Like whole life insurance, reverse mortgages and those who sell them have a terrible reputation among financially savvy folks. Over the last couple of years, I have run into people advocating their use, not just for the classic use of relatively house-poor people but even for the relatively well-to-do. Some of these proponents claim that things are different now, and these aren't your father's reverse mortgage. Like with whole life insurance, the biggest advocates are those who sell the product, which results in a lot of hype and salesmanship. As Upton Sinclair said, “It is difficult to get a man to understand something, when his salary depends on him not understanding it.” This week, we're going to attempt to cut through the hype and salesmanship, explain how a reverse mortgage works, explain the reasons why a wealthy high-earner might want to consider it, and give some reasons why that might not be such a good idea.
As I started writing this post, Josh Mettle sent me a lengthy guest post about reverse mortgages and subsequently a copy of Wade Pfau's excellent Reverse Mortgages book. By the time I finished the book, I realized this subject couldn't be covered in a single blog post (even Josh's mammoth 5000 word first draft he sent me), so we decided to run three this week on the subject. Today's post will be mostly a nuts and bolts explanation of how a reverse mortgage works. The other two posts this week aren't really a “Pro/Con” series, since Josh and I have somewhat similar opinions of the product, but since he is slightly more positive on the topic, I asked him to focus on the really cool uses of the product and I'll focus my post Friday on some cautions and other considerations with it.
The Too Long Didn't Read (TLDR) Version
However, we both felt that in the continuum of financial products, reverse mortgages fit in somewhere around here:
- Right for Almost Everyone
- Roth IRAs
- Index Funds
- 5 Year Variable Refinanced Student Loan coupled with a willingness to live like a resident
- Single Premium Immediate Annuities
- Reverse Mortgages
- Longevity Insurance
- Long-Term Care Insurance
- Whole Life Insurance
- Loaded, Actively Managed Mutual Funds
- Right for Almost No one
Reverse mortgages can be a great thing for the right person, and the percentage of people for whom it is a good idea is certainly higher than the 1% or so of doctors that whole life insurance is right for.
How A Reverse Mortgage Works
A reverse mortgage is a loan with some annuity-like features. It has some guarantees, backed first by the lender and then by the government. There is a price to be paid for those guarantees. The bottom line is that a reverse mortgage is a way to use home equity for something besides providing a place for you to live and leaving your heirs a valuable asset. With reverse mortgages, or the government's favored term “Home Equity Conversion Mortgage” or HECM, there are “Four Nevers”:
- You NEVER give up title to your home
- You NEVER owe more than the home's value upon leaving the home
- You NEVER have to leave the home so long as taxes and insurance are paid and maintenance continues
- You NEVER have to make loan payments in advance of leaving the home unless you choose to do so
While there are some private, jumbo reverse mortgages out there, the vast majority are done through FHA and the federal HECM program. You have to be both an eligible borrower and own an eligible home.
An eligible borrower is at least 62 years old, is mentally competent, has equity in her home, has financial resources to cover tax, insurance and maintenance expenses, has no other federal debt, and has attended the mandatory counseling session.
An eligible property must serve as a primary residence, meet FHA standards including flood requirements, pass an FHA appraisal, and be maintained to meet FHA health and safety standards. Note that the home does not need to be paid off. In fact, it doesn't even have to be bought yet.
The Terms To Understand
There are three terms you need to understand in order to “get” how a reverse mortgage works.
Diagnose your financial situation carefully before reverse mortgaging your house
The first is the Principal Limit Factor (PLF). This is the percentage of home value that you can borrow out of the house and it ranges from 15-75%. That percentage is determined by your age when you take out the loan and by interest rates. At current interest rates, that percentage is 52% for a 62 year old and 75% for a 90 year old. As interest rates climb, the percentages fall. The initial loan amount is determined by multiplying the Principal Limit Factor by, well, the Principal. That's either the value of the home or the maximum of $625,000. So if you have a $500,000 home and a PLF of 52%, your maximum initial loan amount is $260,000. If you have a $1 Million home and a PLF of 60%, then your maximum initial loan amount is $625K*60%= $375K. If you're rich enough that an extra $375K isn't going to make any significant difference in your life no matter how it is used, you can stop reading right here, because that's about all you're going to get out of a HECM.
The second term is the Expected Rate. This is the rate which is used to determine the PLF and is essentially your cost for borrowing the money. If you were able to borrow the entire principal amount when you originate the loan, and that borrowed principal grew at the expected rate between origination and your moving out of the home or dying, then the loan would theoretically equal the home's value when you moved out of it. The expected rate is the sum of the 10 year LIBOR Swap Rate + a “Lender's Margin.” On the day I wrote this post, the 10 year LIBOR Swap rate was 2.48%. Add on a lender's margin of perhaps 3%, and the effective rate becomes 5.48%. On the day I wrote this post, 15 year fixed mortgage rates were about 3.3% and 30 year fixed mortgage rates were 4.2%. Obviously, the interest rates on a reverse mortgage are significantly higher than a regular mortgage.
