House Value

Reverse Mortgages: What You Need to Know

House Value

There has been a sharp rise in the reverse mortgage market in the last decade within the United States. According to the National Reverse Mortgage Lenders Association (NRMLA), the annual number of reverse mortgage loans issued has grown from 157 in 1990 to over 58,000 in 2015. Commercials featuring Henry Winkler (aka The Fonz) and Fred Thompson have invaded our televisions, giving their endorsement for this particular financial product. While there may be numerous reasons for this growth, general intuition can tell us that most of those in retirement are having a very tough time making their personal savings last. So let’s start with the WHAT.

A reverse mortgage, more formally known as Home Equity Conversion Mortgage (HECM), is a loan made to homeowners 62 or older that essentially converts the equity that the homeowners have in their home to a cash flow back to the homeowners for them to use at their discretion. In a regular mortgage, homeowners will borrow money from a bank and pay a monthly payment of principal plus interest. In a reverse mortgage, the bank pays a monthly cash flow to the homeowner while the principal balance (home equity) grows at a certain interest rate. It is important to note that homeowners are still responsible for paying property taxes and homeowners insurance. The loan comes due in the event that the homeowner dies, sells the house, or does not pay the homeowners insurance or property taxes. The heirs to the homeowners’ estate can then sell the property to cover the loan or keep the house and payoff the loan with other assets or have the lender take ownership of the home.

The variables that go into determining the loan amount available to a homeowner includes the age of the youngest borrower on the loan (possibly a younger spouse), the appraised value of the home, and current interest rates. The maximum claim allowed by the FHA is $625,500, so value of homes with an appraised value over $625,500 will not be considered when looking to issue a reverse mortgage. Lower interest rates benefit homeowners looking for a loan amount. Lastly, the older the youngest borrower is, the larger the payout, all else equal. For those who are curious about potential payout options, online calculators are available.

It is important to note that there are both fixed and variable rate reverse mortgages. A fixed rate allows a homeowner to receive a lump sum payment of cash up front. A variable rate loan allows the homeowner to receive a lump sum, multiple payments, a line of credit, or a combination of the three. As of December 2015, the average interest rate for a fixed rate reverse mortgage in the US was 4.92% and the average variable rate loan was 3.40%. There is an additional 1.25% mortgage insurance premium added on top of each interest rate.

Let’s give an illustration.

Let’s say we have a 70-year old homeowner that would like to have flexibility in her payouts. She would then choose the variable rate loan. Let’s say that the total interest rate (index margin insurance premium) is 5%. Based on the home appraisal of $600,000 the approximate total principal to borrow from would be $345,600. The initial loan amount would be $105,000 ($100,000 outstanding mortgage balance $5,000 in fees and closing costs), which gives the borrower a total of $240,600 of credit to take at her discretion. The loan balance and the credit line will both grow at the 5% rate. For simplicity let’s assume she wants to receive monthly payouts and interest is compounded monthly. Let’s also assume that her home appreciates at an average rate of 4% per year. What would this look like over a 20-year time horizon?

This line of credit would give the homeowner an extra monthly cash flow of approximately $1,580. The value of her home would be approximately $1,550,638 in today’s dollars with an ending loan value of $931,498. This would give the heirs to her estate $619,140 after the outstanding loan is paid off. The chart below displays the values over time. The shaded area of the chart represents the equity the homeowner has over time, which depends on how her property appreciates over time compared to the stated 5% interest rate on her reverse mortgage.

This is just a simple illustration, which assumes interest rates stay flat over the entire 20 years, which is very unrealistic. What is more realistic is that the interest rate will fluctuate over the 20-year period. It also paints a very rosy picture of the benefits of a reverse mortgage. Realistically, anyone who utilizes a reverse mortgage is utilizing the equity in his or her home as an asset of last resort. If there is any residual equity left over to bequest to beneficiaries and after the balance of the reverse mortgage is paid, it should be seen as icing on the cake.

It is also important to point out the real inherent risks associated with reverse mortgages.

  • First, it is required that the homeowner maintains the property and pays all property taxes and homeowners insurance. These expenses need to be accounted for when putting together a personal budget. If the homeowner fails to keep up with required taxes, insurance premiums, or maintenance, then the loan is considered in default and the homeowner could lose their home and be displaced
  • Second, as we mentioned before, once the homeowner uses up the line of credit, there are no additional funds available. This is important from a planning perspective. Depending on how much money is available, in total, the homeowner should look to divide it up appropriately to smooth her consumption over time. Using the entire line of credit within the first 5 years doesn’t benefit the homeowner since she will still not have enough resources to live in retirement.

What if the value of the loan exceeds the value of the home at the time the loan comes due? It depends! If the reverse mortgage was issued by the FHA, then the lender can only use the value of the house to pay off the value of the loan. The remaining estate cannot be touched by the lender to cover the loan. Any loss incurred by the bank is covered by the FHA mortgage insurance fund. If the reverse mortgage is proprietary, which is less common, then the lender can go after remaining assets in the estate to cover the debt.

An important distinction that needs to be made is that those who are familiar with a traditional mortgage know that as their debt goes down, their equity goes up. The chart below displays the equity and debt over a typical 30-year period for a $500,000 home, assuming a 5% fixed rate compounded monthly. For simplicity, let’s also assume that the value of their home increases at 4% per year.

As you can see, as time passes, the debt is paid down while the equity to the homeowner increases. In a reverse mortgage, this isn’t necessarily true. The loan made to the homeowner continues to grow at its stated interest rate. Once a borrower has used up its line of credit, then there are no additional funds available, so a borrower needs to use the line of credit wisely. The loan will continue to grow until the homeowner either settles the debt by selling the property or passes away.

The Federal Housing Administration (FHA) federally regulates all reverse mortgages issued in the United States and potential borrowers must go through a counseling course in order to fully understand the ramifications of getting involved in a reverse mortgage. You can find out more details about the required counseling course here.

Reverse mortgages thus far have received mixed reviews from the likes of economists and policy makers. In theory, reverse mortgages are an excellent way for retirees to smooth their consumption in retirement, which speaks to the great benefit of converting home equity into a cash flow. For those homeowners who do not plan on keeping their home in their estate once they pass away, they can benefit substantially from this type of product. You can’t take your home with you to the grave, right?

The downfalls associated with reverse mortgages, which have been highly criticized by the Consumer Financial Protection Bureau, include costs and commissions, predatory lending practices, and less than stellar guidance from the mandated counseling course. While we would anticipate increased competition given the high level of growth and thus future decreases in costs, it would still be in consumer’s best interest to seek guidance from an independent third party about how a reverse mortgage would fit into their particular financial plan.

As more and more future retirees face the realization that they do not have adequate resources to live the life they want to live in retirement, there will be continued growth in the reverse mortgage marketplace. As independent advisors, it is our duty to educate the public about how these products work and when they are best utilized to do what they were originally intended to do.