On Monday, we discussed the nuts and bolts of reverse mortgages. On Wednesday, Josh Mettle went into more detail with some of the creative uses for a reverse mortgage. Today’s post is going to be more critical about them. Now, you need not assume by this post that I have anything against you using a reverse mortgage or that I think they are a bad product and those who sell them should get some cement shoes. If you truly understand how a reverse mortgage works and still want to use one, I don’t have a problem with that. But one of the best ways to understand something is to see the problems with it. Then you can decide if those issues are a big deal to you or not.
Home Equity Isn’t Doing Nothing
Perhaps the thing that bothers me the most about the reverse mortgage thing is the same thing that bothers me with those who advocate carrying a mortgage long into retirement and using HELOCs for various purposes during your career. They like to sell this concept that home equity isn’t “doing anything. It’s just sitting there being useless.” I vehemently disagree. The home itself provides “dividends.” That dividend is saved rent. Technically, that home provides the same dividend whether the home is paid off or if you have a 100% LTV mortgage on it. So what the home equity itself is really doing is reducing your interest cost for that home. All the other expenses are precisely the same. If the home is 100% paid off, there is no interest cost. If you only have a little home equity, there is a substantial interest cost. The rate for that depends on your tax situation, but the return on your investment is your after-tax mortgage interest rate. Sure, that might not be a very good rate of return in comparison to the expected long-term return on riskier investments, but it certainly isn’t zero and it is probably better than the guaranteed return on many low-risk investments. In addition, the paid off home eliminates a risk in your life- the risk of the home being foreclosed on if for some reason you can no longer pay the mortgage. That risk might not be very high, but it isn’t zero. Bottom line: Home equity isn’t doing nothing.
A Reverse Mortgage is a Loan
An important thing to understand about a reverse mortgage is it is a loan. With that loan, comes (almost) all of the problems with owing money to somebody else. These include having to pay interest, carrying the psychological burden of debt, and reduced future options. For example, if you borrow against something now, you can’t borrow against it later.
In addition, a reverse mortgage isn’t a particularly attractive loan. Not only is the interest rate 1-2% higher than a typical mortgage, but you can’t even deduct the interest. You see, the IRS rules are that you can only deduct interest you actually pay. Reverse mortgage interest isn’t paid until the home is sold. To make matters worse, the interest rate is generally variable. Now that doesn’t seem like a big deal in times of low interest rates, especially for a short-term loan. But a reverse mortgage is not short-term (you hope). It’s for the rest of your life. So when you sign-up for a reverse mortgage, you are committing to a high-interest rate, non-deductible, variable rate loan. That sounds kind of bad when you put it that way, doesn’t it?
A Reverse Mortgage is an Annuity
In some ways, a reverse mortgage is also an annuity. Except it isn’t a very good one. It doesn’t really care about your gender or health status. It also doesn’t guarantee to make payments until you die, even if you choose the tenure option. It only guarantees to make payments while you are living in your house. Want to move? Forget it, no more payments. Need to go to assisted living? There goes your house (unless you or your heirs pay off the loan) and your “annuity” payments. If you’re not a big fan of loans, and you’re not a big fan of annuities, you might not be a big fan of reverse mortgages, which combines the two concepts.
Reverse Mortgages Are Complex
I’m not a big fan of financial products I can’t explain to a seven year old. Complexity generally favors the issuer and those who sell them. If you’re going to bring me a complex product, its advantages better be so overwhelming that it makes up for the fact that I need an actuary to tell if I’m getting a good deal or not. Mixing insurance and investing is usually a bad idea. Mixing home equity, an annuity, and insurance sure makes it hard to tell whether it is a good idea or not.
You Only Get To Use Part of Your Home Equity
One of the things that bothers me about a reverse mortgage is that you only get to use part of your home equity. Given expected rates around 5%, that amount is 52%. But the expectation is that on average you will lose all or almost all of your home equity in exchange for it. If you really want to use your home equity to its maximum, sell the house, buy a SPIA, use part of the SPIA proceeds to pay the rent on a similar (or even the same) house and spend the difference on something else. When you move out, you still get the SPIA payments.
