Reverse Mortgages: Now OK

Reverse mortgages, a controversial income source for older people, are a better deal for homeowners now. Like most financial advisors, I advise against using your home as a source of retirement income. But some creative new tactics and a lowering of fees make reverse mortgages worth a closer look.  
 
Reverse mortgages allow homeowners age 62 and older to borrow against the equity in their homes. They receive either a lump sum or monthly payments for life.
 
When the homeowner dies or moves out, the property is sold to repay the loan. Any equity left over belongs to the owners or their heirs. The lender must forgive any outstanding loan balance. The U.S. government insures most of the loans.
 
Reverse mortgages may be useful for elderly people in good health who have limited income or assets but who are living in paid-for homes. Until now, I have viewed them as options of last resort because of their disadvantages. A report by financial advisor Michael Kitces gave me cause to re-evaluate that position.
 
One major disadvantage of reverse mortgages is that the income uses up the equity in the house – and limits the homeowner’s flexibility. Seniors who take out reverse mortgages too early risk spending most of their home equity to cover living expenses. As long as they can stay in the house, that’s no problem. If they have to move, however, they will pay rent in their new home or long-term care costs. Without income from the sale of their house, they may be left with little except Social Security to pay their bills.
 
A second disadvantage is high upfront fees. A new option described by Kitces, though, significantly lowers those costs. Introduced in December 2010, the federal government’s Home Equity Conversion Mortgages program’s Saver option eliminated the upfront mortgage insurance premium of 2%. This drops the costs of a reverse mortgage on a $500,000 home from $17,000 to $7,000. The tradeoff is that seniors get a lower lump sum or monthly payment.
 
Typically, homeowners use the money to pay the bills when all other means of support become exhausted. Instead of selling or refinancing, the homeowners can choose to stay in the home. They don’t have to sell the property until they can no longer continue to live in it.
 
Another way to use a reverse mortgage is to refinance an existing mortgage. This both eliminates the monthly mortgage payment and, if there is enough equity in the home, provides the monthly income or lump-sum payment.
 
Kitces uses the example of a 70-year old couple paying $1,000 a month for a $175,000 traditional mortgage on a $450,000 property. A $175,000 reverse mortgage would eliminate the $1,000 payment. Assuming the net principal limit for the borrowers was $250,000 on the property, they could use the reverse mortgage to extract an additional $75,000 of equity. They could receive this in a lump sum, create a $75,000 line of credit or receive lifetime monthly payments based on the $75,000.
 
This couple’s monthly expenses, including the mortgage payment, are $5,000. They receive $1,500 a month from Social Security and withdraw $3,500 a month from their $600,000 investments. The total $42,000 annual withdrawal is an unsustainably high 7% of their portfolio. Most advisors recommend no more than 4%, to prevent retirees from depleting their investments.
 
The reverse mortgage eliminates the $1,000 mortgage payment and reduces the investment withdrawal to $2,500 a month. This totals $30,000 annually, a more sustainable withdrawal rate of 5%. Investing the $75,000 of excess proceeds would produce additional monthly income and reduce the withdrawal rate even further. Using a reverse mortgage in this way makes sense if the lost home equity is offset by an increase in investment assets.
 
Rick Kahler, CFP, is president of Kahler Financial Group in Rapid City, S.D.
 
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