The third term is the Effective Rate. This is the rate at which the amount of money you can borrow against the home grows. That's right, that amount can change as time goes on. This rate is the sum of the One-month LIBOR Rate + Lender's Margin + Annual Mortgage Insurance Premium. Today's one month LIBOR Rate is 0.94%. If you add that to a 3% Lender's Margin and a 1.25% mortgage insurance premium, your effective rate would be 5.19%. This effective rate is all that matters once the loan is originated. This is the rate at which the loan balance grows AND the overall principal limit grows. This is a key point to understand. If you don't borrow out as much as you can in the beginning, the line of credit associated with a HECM will generally get bigger over time and given a long enough time period, may even exceed the value of the house, depending on the rate of appreciation of the house.
How a Reverse Mortgage Ends
When the borrower, or both borrowers, die or move out of the house, the loan must be paid back. The lender always gets their money. Typically, the house is sold. Whatever is owed is given to the lender and whatever home equity is left (if any) is given to the heirs. However, the estate and heirs can certainly pay off the loan and keep the house. If the value of the loan is larger than the value of the house, the government insurance steps in and makes the lender right.
What Has Changed?
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There have been a few rule changes for reverse mortgages in the last few years. These have primarily been designed to help low-income seniors from being taken advantage of by unscrupulous lending agents. But they have not necessarily done much to make these products more attractive to retired high-income professionals. Here are some of the changes:
# 1 Merged the higher cost product with the lower cost product.
There used to be a “Standard” product with 2% Private Mortgage Insurance (PMI) and a “Saver” product with 0.01% PMI. Now there is just one product with 0.5% PMI. Unless you want more than 60% of the proceeds of your loan in the first year, in which case the PMI goes to 2.5%. But wait, you say. Why does the borrower have to pay PMI at all? The borrower doesn't have to make payments, so she can't default on the payments. PMI is supposed to protect lenders from the borrower defaulting on her payments. In reality, this is just a fee that comes out of your pocket and into the lending industry's. The theory is that it provides the money that the government uses to back the lender in case your loan amount exceeds the value of the house.
# 2 Financial assessment required.
Apparently Congress got sick of hearing stories of people getting reverse mortgages who had no business getting them. So they made them harder to get. That's great for some, but doesn't do much for the high-income professional who wasn't going to default anyway.
# 3 You can't borrow as much as you used to be able to.
For a given age and interest rate, you can't borrow as much as you used to be able to. That's a bad thing if your goal was to use this as a “put” option on your house.
# 4 Some borrowers forced to set aside part of loan in an escrow account.
If your finances look sketchy to the lender, they can require you to set a bunch of the loan aside in an escrow account to pay your property taxes and insurance. Why is that a big deal? Almost 10% of reverse mortgage borrowers defaulted on their loans in 2012, despite the fact that they didn't have to make any principal and interest payments. They defaulted (and could be foreclosed on) because they couldn't pay the property taxes (not insignificant in expensive areas like New York) or the insurance (not insignificant in places where flood insurance is required like Florida.) The more money that must be set aside for taxes, insurance, and maintenance, the less you get to use for something else.
That's it. Nothing else has changed. And none of those changes are beneficial to the high income professional with a nice nest egg who is now being pitched this product. The real change is in the target market. Instead of going after house-poor seniors, lenders see the opportunity to expand their market dramatically by lending to financially stable folks with plenty of home equity. Larger loans = larger fees and more interest.
How A Reverse Mortgage Can Be Used
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There are lots of ways you can use a reverse mortgage. Here are some examples:
- Buy a house for less than it's worth and never have to make a mortgage payment on it. The reverse mortgage is the mortgage. The loan amount is the difference between what you put down and what the house is worth.
- Borrow as much equity out of the house as you can and spend it without having to worry about losing more than the house.
- Get a reverse mortgage at age 62 but don't draw on it. Then, when markets are down, draw on the line of credit instead of selling your investments while their value is temporarily down. You can even pay the reverse mortgage back when markets are up if you want.
- Get a reverse mortgage at age 62. Don't draw on it. If the principal limit grows to be larger than the value of your home, borrow the money out and invest it elsewhere to leave more to your heirs. In this way, it functions as a “put” option.
- Get a reverse mortgage at age 62 but don't draw on it. If you run out of other assets, then tap the reverse mortgage. If you never need it, you're only out the origination fees. You will likely have access to more money than if you waited until you were older to initiate the reverse mortgage. In this way, it functions a bit like an insurance policy.
