November 29, 2016
If you watch much television then you have probably seen at least one commercial with a senior citizen celebrity encouraging you to consider a reverse mortgage. Reverse mortgages have been around since 1988 and now that the number of people entering retirement is rising quickly (almost 10,000 per day) many are considering this option as one of the tools available to fund their lifestyle.1
A reverse mortgage, or home equity conversion mortgage, is a loan that allows a home owner to access the equity in their home without the burden of making monthly loan payments. To qualify, a borrower needs to be at least 62 years old, live in the home as a primary residence and have enough equity to meet certain Federal Housing Administration (FHA) guidelines. A good rule of thumb is 50% equity.
Despite the rising popularity of reverse mortgages, there are still many misconceptions about this product. I often hear clients say, “Isn’t that the thing where you give your house to the bank?” or “Isn’t that for people who have run out of money?” Also, I have found that while a reverse mortgage can be a useful tool in a solid financial plan, clients often have reservation about establishing a mortgage against their currently paid-off house. Polaris Greystone and its team of wealth advisors can assist you in determining if a reverse mortgage is the best solution for you.
It’s Still Your House
One of the biggest misconceptions about a reverse mortgage is who owns the house. A reverse mortgage is no different from a traditional mortgage or a Home Equity Loan in this regard. You still own your home, and you still have all the same rights and responsibilities. You have the right to sell the home at any time. Any equity left after the reverse mortgage is satisfied belongs to you or your estate. You can make payments against the loan as well, with no penalties. But with a reverse mortgage making payments is optional.
When you establish a reverse mortgage, the lender, using FHA guidelines, will determine how much they are willing to lend against your home based on the homes fair market value, your age and interest rates at the time of application. They will place a lien against the property, just like a traditional mortgage or home equity loan to ensure that when the house is sold the reverse mortgage is paid off.
Not Just a Last Resort Anymore
In 2015, the FHA changed many of the rules associated with reverse mortgages. As a result, borrowers now have to qualify for a reverse mortgage on both an income (including investment account withdrawals) and credit history review basis. What this means is waiting to see if you will “need” to use the equity in your home during retirement isn’t really a viable option. If you are using retirement savings to make mortgage payments or even suspect that you could spend down a significant portion of your savings during retirement you may want to consider having a plan in place to use your home equity well in advance.
Recently, there have been numerous studies published within the financial planning community that determined that establishing a reverse mortgage earlier rather than later can be beneficial, even if you don’t use it for several years. In an article titled “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income” published in the Journal of Financial Planning, February 2012 edition, brothers Barry and Stephen Sacks show that establishing a reverse mortgage at the beginning of retirement and then either waiting to use it only if you need the resources, or using it strategically throughout retirement (in years when the markets are down) provide better outcomes than waiting to establishing the credit line.2
You Want Me to Have Debt?
It may seem strange to consider adding a new mortgage against your house after spending your entire career working to pay off your home, so you can be debt-free in retirement. When you take a step back and clinically look at the equity in your home as just another “bucket” of wealth (like your IRA, Roth, Annuity or Trust account), you can start to see certain advantages for your cash flow.
There are three ways to access the equity in your home through a reverse mortgage: lump-sum, systematic or occasional.
- The lump-sum option is most often used to pay off an existing mortgage so the home owner no longer has to make payments. This can be very beneficial for clients looking to put off starting Social Security or who would need to draw heavily on their retirement savings to fund their mortgage payment. By reducing the draw from an Individual Retirement Account (IRA) we can reduce a client’s taxable income and possibly reduce the amount of Social Security benefits subject to taxation as well.
- Systematic payments are used by clients that have enough equity to provide a regular cash advance from the equity in their home. This money is tax-free and it can reduce dependency on your retirement portfolio allowing for more growth from your investments and reducing taxable withdrawals from IRA accounts.
- Establishing a reverse mortgage and drawing on it occasionally allows you to be strategic when planning how to fund your retirement. You may be able to reduce your overall tax liability, limit withdrawals from your portfolio during difficult market periods, or just budget certain expenses to be specifically covered by the equity in the home, i.e. property tax, insurance payments or home improvements.
However, say you decide to use the reverse mortgage, it becomes a tax-free bucket of money you can draw from to fund your retirement. It provides you with cash flow options that allow you to manage taxes and other income sources. Consider this tool when combined with a withdrawal strategy like the one Polaris Greystone’s own Meridith Hutchens wrote about in our March 2016 educational piece titled “Income Distribution in Retirement” and you can see a whole new perspective on some powerful options for funding your retirement
Like a traditional mortgage, reverse mortgages are required to be paid back at some point. In this case it is at the time the house is sold or within 12 months (technically, it’s 6 months but you can apply for two 90 day extensions) from when the last borrower leaves the home.
Also, like traditional mortgages, reverse mortgages have closing costs. The fees associated with establishing a reverse mortgage are regulated by the FHA and fairly standard in the industry. Most of those costs can be rolled into your loan so the out of pocket costs are limited. You and your Polaris Greystone Wealth Advisor will want to weigh those costs against the benefits from tax savings and improved cash flow.
Since you do not have to make payments against the balance of the loan, the interest accrues each month, meaning over time your balance is going up. This may limit the amount of equity in the home at time of sale, depending on how much the home has appreciated in value and how long you had the reverse mortgage. Of course, the interest depends on whether the rates are fixed or adjustable. If the interest rates are adjustable then they can change, in which case the size of the interest rate change will result in a smaller or larger rate of increase in the balance due. One thing to note is that if there is a negative equity situation at the time of sale, neither you nor your estate are responsible for the balance beyond the sale price. This is a nonrecourse loan. So you need not worry about passing a debt along to your children.
Reverse mortgages can be a powerful tool in a solid financial plan, but like any financial product they come with certain costs and benefits. Your Wealth Advisor at Polaris Greystone can talk you through the basics, help you find a professional in the reverse mortgage industry and guide you to the best decision for your situation.
I welcome your questions or comments regarding any of the information above.
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