Kevin Michels, CFP®, EA
As an undergraduate student studying Personal Financial Planning at UVU, my first course in the program was “Intro to the Personal Financial Planning Profession”. One of the first discussions we had in the class was centered around why we wanted to become financial advisors. For one reason or another I vividly remember the first comment that was made…
“I just found out my mom took out a Reverse Mortgage per her broker’s recommendation. I want to be able to keep people like my mom safe from dumb recommendations made by greedy salespeople!”
I knew a little bit about reverse mortgages at the time, most of which was from Dave Ramsey on how terrible of a product they were. That, in addition to my classmates’ comment, cemented in my mind the idea that Reverse Mortgages were terrible products only sold by commission-hungry salespeople (in addition to cash-value life insurance, annuity contracts, loaded mutual funds, etc.)
While many of these products are grossly expensive and over-sold to people who don’t actually need them, in some cases there are times when they can be useful, and such is the case with Reverse Mortgages.
Before we get into how they can be helpful for a retiree, let’s quickly summarize what a Reverse Mortgage is.
What is a Reverse Mortgage?
A Home Equity Conversion Mortgage (HECM or simply a Reverse Mortgage) is a type of loan available to people aged 62 or older and is used as a way to convert home equity into a lump-sum payment of cash or a series of cash payments. Since the equity in the home is taken out in cash, your equity decreases, and your debt increases over time. However, you always retain ownership of the home (as long as you pay your taxes, insurance, and maintain the home) even if the amount of your debt exceeds the value of your home.
Once you (and your spouse if you’re married) pass away, the outstanding debt becomes due. This can be paid off with outside funds or by simply selling the home. If, at that point, you are underwater in the home, the lender eats the loss. If any equity is left over its distributed to your heirs per your estate distribution plan.
When you take out a Reverse Mortgage there are three ways you can receive payments:
- A one-time lump sum.
- As a monthly annuity that pays for a guaranteed period of time.
- As a line of credit from which you can withdraw money on an as needed basis.
Keep in mind that like all loans, there are fees and interest associated with the loan. Generally, you will pay an origination fee, mortgage insurance premiums, and closing costs and interest is accumulated on the outstanding balance of the loan.
As an example, assume Bob and Mary Smith are 62 and decide they want to have the ability to tap the equity in their home to supplement their income in retirement. Based on a $500,000 home value, they take out a $200,000 line of credit. Anytime Bob and Mary need to access cash, they can draw on their line of credit. Each time they take a draw it increases their outstanding debt and accumulates interest based on their variable interest rate (about 5% based on today’s rates).
After 30 years Bob and Mary pass away having accumulated $150,000 of outstanding debt on their line, and their home is now worth $800,000. Their kids sell the home, pay off the debt and keep the remaining $650,000 of equity.
How Can It Be Helpful in Retirement Planning
Reverse Mortgages can be used to help supplement income in retirement in three general ways:
- Last Resort Option – For a variety of reasons, retirees can find themselves in a situation where they are spending their portfolio down quicker than they expected to. A Reverse Mortgage allows them to access extra cash after they’ve exhausted their financial portfolios to fund retirement expenses.
- Standby Funds – Having a line of credit can be useful in years when your investment portfolio experiences a downturn and you want to avoid locking in losses by taking withdrawals. This can be done by accessing your line of credit instead and allowing your portfolio some time to recover.
- First Resort Option – Some retirees who aren’t interested in leaving behind an estate will spend down the entire value of their reverse mortgage before they begin taking withdrawals from their investment portfolio. This allows their portfolio to grow over time and can even provide an opportunity to perform sizable Roth conversions early on in retirement while their income is low (since payments from a Reverse Mortgage are considered loan advances).
Risks and Downsides
Keep in mind, there are risks and downsides associated with taking out a Reverse Mortgage. Some of the more deceptive advertising will sell you on the following:
- You will never lose your home – You can, in fact, lose your home. If you don’t pay your taxes, HOA fees, or insurance premiums your home can be foreclosed on.
- Reverse Mortgages provide tax free income – The payment you receive from a Reverse Mortgage is not income, it’s a loan advance. Loan advances aren’t taxable because you are required to pay back the loan.
- No upfront costs – When you take out a Reverse Mortgage you will pay an origination fee, a mortgage insurance premium, and closing costs. These are commonly rolled into the loan instead of being paid out of pocket. In addition, interest will accumulate on your outstanding debt balance.
Reverse Mortgages have gotten a bad rap over the years thanks to pushy brokers and deceptive advertising. However, recent regulations have helped curb some of the improper uses and risks of Reverse Mortgages. Reverse Mortgages definitely aren’t for everyone, but completely eliminating them from consideration could limit your flexibility in designing a retirement income plan.
At Medicus Wealth Planning we are fee-only financial advisors, meaning we don't receive any compensation from third-parties, only directly from our clients. This article doesn't constitute an individual recommendation to take out a reverse mortgage. If we were to recommend a reverse mortgage for one of our clients (after going through the financial planning process), we would help the client find the best deal possible and we would not receive any compensation nor referral fee from any third-party.