Reverse Mortgage

Reverse Mortgage
The following should be considered only an introduction to reverse mortgages. I have no personal experience with them, but if after reading this you still think that you want to explore this further, then you should get independent professional help to explore applicability to your specific circumstances and alternates to reverse mortgages.
What is it?
A “reverse mortgage” is driven by your desire to stay in your home, yet allows you to tap into some of its accumulated value. It is a loan secured by your home that you do not have to pay back so long as you live in that home. When the last of you or your spouse dies or no longer can or want to continue to live in the home, then loan and accrued interest become repayable. Neither you nor your estate will ever owe more than the value of the home. By the time you die ,or have to move from your home, it may have zero residual value to the estate if accrued loan value exceeds the value of the home . There are some low probability scenarios which could help make a reverse mortgage an acceptable financial, not just emotional decision if: (1) the house value grows faster than the accrued loan value so the residual asset value does not diminish every year, (2) if one ends up living in the house much (much) longer than expected given the ages of the couple who own the home, (3) if the property values drop so precipitously after engaging in the reverse mortgage. I would not count on any of these low probability outcomes to justify your decision.
How does it work?
To be eligible in the U.S., the only requirement is that the home owners must be 62 years or older. There are no credit hurdles that you must jump over. Essentially you can get a single cash payment or a series of monthly payments or a (growing) credit line for as long as you live in the home. Typically loans would be available for up to 40-70% of the value of the house. Dependent on prevailing interest rates and home values, 65, 75 and 85 year old couples may be eligible for loans up to 50%, 60% and 75% of the value of the home, respectively.
If you have no outstanding mortgage against it; the AARP estimates total upfront cost of about 10% of the value of the home, though a reverse mortgage broker suggested that 5-6% is more typical in his experience. In Canada you must be 60 and the available loans are a lower range of 10-45% of the value of the house with the higher percentages being for people in their late 80s.
The actual amount available will be a function of the owners’ ages, prevailing interest rates, current appraised value and location of the home. If there is still an outstanding mortgage on the home, you can get the equivalent of the residual after the remaining mortgage has been first paid off and up-front costs to set up the reverse mortgage are paid. The cash received is tax free as you are getting back your own assets built up in the house. The ‘only’ ongoing costs borne by the homeowner (beside the reverse mortgage costs) are property taxes, insurance and maintenance of the home.
What are costs and borrowing rates? Variable or fixed rates?
For U.S. based persons, typically there are upfront costs (see AARP’s summary) associated with a reverse mortgage. For a HECM (Home equity Conversion Mortgage) reverse mortgage these include: origination fee (2% of home’s value), legal/inspection/title/other-closing costs ($2,000-3,000), mortgage insurance premium (2% of home value up front plus a 0.5% ongoing extra interest charge), and servicing fee (for the life of the loan paid up front). The previously referenced AARP website estimates the total upfront costs for a $250,000 home to be $25,000, while for higher valued homes in higher cost areas could exceed $50,000! The rates are variable, though they could be fixed in case of a lump sum extraction. For HECM they are quoted at some margin (a major bank I called quoted 1.0% and 2.6% for the monthly and yearly adjusting rates) over some benchmark (the one-year Treasury rate). There are additional considerations, associated with monthly or yearly adjustable rate decision, relating to caps on the rates for the loan.
With the current (January 20- 30, 2008) interest rates being low and expected to drop, one reverse mortgage broker quoted rates in the range of 3.81-4.59% for the monthly and annual adjusting cases and 5.7-5.8% for the fixed rate (I could not determine if this was for the life of the loan or some fixed term). Another mortgage broker quoted 6.5-7.0% fixed rate for the life of the loan. You have to add the 0.5% ongoing mortgage insurance premiums to these rates. There are maximum loan values set for the federally insured mortgages, but there is the option to explore non-insured alternatives which could provide higher loan values for more expensive houses, at higher loan rates. When I called a major bank, I was told that they did not offer fixed rate reverse mortgages.
For Canadians there are similar up front set-up costs like appraisal, legal and closing , but these were quoted at about $2500, which is much lower rate than the U.S. The lower Canadian upfront costs are likely due to lower initiation, legal and appraisal fees. The costs are also lower since there is no mortgage insurance component, which would partly explain the higher interest rates in Canada. The interest rates from two currently available lenders were: (1) in the 8.5-9% range for variable and 6 month to 5 year fixed rates from CHIP and (2) 7.5% (prime plus a max of 2%) variable from Seniors Money quoted at their websites. The available rates can be expected to change with prevailing interest rates. At the CHIP website for an $80,000 loan example, depending on the term of the loan the resulting interest rate ended up at about 10.5%, when adjusted for closing costs. It is very likely that many who have good credit rating could borrow at a lower rate by other means, but with a reverse mortgage you have an option to stay in the house until death (or as long as you are able to) without having to make any payments. However, there may not be much or any capital left in the house for the estate. You will note that the Canadian reverse mortgage ‘deal’, as usual, is much less favorable than that in the U.S. because of the offered rates, percent of home value available to borrow and payout options. Options in Canada in how you can access the loan are also somewhat restricted. You can access the loan in a lump sum or in stages as you need it or arrange for a monthly payout until you hit the max loan value. Unlike in the U.S., there are no (increasing) credit line options or monthly payment as long as you live in your home options as with HECM reverse mortgages.
Why people resort to reverse mortgages?