- Get a reverse mortgage and choose the “term” option. Like an annuity, you will get payments for a certain term of time. After that term, you can still stay in the house, but you won't get any more payments. A possible use for this is an 8 year term starting at age 62 which would allow you to delay Social Security to 70.
- Get a reverse mortgage and choose the “tenure” option. This is a lot like an immediate annuity. It will pay you a set amount every month until you die or move out of the house.
On Wednesday, Josh will discuss more of these creative uses of a reverse mortgage. On Friday, I'll issue a few cautions.
What do you think? Have you ever considered a reverse mortgage? Why or why not? Comment below!
Interesting read, particularly the list of potential uses. Unfortunately many of the “uses” require using quasi market timing techniques, that I fear could seduce one to the dark side. Interested to read parts II & III, but as of now I might still bump reverse mortgages a few spots down, perhaps just below long term care insurance on your usefullness list.
Thats pretty much the type of logic they use though to justify the high costs. You will tap this when the market is down and possibly pay off the loan when it goes up to reduce loan costs. Of course how do you know when it is at the top or bottom or which way it will go next. You don’t. This is a pretend solution to sequence of events issues but you are just changing one risk for another. I think the main issue with the ladder diagram is there needs to be more spaces between the good stuff and the bad stuff. The way it is written, one might think its just below a SPIA and the truth is that yes its below a SPIA but by a lot more than one line.
Wait until the end of the week and see if you still feel the same way.
Looking forward to the rest of the post. My parents (in their 80s) discuss one as a backup backup plan. Glad to get some info on something I may end up helping them with someday. Doubt we’d ever use one. But, like many of you, I end up being the go to finance person in my family. So, good to learn about products like this from sources like WCI that I trust.
Without Wade Pfau providing academic cover for the product I believe most folks would not even give the product a second look. He makes a compelling case for getting a line of credit at 62 and letting the line of credit grow without tapping it unless absolutely necessary. There are so many moving parts between the interest rates, origination fees etc. that it is really hard to compare how much it costs. Hopefully the complexity can be minimized since the concept of using the illiquid asset makes a lot of sense. I have a CFA and RICP and haven’t got my arms around what the real “catch” is myself. Good luck to the 75-year olds grasping that in an hour educational briefing.
I am very glad you are doing this. Since reading Pfau’s abstract of his book I have been interested in the concept. Of course, he was very positive and I look forward to your critical view. I am 74 (retired) with sufficient other assets that I don’t need the house equity to make my heirs well off. I have sold my home and am renting now but I calculate that if I live for more than 6 years I would be money ahead even with taxes and insurance.
I haven’t done much research so I hope you will comment on taxes and the idea that you can earn interest on an unused credit line (if I understood Pfau correctly).
Though I am not a doctor I enjoy your site very much.
Great question …I certainly hope they expand on what rate you could expect if you only draw out a small portion and leave the rest in….anything beats the rate a bank pays you
It’ll be discussed in Wednesday’s post.
WCI, formatting for the TLDR section is off, it appears that all items are listed under right for everyone including Whole life insurance. I know that is not the case, unless the insurance sales people have finally gotten to you 🙂
I also was confused even on the email but finally noted your continuum and knowing where whole life stands, understood the point that reverse mortgages MIGHT be better than whole life.
Yeah that’s definitely how it comes across 😀
Sorry if that didn’t work out on the mobile version. Looks fine on desktop, but basically it is a list with the stuff that is right for most at the top and right for few at the bottom showing that a reverse mortgage could be right for lots of people.
Readers need to be aware that if they take a lump sum and gift it to someone other than a spouse , the gift will be subject to the 5 year medicare long term care look back.
You mean medicaid and not medicare
Excellent point.
The original products were tainted by inadequate information, often the heirs not aware or understanding (elderly seniors taken advantage of? just forgetting deals made earlier?). I guess there was some egregiousness and of course getting only 80% of a home’s value seems unfair (did the reverse mortgage company get 99% for free if the home dweller died the first month of the contract? I was never clear on that) in any financial product (but that’s just the costs/ fees/ interest rates the banksters charge). But all these children popping up and saying “I want to keep the house that the bank gave my mom money for already! No fair!” Where were they when mom decided she needed money? Probably the reason she needed money- helping them out earlier.
80% is more than you should expect, but no, the reverse mortgage company doesn’t get 99% for free, at least under current rules. I do not have a firm grasp on all the previous rules.
Never even thought about reading up on Reverse Mortgages. It did not seem like something high income earners would need….still this was really interesting. Thanks for summarizing and looking forward to the upcoming posts.
