You see a verdant green forest and a well-groomed dirt path. A moment later, the Magnum PI, Tom Selleck, appears and begins to tell you about how this isn’t his first rodeo and he wouldn’t be talking to you about reverse mortgages if he thought they were a scheme to rip you off or take your home away from you. You might be a bit taken aback. Isn’t this guy usually putting away bad guys on TV? What’s all this about a reverse mortgage and why is the starting right off the bat with an attempt to reassure you that reverse mortgages aren’t a scam? Well, the answer is that reverse mortgages are a complex product that have gotten a lot of bad press over the last few decades. Yet, in contrast to what the news has had to say about them, but academic coverage for reverse mortgages is quite complimentary, with multiple papers in the past few years touting their benefits as a means of funding retirement or assisting in preserving retirement assets. So what’s the big deal? This week, we’re talking about reverse mortgages, their rough history, the academic arguments for them, how they work, and why they should or shouldn’t be part of your retirement plan.
What is a Reverse Mortgage?
A reverse mortgage is essentially what it sounds like: a mortgage that pays you, rather than you paying it. Yet, despite this seeming contradiction, reverse mortgages essentially come in two flavors. These are loans granted by financial institutions based on the value of your home when you’re in retirement and can either guarantee a stream of income so long as you live in the home and there’s equity or provide a line of credit that doesn’t have to be repaid while you live in the home. We’ll call these the “annuity option” and the “credit option” for simplicity, as it’s easier than writing out “home equity conversion mortgage” every time. In the case of the annuity option, the value of your home is appraised and an interest rate is assessed. This is then compared to your age and your actuarial life expectancy, and an estimate for a stream of income based on the value of the home with an assumption of accumulating credit (this is a loan to you, after all) is applied. For example, if you owned a $500,000 home, were age 70, and were expected to live until the age of 83, with an interest rate of 6% and $5,000 in closing costs, you’d be provided a monthly income stream of approximately $2,990.40, based on a 66% valuation of your home. This would equate to a loan providing a stream of income totaling $466,502.40 over the next 13 years. But what if you outlive their expectations? Well, in that scenario, you’d keep receiving loan payments so long as there was still equity in the home. Assuming you reach the cap on that finite resource, then the payments may stop, but the loan is still not due until you move out or pass away, and ultimately the only claim by the lender is against the value of the home, not the rest of the estate. In the case of the credit option, the reverse mortgage acts much like a home equity line of credit (HELOC), except that rather than receiving a stream of income, you simply have access to a large lump-sum loan that can be used in a pinch or to help consolidate other forms of debt. Like the annuity option, payment is not due until the sale of the home or you pass away. There is one critical element to note here: a reverse mortgage may act like a form of income, but it is not income. As a loan, it is not subject to income taxes, and thus it can be tempting to spend it all and live like a king or queen in retirement, but remember it is a loan. Like all loans, it will eventually have to be repaid.
Having your Cake and Eating it Too
So why the bad rap of reverse mortgages and why is the Magnum PI being so defensive about it in that advertisement? Simply put, marketing for reverse mortgages used to be a lot less forthright, and a bit more confusing, and ultimately, many borrowers came away with the impression that they could have their cake (all the equity and value in their home) and eat it too (spend the equity.) Issues arose for retirees who took out reverse mortgages early after their offering, thinking that they were getting tax-free income and not a loan, and who were then often surprised that a few years into their retirement, that they’d borrowed a lot more principal and been charged a lot more interest than anticipated, and had very little equity left in their home for emergencies or to help pay for a new home when they later chose to relocate. This was particularly problematic for those who had planned to live in their home their whole retirement, only to have a sudden health event that led them to need assisted living, and suddenly realized that they couldn’t sell their homes to pay for it. Simply put, reverse mortgages had been so attractively advertised that many retirees didn’t quite understand all the terms and conditions and were being blindsided by the cost of the loans.
Several laws and best practices improvements have been passed over the past few decades to provide much greater clarity and disclosure around the structure, cost, and fees of reverse mortgages. Ultimately, someone taking out a reverse mortgage today is doing the same thing as their peers over the past few decades, but there is much greater disclosure and many more requirements for transparency in the application, underwriting, and closing process to help ensure that seniors are as well-informed about these loan products as possible, before they sign on the dotted line.
What Do the Academics Say About Reverse Mortgages?
As promised in the intro, academics have had a lot of good things to say about reverse mortgages. In the simplest terms, the average American household is often house-rich and cash poor, or at least more house-rich than they are cash-wealthy. This leads many people entering retirement to have a balance sheet that is significantly or even by majority the value of their home, with moderate levels of retirement savings. Because we often think of our homes as illiquid assets, many plan their retirement timeline and their retirement needs around their more accessible assets such as 401(k) plans and IRAs or look at the amount of income they expect from social security and pension plans, as the primary funding source of their retirement. Yet, reverse mortgages can provide access to the value within what is many people’s largest asset! Academics thus like reverse mortgages for two major reasons, which conveniently tie back into our annuity and credit options.
The academic literature has shown evidence for support of the annuity option as a form of asset preservation: essentially because the loan isn’t taxable income, it allows retirees to take less from other investment assets that may incur income taxes (traditional IRAs and 401(k) plans) or capital gains taxes, which ultimately helps preserve them and keep retirees in lower tax brackets. While the final cost of the loan then becomes an obvious potential issue if the borrower sells their home before they pass away, many academics assume that borrowers will be successful in their plan to stay in the home forever.
The credit option is commented on favorably in the literature because it can help form a bridge over time periods in which sequence of returns risk would be an issue. Sequence of returns risk is the potential event that the market crashes in retirement (with particular emphasis on the risks of it happening early in retirement), and it leads retirees to deplete their retirement savings early. The credit option of a reverse mortgage then is favored as a tool that can be used to provide money to live on and to stop taking money out of retirement assets while they’re lower in value, thus allowing them to recover from the market downturn and helping preserve the value of the assets.
Should you have a Reverse Mortgage?
As with all things, it depends. My basic framework in approaching this consideration with clients are the following questions:
- Is this your forever home?
- Do you have children or family members to whom you plan to leave an inheritance?
- Do you want to leave this particular house to your heirs for any reason?
The basic point of these questions is to address risks: Are you planning on leaving this home in the future? If so, a reverse mortgage would be a bad idea since the loan will come due during your lifetime. Do you have family members you care about and want to leave money to? Well, then borrowing money against your home reduces the value of the potential gifts you can leave behind in your legacy. Of course, the last question then is important: Is this home important to your family? Did you raise your kids in this home? Is this a legacy family home passed down from generation to generation? If so, then a reverse mortgage could result in the forced sale of that home later in life or after your passing, so it would be unwise to borrow against it. But what if your answers are “yes, no, and no” or “yes, yes, and no”? Well, in that scenario, the home is potentially a great source to supplement your retirement, and a reverse mortgage could be a valuable addition to your retirement plan. As always, and particularly with such a big financial decision as a reverse mortgage, consult your financial planner, your CPA or EA, and your family first and foremost. Get well educated on the subject (moreso even than I’ve provided here), and be absolutely certain you think it would make sense for you. After all, it’s fine to have a cake or to eat a cake, but as many have learned before, you can’t have it and eat it too.