People take reverse mortgages because they absolutely want to stay in their home but need/want extra income for basic living expenses, one-time cash for travel, pay off credit card or credit line debts, renovation, to pay-off the existing mortgage on the house (and thus reduce monthly expenses) and/or prevent loss of their home because they can’t pay their mortgage.
Why people don’t take reverse mortgages?
People don’t take reverse mortgages because they tend to be costly in terms of upfront costs and interest rates. Also if relatively young retirees facing a long retirement (remember that there is a 45% probability that one of a 65 year old couple will live past 90) tap their house assets by means of a reverse mortgage, they likely lose the ability to have that asset in reserve should a later (health or financial) emergency occur. Of course, unlike a regular mortgage, the outstanding loan grows continuously while you are accumulating interest not only on the original loan but also on the compounded interest.
Alternatives to reverse mortgages?
Before entering into a reverse mortgage arrangement, one should consider other options for resolving the funding shortfall and in all cases get independent professional advice. Some of the options for consideration are: -Delaying the reverse mortgage, thus preserving a larger residual (home minus accrued loan) value. -Sell house and move to a less expensive one or rent -Rent out the basement or just a room in your house -Take a regular mortgage or home equity loan -Take a part-time job
So is it good for you?
Well, it is not obvious. If reverse mortgages do make sense in some situations, the current apparently relatively low U.S. loan rates would certainly facilitate their justification. But even in the U.S. I would recommend that you engage independent professional advice before signing on the dotted line. But here is a thought and a back of the envelope calculation for the U.S. scenario in the current low interest rate environment. Say that long-term house values and inflation increase at 3%/year. Also assume that you can lock in a reverse mortgage at a fixed rate of around 6%. Then according the AARP calculator a 62 year old couple who own a $360,000 house would receive about a $200,000 loan. They could stay in their house and from a properly constructed portfolio, draw about an inflation adjusted 4% per year (see Withdrawal Strategies https://retirementaction.com/Retired.aspx ) or an annual $8,000 increasing with inflation. At the 4% withdrawal level there is a very low probability of exhausting the portfolio and still have a reasonable expectation to preserve about 75%+ of the inflation adjusted $200,000 for the estate. By the way, after about 20 years of 6% interest on the $200,000, the outstanding loan will have grown to about $640,000; at the same time if the house value will have increased at the assumed 3% per year it’s $360,000 initial value will have increased to about the same value $650,000. Therefore the residual value of the house will be zero, but you can continue living in it without additional payments. Considering that after 20 years the couple will be only 82, there is a good chance that at least one of them will live another 8-10 years. The $8,000 should help defray the property taxes, insurance and maintenance costs associated with the home. Another interesting approach would be to use Vanguard’s recently announced and soon to be available Managed Payout Funds (e.g. “Managed Payout Moderate Growth Fund–structured for investors who want to balance their initial payout stream with maintaining the purchasing power of their future payouts and capital. This fund is expected to sustain a managed distribution policy with a 5% annual distribution rate.”)
However, if you take a couple of 62 year old Canadians with a home valued at $300,000, they can probably get a loan of only about 25% or $75,000 maximum. (A 4% withdrawal rate from $75,00 would only yield $3,000 per year.) They would continue to be responsible for the taxes, insurance and maintenance of the house which would no doubt require about $4,000-5,000 annually even if the original mortgage was retired. In the meantime, the couple would be paying about 10% interest on the loan which, if it stays constant, would transform the $75,000 loan into $150,000,$300,000, $600,000 and $1,200,000 after about 7.5, 15, 22.5 and 30 years, respectively. Long-term home values tend to increase about in line with inflation, so say 3% per year. Then after about 22.5 years their home’s value would have doubled to $600,000, but they’ll still end up with zero residual value in the home, since outstanding loan would also be $600,000. By then the carrying costs of the home would likely have doubled as well, so if they needed the funds generated by the reverse mortgage to carry the home initially, they would likely have difficulty to carry the growing load. An older couple would likely get a little more than 25%, but 40% appears to be the indicated maximum available. The punishing Canadian interest rates (apparently 8-10% range) on top of the upfront costs would certainly be a hard sell to me; but then there are lots of people who seem to be routinely paying 20%+ on their credit cards, which I also think is not a very advisable long-term plan.
Alternatively, if they sold their $300,000 home, the 62 year old Canadians could safely extract an inflation adjusted 4% or $12,000 a year (presumably at minimal tax impact for an otherwise low income couple) with a high probability of not running out of money, and reasonable expectation that they’ll still have their (inflation adjusted) capital (for the estate) when they die. They could then rent a smaller/cheaper (say valued at about $200,000) home or apartment for about $10,000 per year (or 5% of the home’s value) and still have about $2,000 inflation adjusted annual incremental income, while having a reasonable chance of preserving much of the original capital.
Summary
While on the surface a reverse mortgage sounds attractive (live in your house as long as you can stay in it), it is really for somebody who values staying in their home without regard of the impact of that decision on one’s estate. You should certainly not choose a reverse mortgage without professional advice and exploration of other potentially more advantageous options!
Many an advisor has indicated that after exploring other available options, they never had to resort to a reverse mortgage. But, who knows, as with annuities there may be very unique circumstances when this will still be the only viable option. A good conclusion of the above analysis is to quote Canadian financial planner Alan Hoffman that “It costs you 2.5 times the value of your home to buy it from the bank when you use a mortgage, and in a reverse mortgage the bank buys it back from you for 10 to 40 per cent” of its value.” That sums it up pretty well.
U.S. links:
Canadian links:
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