IF YOU’RE LIKE MANY people, you’ll cringe when I mention reverse mortgages. The perception is that they’re loans of last resort for desperate retirees who don’t have any other options. But I suggest keeping an open mind. I believe reverse mortgages can be a shrewd way to unlock liquidity during retirement.
Reverse mortgages have evolved significantly, and retirees are often pleasantly surprised when they learn how today’s loans work. They find that many of the negatives they’ve heard are no longer true. Full disclosure: I run a website devoted to reverse mortgages, so I’m not a disinterested observer.
According to U.S. Census Bureau data from 2019, households headed by 65-year-olds have an average net worth of $268,700. Almost 68% of that is tied up in home equity. The problem, of course, is that home equity is illiquid.
Consider a retiree living paycheck-to-paycheck in San Francisco who owns a $1 million home outright. He’s technically a millionaire, and yet he can barely afford the utility bill. In the past, there were two ways for our retiree to convert his home equity into cash: sell the home or do a “cash out” refinancing. The first option doesn’t work if the goal is to stay in the home. The second option offers more flexibility but requires a new monthly payment.
Don’t like the sound of either option? This is where the reverse mortgage comes in. The most popular reverse mortgage is the Federal Housing Administration-insured home equity conversion mortgage, or HECM (often pronounced hec-m). If you’re age 62 or older, a HECM allows you to convert a portion of your home’s value into cash without making an ongoing monthly mortgage payment. The main stipulations are that you live in and maintain your home, and that you pay your property taxes and homeowner’s insurance.
The HECM program has some additional attractive features. You remain the owner of your home and you can leave it to your heirs. If your heirs want to keep the house, they’ll need to repay the loan balance after your death. If they don’t want the place, they can either sell it or let the lender do so. Because the HECM is a nonrecourse loan, the Federal Housing Administration will cover any shortfall if the home is worth less than the amount owed at the time of repayment.
HECM proceeds have no impact on income taxes owed, Medicare or Social Security benefits. A HECM is also versatile. You can take the proceeds as a lump sum, line of credit or monthly income. In my opinion, the line of credit is where the HECM really shines.
A HECM line of credit is similar to a standard home equity line of credit but with fewer risks. Home equity lines of credit can be risky for retirees because they’re usually interest-only and have variable rates. When the initial interest-only period is over, the borrower must begin repaying principal as well, usually over a relatively short loan term. This can mean significantly higher payments.
The HECM line of credit doesn’t require monthly payments. Your credit line is secure as long as you remain in good standing by living in the home, and paying the property taxes and homeowner’s insurance. The best part, however, is that your available credit line is guaranteed to grow over time, which unlocks more home equity.
The strategy I suggest is to set up the line of credit early in retirement and leave it untouched for as long as possible. This works best for retirees who are financially stable, owe little or nothing on their homes, and don’t need immediate cash. This is not a strategy for the broke and desperate.
To see how this works, let’s assume a retiree named Walter is age 62 and has a $450,000 home with no mortgage. Let’s also assume Walter qualifies for total proceeds of $190,000 from a HECM.
Closing costs can vary widely. But they might run $15,000 to cover the upfront Federal Housing Administration mortgage insurance premium, as well as any origination and third-party fees charged by the lender. Closing costs are typically paid out of the proceeds, so the starting loan balance would be $15,000.
Ongoing costs include the interest charged on the balance and the 0.5% mortgage insurance premium levied by the Federal Housing Administration. If no payments are made by the homeowner—which is the point of a reverse mortgage—the interest and insurance premiums get added to the loan balance. Let’s assume the interest and insurance total 5% of the balance.
Once the closing costs are paid, Walter is left with a line of credit that starts at $175,000. The growth rate of the credit line is equal to the interest rate plus insurance, so it, too, would be 5%. The interest and growth rate can change over time, but—for simplicity’s sake—we’ll assume they stay the same.
Result? Walter’s line of credit would grow to $183,953 if he leaves it untouched for a year. That’s an increase of almost $9,000. Meanwhile, his loan balance would grow to around $15,636, thanks to accrued interest and insurance premiums.
Meanwhile, the line of credit would balloon to $224,588 if he leaves it untouched for five years—an increase of almost $50,000. Over that period, the loan balance would grow to about $19,170.