Interesting reading, thank you. For those who are not house poor, wondering if it would make more sense to get a HELOC line of credit instead of a reverse mortgage?– would the origination fees and interest rate for a HELOC be different than for a reverse mortgage? Less risk of having to sell your house with a HELOC?
Probably not, but wait for Wednesday’s post.
I have read Wades book. I like the put option concept letting balance accumulate. A hedge against home values falling
Exactly that is Wade’s number 1 recommendation. My only question is “how much does the put option cost”?
The origination fees associated with taking out reverse mortgage
I started a Reverse Mortgage company 13 years ago. There are many people who would benefit from a Reverse Mortgage today. Anyone who isn’t concerned about the amount they are leaving behind can use the proceeds from the Reverse Mortgage during their lifetime. Many people today in states with high houing cost find themselves house rich and cash poor. These people can drastically improve their lives by eliminating a mortgage payment if they have one or by getting a lifetime annunity if they don’t. During a 4 year period before selling my company to a Credit Union I brokered over 700 Reverse Mortgages and only had 1 complaint from someone who years later thought they should not have taken out the Reverse Mortgage.
Have you had offers to write about long term care insurance as well? I was surprised to see you rate it worse than reverse mortgages, though I know little about both. Instinctively reverse mortgages seem like a scam, mostly because I’ve only ever seen ads for them on insomniac hours TV show reruns.
Reverse mortgages are not a scam. This word is used far too often. Reverse mortgages are simply financial products that have an associated cost. You may decide the cost is too high for your needs, and that’s fine.
These products could potentially be used in scams if a salesman does not make adequate disclosures about the products or otherwise misleads the customer. When we start calling everything a scam, we veer into Elizabeth Warren land where every product that makes a financial profit should be outlawed.
Exactly why this series of posts needs to be written. I hope most readers of this site will never need to buy LTC insurance as it has some significant issues.
https://www.whitecoatinvestor.com/long-term-care-insurance/
In the article “Features you want” IS available at OneAmerica. It is called Assetcare. Unlimited care and a fixed price. Of course if you say anyone who can sell a product is obviously tainted then who would you recommend to go to for advice? By the way Wade Pfau and Michael Finke have an in-depth white paper out on long term care pro’s and cons.
One should be very cautious about that since he has done other sponsored research….
Agreed. As I said he is the author of the Reverse Mortgage book too.
That was a good re-read.
A great related post would address the pros/cons of a irrevocable medicaid trust (to shelter assets from a nursing home) vs the excess taxes of having to transfer all funds out of your tIRA & Roth IRA, and into the trust in a taxable account, much quicker than you would’ve preferred under an ideal withdrawal plan (if you know you were not going to need prolonged care). Sadly IRAs can not go into Medicaid trusts but are counted towards assets to pay for care and disqualify from Medicaid. This gets complex and what we are currently advising my wife’s parents through. Strategies also differ by state on income definitions/limits pertaining to IRA withdrawals.
I would hope most of my readers never have a need to spend down to Medicaid levels for nursing home care, but it might be good knowledge for people to know for family/friends.
Medicaid planning related law is all state specific, so really tough to write a very specific post.
Program was never intended to allow for unlimited LOC growth to ultimately exceed the value of the home. Look for that loophole to be closed. The MIP is required by FHA. The lender nor the government benefit from those fees. MIP fund must always run in black and taxpayer dollars aren’t used to prop up the fund.
I agree. There is real risk there. Not sure if people would be grandfathered in or not. But all I can do is write about the current laws/rules/loopholes. But bear in mind that there are plenty of government programs that don’t run in the black without heavy subsidy from the taxpayer.
Thanks for tackling this topic guys, it is not an easy product to analyze due to it’s complexity. I’ve been intrigued since learning of this from Josh. For the right person I think this can be a great product if the upfront fees can be managed. They way I see it conceptually is using home equity as insurance against sequence of return risk in retirement, potentially letting someone retire a couple of years earlier than they otherwise would have. What would really be powerful is if this were available to someone in their 50’s who wanted to retire early in a geographic area with high home prices. Unfortunately, I think that for many physicians too much of their net worth is their personal residence.
I imagine this will be addressed in a future post, but were you able to quantify (roughly) the tax savings of this strategy to see when it made sense or if there was a way to calculate the ‘breakeven’ point where the tax savings offset the fees?This would probably only make sense in scenario 6 or 7.
I think you’ll enjoy the posts later this week.
My grandparents downsized to a nice mobile home in a nice park with many amenities after they retired. Unfortunately they discovered that mobile homes are not eligible for reverse mortgages (they are in CA, perhaps the rules are different elsewhere). Maybe not may docs will follow suit, but it may be worth mentioning that fact as a word of caution.