In Pfau’s excellent Reverse Mortgages book, he shows how the tenure payment for a reverse mortgage is calculated. On a $500K house owned by a 62 year old, he calculates out a monthly payment of $1,498, assuming the upfront mortgage costs are paid from other resources. If you reduce the value of the house by 6% to account for realtor fees, a SPIA for a 62 year old male on $470K is $2,431, or 62% more. Now, granted the reverse mortgagee also gets to stay in the house, and that’s worth something. However, he is also still responsible for the insurance, taxes, and maintenance that the renter would have covered by a landlord. A reasonable rule of thumb used by real estate investors is that the non-mortgage expenses on a rental property will be about 45% of the rent.
Tricky comparison, right? Most 62 year olds aren’t going to be able to do the math to really know which option comes out ahead, right? So they’re not going to make this decision based on math. But guess who has done the math? The actuaries that work for the lender, and you can bet they’re not going to lose money on the deal.
High Interest Rates Make Reverse Mortgages Much Less Attractive
But wait, there’s more. In Pfau’s example, expected rates are quite low, so low in fact that the 62 year old was able to borrow 52% of the home equity as a reverse mortgage. At higher effective rates, such as 9.5%, that percentage falls to 15%. It’s a lot less attractive to reverse mortgage your $500K house when all you get out of it is a loan for $75K. I think part of the interest in reverse mortgages the last few years is that the structure of a reverse mortgage makes it much more attractive in a period of low interest rates. While annuities become less attractive, reverse mortgages become more attractive with low rates. Conversely, as rates rise, you’re probably much better off with a paid off home than a reverse mortgage. If your expected rate is 9.5%, a 62 year old can only borrow 15% of the home’s value. Yet the estate might lose the entire value of the home at death. Does that sound like a good deal to you? I think I’d rather give granny some spending cash myself and get 100% of the home’s value when she passes.
The Lender Can’t Lose
Another aspect of this that I don’t like is that it is set up so the lender can’t lose. The lender isn’t making a bet that you’re going to die soon. He doesn’t come out any more ahead by you keeling over the year after you take out the reverse mortgage than 30 years later. His profit comes from the up-front fees, and if you include the investor in the securitized note in your definition of lender, from the years of interest. His downside is covered by the federal insurance fund. Guess who pays for that insurance? You did with the mortgage insurance. The reason you either put 20% down or used a physician mortgage when you bought your home was to avoid mortgage insurance. Yet now you want to buy it in retirement? Seems odd.
You want to know why lenders are so big on these? Higher fees, higher interest rate, higher closing costs, losses covered by mortgage insurance–it is all good and no bad for the lender. In fact, there is so much potential bad in this for you that the federal government requires you to go to a counseling session provided by someone besides the lender before you can buy one. What other consumer products out there do you have to go to a government-mandated counseling session before you buy? A child? No. A firearm? No. A primary mortgage? No. A Roth IRA? No. Whole life insurance? No. But you do for a reverse mortgage. If that doesn’t say “Caveat Emptor” I don’t know what does. At any rate, when the lender can’t lose in this deal, someone else has to, and that someone is you. (Okay, that’s a little harsh. It could be a win-win deal, but it certainly isn’t going to be a lose-lose deal, I can tell you that.)
