If, after considering other housing options, you have decided to remain in an eligible home (or move into one), you may want to consider a Home Equity Conversion Mortgage (HECM – commonly pronounced “heck-um”)—more commonly known as a “reverse mortgage”—as a source of retirement spending.
The vast majority of reverse mortgages in the United States are HECM reverse mortgages, which are regulated and insured through the federal government by the Department of Housing and Urban Development (HUD) and the Federal Housing Authority (FHA). Other options outside of the federal program pop up occasionally, like jumbo reverse mortgages for those seeking amounts that exceed federal limits.
The HECM program includes both fixed- and variable-rate loans, though fixed-rate loans only allow proceeds to be taken as an initial lump sum, with no subsequent access to a line of credit. We will not concern ourselves with fixed-rate or non-HECM loans here but focus only on variable-rate HECM options that allow for the line of credit. Two cases where a fixed-rate HECM might be a relevant consideration include when the strategy is to refinance a large existing mortgage or when using the HECM for Purchase program.
In the past, any discussion of reverse mortgages as a retirement-income tool typically focused on real or perceived negatives related to traditionally high costs and potentially inappropriate uses of funds. These conversations often included misguided ideas about the homeowner losing title to the home and hyperbole about the “American Dream” becoming the “American Nightmare.” Reverse mortgages have been portrayed as a desperate last resort.
However, developments of the past decade have made reverse mortgages harder to dismiss outright. Especially, since 2013, the federal government has been refining regulations for its HECM program in order to improve the sustainability of the underlying mortgage insurance fund, better protect eligible nonborrowing spouses, and ensure that borrowers have sufficient financial resources to continue paying their property taxes, homeowner’s insurance, and home-maintenance expenses.
The thrust of these changes has been to ensure that reverse mortgages are used responsibly as part of an overall retirement-income strategy rather than to fritter away assets.
On the academic side, several recent research articles have demonstrated how responsible use of a reverse mortgage can enhance an overall retirement-income plan. Importantly, this research incorporates realistic costs for reverse mortgages, both in relation to their initial up-front costs and the ongoing growth of any outstanding loan balance. Quantified benefits are understood to exist only after netting out the costs associated with reverse mortgages.
In short, well-handled reverse mortgages have suffered from the bad press surrounding irresponsible reverse mortgages for too long. Reverse mortgages give responsible retirees the option to create liquidity for an otherwise illiquid asset, which can, in turn, potentially support a more efficient retirement-income strategy (more spending and/or more legacy). Liquidity is created by allowing homeowners to borrow against the value of the home with the flexibility to defer repayment until they have permanently left the home.
The media has been picking up on these developments as of late, and coverage is improving. For instance, Pat Esswein wrote a long follow-up to an April 2016 column about reverse mortgages in the October 2017 issue of Kiplinger’s named, “Use Your Home to Get More Income.”
But the trend of positive coverage is still a new phenomenon, and with so much preexisting bias, it can be hard to view reverse mortgages objectively without a clear understanding of how the benefits exceed the costs. To understand their role, it is worth stepping back to clarify the retirement-income problems we seek to solve.
Retirees must support a series of expenses—overall lifestyle spending goals, unexpected contingencies, legacy goals—to enjoy a successful retirement. Suppose that retirees only have two assets—beyond Social Security and any pensions—to meet their spending obligations: an investment portfolio and home equity. The task is to link these assets to spending obligations efficiently while also mitigating retirement risks like longevity, market volatility, and spending surprises that can impact the plan.
The fundamental question is this: How can these two assets work to meet spending goals while simultaneously preserving remaining assets to cover contingencies and support a legacy? Spending from either asset today means less for future spending and legacy. For the portfolio, spending reduces the remaining asset balance and sacrifices subsequent growth on those investments. Likewise, spending a portion of home equity surrenders future legacy through the increase and subsequent growth of the loan balance. Both effects work in the same way, so the question is how to best coordinate the use of these two assets to meet the spending goal and still preserve as much legacy as possible.
When a household has an investment portfolio and home equity, the “default” strategy tends to value spending down investment assets first and preserving home equity as long as possible, with the goal of supporting a legacy through a debt-free home. A reverse mortgage is viewed as an option, but it’s only a last resort once the investment portfolio has been depleted and vital spending needs are threatened.
The research of the last few years has generally found this conventional wisdom constraining and counterproductive. Initiating the reverse mortgage earlier and coordinating spending from home equity throughout retirement can help meet spending goals while also providing a larger legacy. That is the nature of retirement-income efficiency: using assets in a way that allows for more spending and/or more legacy.
Legacy wealth is the combined value of any remaining financial assets plus any remaining home equity after repaying the reverse-mortgage loan balance. Money is fungible, and the specific ratio of financial assets and remaining home equity is not important. In the final analysis, only the sum of these two components matters.
For heirs wishing to keep the home, a larger legacy offers an extra bonus of additional financial assets after the loan balance has been repaid. The home is not lost.
While taking money from the reverse mortgage reduces the home-equity component, it does not necessarily reduce the overall net worth or legacy value of assets. Wanting to specifically preserve the home may be a psychological constraint, which leads to a less efficient retirement. As Tom Davison of ToolsforRetirementPlanning.com has described the matter to me in our discussions, a reverse mortgage allows a retiree to gift the value of the house rather than the house itself. Should the heir wish to keep the house, the value of the house received as an inheritance can be redeployed for this purpose.
For more information on Reverse Mortgages, read our Reverse Mortgages 101 cheatsheet.
I’m a Professor of Retirement Income, Retirement Income Certified Professional (RICP®) Program Director, and Co-director of the Retirement Income Center at The American Collage of Financial Studies
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