In challenging times, federally insured home equity conversion mortgages offer an outside-the-box income option for those 62 and older.
By CHARLES RAWL, CFP®, RICP® | Charles W. Rawl & Associates
Generating retirement income has rarely been as challenging as it is right now, thanks to a combination of market volatility in the midst of the coronavirus, low interest rates, disappearing pensions and an uncertain future for Social Security.
This is no time to be stuck in “conventional wisdom” paradigms.
For example, despite the popularity of 401(k)s and IRAs, it can be risky to save almost exclusively in tax-deferred retirement accounts. The strategy of putting off paying taxes as long as possible, which seems so appealing in one’s working years, can result in a significant tax burden for retirees, or for the beneficiaries who inherit those accounts.
On the other hand, tools that may have developed a bad reputation in the past, such as reverse mortgages, may deserve a second look. While their history of misuse is well documented, the industry has repositioned itself so that today’s reverse mortgages might be considered an important and sophisticated financial tool for some. The intelligent use of a reverse mortgage, particularly a federally insured home equity conversion mortgage (HECM) line of credit, could extend an individual’s or couple’s retirement resources in a way that more traditional strategies cannot.
What is a Home Equity Conversion Mortgage?
An HECM is a way for homeowners 62 and older to turn a portion of their home’s equity into tax-free cash. Borrowers can eliminate their monthly mortgage payments while also gaining access to any additional eligible equity.
Unlike a traditional home mortgage or home equity line of credit, paying off this type of loan while you’re alive is optional, but borrowers must continue paying property taxes, along with maintenance, mortgage insurance premiums and homeowner’s insurance.
The proceeds from a reverse mortgage can be used to pay for unexpected costs in retirement, including the kinds of long-term health care expenses that can cripple a financial plan. But strategic use of an HECM can help with other retirement outcomes, as well.
Using an HECM as a Tool to Help Preserve Residual Net Worth
If you’re nearing retirement, hopefully your financial adviser has spoken to you about “sequence of returns risk.” It was already a legitimate concern before the coronavirus pandemic and recent market volatility. Now, it is even more important. When the market experiences a downturn early in your retirement, when you’re no longer contributing to your retirement accounts and you’ve begun to take withdrawals, it can be tough to recover from a major loss. An HECM line of credit can be used as a buffer to help protect against adverse portfolio returns, because retirees can carefully coordinate distributions from their portfolio and their HECM line of credit based on their needs and current market conditions.
According to research by Barry and Stephen Sacks published in the Journal of Financial Planning, using home equity to supplement retirement income can have a dramatic impact on a retiree’s residual net worth (defined as the value of the retiree’s portfolio plus the equity in his or her home at the end of a designated period of time). Their research suggested that investors who use an active strategy with an HECM line of credit during stock market down years could be up to twice as likely to have a higher residual net worth after 30 years.
Using an HECM to Pay for Unexpected Expenses
The use of a tax-free HECM line of credit for unexpected (or even planned) purchases or shortfalls in cash flow can be extremely beneficial in retirement — and not just because it can provide much-needed funds. An HECM also can protect against the raiding of other retirement resources when those costs come up.
Another bonus: An HECM line of credit has a clear-cut advantage over the use of a traditional credit line in that it has a guaranteed growth option (the growth applies to unused funds) and a “non-recourse” feature. Unlike traditional home equity loans or lines of credit, an HECM line of credit can never be prematurely closed and collected.
The costs associated with the HECM include mortgage insurance premiums, an origination fee, servicing fees and third-party charges for items such as appraisals, title checks, and more. In many cases, these fees can be deducted from the proceeds of the HECM loan, reducing the amount of cash available to you. While the cost of setting up an HECM line of credit can be somewhat higher than more traditional tools, for some people the advantages can outweigh the costs. That’s because unused funds are guaranteed to grow regardless of fluctuations in the economy, mortgage interest rates, or the appreciation/depreciation in an investor’s home value. The earlier homeowners set up an HECM line of credit, the more growth they can expect. Depending on local real estate market appreciation rates, it’s possible for that growth to outpace the value of the home.
Who is Eligible for an HECM?
- HECM borrowers must be 62 years old or older;
- They must either own their home outright or have significant equity, and the home must be their primary residence (they must live there six-plus months per year);
- Borrowers must meet minimal credit and property requirements;
- They must receive reverse mortgage counseling from a HUD-approved counseling agency;
- They must not be delinquent on any federal debt; and
- The property must be a single-family home, a two- to four-unit dwelling or an FHA-approved condo.
What are Some Risks of an HECM?
Probably the most talked about (and misunderstood) aspect of HECMs is the possibility that the homeowners’ heirs may not receive the full value of the home. I’m always dumbfounded when grown children — who often helped set up their parents’ HECM in the first place — seem surprised when this happens. When the borrower dies, the home is sold and the proceeds are used to repay the loan, so it’s important that you consider your legacy wishes when deciding if an HECM is right for you.
Anyone considering an HECM should be fully informed regarding this major decision. Investors who wish to transfer their home as an inheritance may certainly do so. According to National Reverse Mortgage Director of Fairway Mortgage Harlan Accola, in his experience, few heirs indicate they want their loved one’s home transferred to them in an estate. More importantly, those who use their home equity responsibly as an active part of their retirement strategy may be able to leave their children a more valuable inheritance.
An HECM certainly isn’t for everyone. However, for some it might be a mistake to overlook this strategy based on misinformation. There are a number of safeguards in place for FHA loans, including FHA insurance and limits on the fees that can be charged.
If an HECM sounds like it might be a fit for your needs and goals, talk to a financial adviser who understands the pros and cons of responsibly using home equity in retirement. Then, if you decide it makes sense for you, enlist the assistance of a properly licensed mortgage lender who specializes in reverse mortgages.