Be Realistic About Taxes
Something that bothered me in Pfau’s book was that he consistently used an example of a $500K paid-for house and a $1M investment portfolio. Yet he used a 25% marginal tax rate for that retiree. While I do not dispute it is entirely possible for a retiree with a $1M portfolio considering a reverse mortgage to have a 25% marginal tax rate, it seems rather high to me. The RMD on $1M at age 70 is $36K a year. That portfolio is likely not all tax-deferred. Some of it may be Roth and some of it is probably taxable. Let’s say $500K is tax deferred. That’s an RMD of $18K. Maybe they get another $30K in Social Security. But with only $18K in taxable income aside from Social Security, they don’t pay taxes on Social Security. And they’re in a low enough tax bracket that their dividends/capital gains rate is 0%. So how much federal income tax is this couple really going to pay? Nothing. 0%. Certainly not 25%. Now, I’m ignoring state taxes as well, but even together it’s pretty tough to get to 25% when your federal tax is so low.
Pfau also uses that same figure in his analysis of how using a reverse mortgage can make your retirement income spending more efficient, which obviously casts at least a bit of doubt onto those results as well. But instead of including the tax bill as part of the 4% withdrawal as I would expect, he adds it to the 4% withdrawal. So in those examples, the person without the reverse mortgage is withdrawing 5.33%. No surprise that there are a fair amount of scenarios where it doesn’t work out well without tapping into additional resources like home equity.
At any rate, when running your own scenarios when deciding to use a reverse mortgage, make sure you’re being realistic about taxes. Taxes in retirement can be ridiculously low- no payroll taxes, much less income than during your peak earnings years, some of that income is taxed at capital gains rates, some (Roth) isn’t taxed at all, and a progressive income tax system. The lower your effective tax rate, the less benefit you’re going to have swapping interest for taxes. Tax-free sounds awesome, but just like with whole life insurance, tax-free but not interest-free isn’t nearly as cool.
The Cap Is Too Low To Move The Needle
The other problem I have with a reverse mortgage for a doctor is the relatively low cap on the amount you can borrow. The maximum home value is $625K. And at best you’re going to be able to use 52% of that, or about $325K. I don’t know about you, but I plan to have so much money to retire on that $325K isn’t going to move the needle for me. Most financially savvy docs I talk to project a financial independence number in the $2-5M range. At $2M, $325K is only 16% more money. At $5M, it’s only 7%. At a certain point, it’s no big deal to just have the house be part of my legacy. When you only have a $1M nest egg, that $500K home is a big part of your assets. When you have a $5M nest egg, a $500K house is not a big part of it, and even if you have a $2M house, you’re only going to be able to use $325K of it using the HECM program.
The House Isn’t Staying In The Family
While technically you (and your estate) get to keep the title to the house, upon your death (or worse, your moving out before death) the loan becomes due. On average, that loan is going to be the vast majority of the value of the home. If the family wants to keep this house, they’re going to have to come up with a lot of money in a hurry to do so. Now, if using this reverse mortgage really did make your retirement income strategy more efficient, maybe that can be paid out of your estate, but more likely, the family is going to have to give up a significant benefit such as a stretch IRA in order to keep the house. I would suspect that most of the time the house isn’t going to stay in the family. That’s not necessarily a big deal; I don’t want my parent’s house for instance, but if it matters to you, try to see the end from the beginning.
Malincentive to Move Out
An overlooked aspect of a reverse mortgage is the creation of a malincentive that otherwise wouldn’t be there. Sometimes the right thing to do is to downsize, move to assisted living, or move closer to family. If you have a reverse mortgage, particularly if you have chosen the tenure option, you have limited your options. As soon as you move out, the loan is due. You’ve given up some future freedom when you took out the reverse mortgage.
The Bottom Line
If you understand the downsides of a reverse mortgage, and still find it attractive for your situation, feel free to go ahead and use it. There are a lot of different ways it can be used and there is no doubt that you can increase the maximum amount of money you can spend during your lifetime by using a reverse mortgage. However, you need to realize there is precious little free lunch here. Even when using it as a “put” option, there is still a price to be paid for that “insurance.” I doubt I’ll ever use one, and I suspect most readers won’t either.
What do you think? Did I miss any downsides of a reverse mortgage? Would you consider one for yourself or a parent? Why or why not? Comment below!