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
- 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.
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?
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
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!