worth roughly $400,000.
The client had opened a traditional HELOC for $75,000 and was carrying a $35,000 balance, but she wanted to do additional home improvements. Cheng recommended she replace the traditional line of credit with an HECM. The change eliminated the monthly payment and “gave her tremendous peace of mind,” says Cheng.
Pfau gives numerous presentations on HECMs, and in his experience, when advisers learn about reverse mortgages and see how a growing line of credit can work, they become much more receptive to the idea. Although the percentage of advisers working with the products is still low, he is optimistic that their interest in and their clients’ use of HECMs will grow.
About the Author
Ed McCarthy is a freelance financial writer in Pascoag, Rhode Island.