After a decade, Walter’s line of credit would be $288,227 and his loan balance $24,602. That means that Walter would have $288,227 of tax-free cash available for home maintenance, travel or long-term-care expenses. The HECM line of credit essentially turns a portion of Walter’s home equity into a liquid and growing retirement asset.
My own reverse mortgage strategy is pretty simple: I intend to do what Walter did. I plan to pay off my home by my early 60s, set up a HECM line of credit and let it grow for as long as possible.
Mike Roberts is a reverse mortgage industry veteran and the founder of MyHECM.com, a leading online resource about HECM reverse mortgages. If you’d like to find out how much you can get from a reverse mortgage, check out his site’s free calculator.
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While reverse mortgages can be great for some retirees (I recommend that one of my sisters go this route), I think this article minimizes their downsides. Most significantly, the closing costs are 7.9% of the $190,000 that Walter qualifies for.
Perhaps I’m missing something, but I’m also not sure why someone would want to take out a reverse mortgage and then leave the balance untouched for 10 years. I’ve always assumed that a reverse mortgage was for those who need to start using their HECM funds shortly after taking out a reverse mortgage. Furthermore, while the line of credit in the example does grow signficantly, the increase in the amount of equity in Walter’s home over 10 years could well make it possible for him to qualify for a larger line of credit without needing to tie his money up in a reverse mortgage.
I’m one of those people who has always thought reverse mortgages were bad. Thanks for clarifying.
Thanks for the article. Some time ago I read about the HECM, specifically the line of credit option that you emphasize, as a good tool to have in your retirement tool belt.
The way I’d envision using it… if my portfolio was down by a certain percentage, I might look to withdraw cash reserves OR tap this line of credit until my portfolio recovered to a certain level. That is why many choose to hold years of cash, so they do not have to sell depressed assets. But I would think that having an HECM line of credit would mean you could hold less cash, generating more total return for your portfolio throughout retirement.
As owners of a large lake-front property with a small house we are well aware that it does not fit the Fannie Mae and Freddie Mac guidelines for a “conforming” mortgage because of the appraised-value to land-value ratio. This has stymied both home equity loans as well as HELOC applications. We assume that this would also be an issue for a HECM, correct?
Yes, that can sometimes be an issue with the HECM because it’s an FHA-insured product. However, there are other proprietary reverse mortgages out there as well. Because proprietary reverse mortgages are issued and backed by private banks, they often have more flexible lending guidelines. I would check with a few different lenders and see if a proprietary reverse mortgage would work for you. Thanks for reading!
Can you explain how a retiree might use a reverse mortgage as a method to bridge between retirement and claiming social security? Thanks
Hi Rick, yes, that’s a great strategy. If you delay taking Social Security, you can get a larger payout once you start taking it. A reverse mortgage can help fill the income gap in the meantime. If you have an existing mortgage payment, a reverse mortgage can get rid of it. Removing a big monthly expense is the same as adding a paycheck because it improves your monthly cash flow. If you don’t have a mortgage payment, you can set up a reverse mortgage monthly “term” income plan for a set dollar amount and/or time period. A term plan works like an annuity, but the “investment” is your home’s equity. Once Social Security kicks in, you can stop the reverse mortgage term payments and convert the remaining proceeds to a line of credit, which I talked about in this article. Thanks for reading!
Thanks for this article. I’ve been learning about reverse mortgages recently as I think they could be a useful financial resource.
It seems like reverse mortgages and annuities suffer from the same affliction: both seem to be instantly dismissed by many people. I like to think every financial ‘tool’ has both good, and bad, points and each may or may not be useful at different times in life.
But by having access to multiple tools, it seems like one can have much more flexibility as they plan, and negotiate, their financial future.
I agree, Kristine. My observation is that many tools have originated by solving a financial challenge effectively (such as annuities and HECMs to solve income challenges in retirement), and it’s when they’re mis-used and mis-sold by salespeople that their reputations are tarnished.
Hi Kristine, I couldn’t agree more. I know somebody who is retired and has both a reverse mortgage and a few annuities. Having multiple sources of cash flow has worked out really great for them.
I’m always wary of people who say a certain financial tool is always good or always bad. Every financial tool can be both good and bad depending on how it’s used.
Thanks for reading!