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Reverse mortgages, and how they fit into retirement planning

"How do reverse mortgages fit into my retirement plan? They don't! I shouldn't need that kind of Hail Mary pass!"

That's what many of my clients say when I bring up the subject, and I hear where they're coming from. There's a lot of noise out there when it comes to reverse mortgages, some of it just incorrect ("the lender holds my title!"), some of it addressed by competition ("the fees go up to 6%!"), and some it addressed by mandated counseling sessions ("I know someone who lost their home because they couldn't pay property taxes!").

The truth is that unless you're hell-bent on someone inheriting your house (and often even then -- see below!), reverse mortgages are an excellent financial planning tool. After all, the equity in your home is a large percentage of your net worth; if you can access it while continuing to live there, isn't that worth exploring?

How does it, does it work?

It's a fair question, and if King Arthur can ask it, so can you. Oversimplified -- but only slightly -- a reverse mortgage is simply a loan on your house. That's it. In that respect, it's just like a standard mortgage or a home equity loan or a home equity line of credit. (In fact, the official name is a home equity conversion mortgage, or HECM, and thus is just another standard offering alongside HEL's and HELOC's.)

So how is a reverse mortgage different from other loans? Here's the kicker: as long as you continue to pay for upkeep, property taxes, and homeowner's insurance, the loan is guaranteed, as is your ability to remain in the home, and you are under no obligation to pay off the loan while you are alive and staying in the home.

This means that you could use a reverse mortgage as a sort of upgraded HELOC: one that (a) you don't have to immediately start paying down once you run a balance, and (b) won't get cancelled by the bank if the value of your home decreases -- which may be during a time of financial stress, when you need it the most!

Also, you can access the loan in the form of "tenure payments", monthly payments to you from the lender that last until either death or leaving the home, whichever comes first. And yes, this is how "reverse mortgages" got their name -- the lender is paying you, rather than the other way around!

Note that in both of these cases, your debt is only equal to the amount you actually borrow (plus interest). In the case of a line of credit, if you have a zero balance, you owe nothing. In the case of a tenure payment, the debt is only based on the payments you've received thus far.

What's the catch?

On the surface, it seems too good to be true: I get money for life? And don't have to pay it back? What's the catch? Well, while there's not a catch per se, there are a few things to be aware of.

First and foremost: you have to stay in the home. As soon as you leave, you have to pay off the loan. So if you're planning on downgrading or moving into a retirement home, there's a much better way to get equity out of your home: sell it!

Also, you've still got to take care of home-related costs: upkeep, property taxes, and homeowner's insurance. Of course, this should go without saying -- if you can't afford to pay for those, you can't afford to live in the house, HECM or no HECM!

And even if you do stay in the home, the loan does eventually have to be paid off -- just not until after you're dead. The bank will get its money! And there are two mechanisms that ameliorate the risk of the home being "underwater" when that happens.

One is the Principal Limit Factor, which limits how much of your equity you can tap. It's based on several factors that we'll get into later, but the general idea is to limit the principal in such a way as to minimize the chance of the loan exceeding the home's value.

The other is that part of your upfront costs and effective loan rate go towards governmental mortgage insurance. Pretty simple: if despite the PLF your home is underwater when you pass away, then the difference between the home value and the loan balance is made up for by the insurance pool. The bank gets its money, no harm, no foul.

Let's get into some details.

How much can you borrow? What does it cost? Let's walk through it:

The PLF I mentioned earlier depends on three primary factors:

  • The older you are, the higher the principal limit. You generally can't even get a reverse mortgage unless you're at least 62.

  • The lower the lender's margin rate, the higher the principal limit. (Just like mortgages, different lenders have different rates and/or origination fees.)

  • The lower current interest rates are (as indicated by the 10-year LIBOR swap rate), the higher the principal limit.

The upfront costs consist of three parts: the origination fee, initial mortgage insurance premium, and closing costs.

  • The origination fee is a strong source of competition, and so it's likely you can find someone offering $0 fee and a rebate towards closing costs!

  • The initial mortgage insurance premium is a 2% fee towards that mortgage insurance I mentioned earlier.

  • Closing costs are standard fare: appraisal, titling, etc.

You can get a current estimate of the PLF and upfront costs through a reverse mortgage calculator. I'm a fan of this calculator, as it's by a third-party retirement researcher.

The ongoing effective rate varies over time, and is equal to several factors added together:

  • Current interest rates, as indicated by the 1 Month LIBOR rate, around 0.2% as of this writing

  • The lender's margin: around 2.25% as of this writing

  • The mortgage insurance premium: 0.5% as of this writing

As you can see, the interest rate is just about competitive with a standard mortgage, even when you factor in the insurance premium -- though be aware that it is a variable rate, not a fixed one!

Leaving a legacy

Let's address two different scenarios: a legacy isn't a priority, versus a legacy is a priority.

95% of my clients fall into the first bucket: legacy is not a priority. If they die before they retire, their kids' needs are taken care of by life insurance, inherited retirement plans, etc.; if they die after they retire, their kids should be fully self-sufficient! (Ref. Die Broke.)

In this case, you're sitting on an asset likely worth hundreds of thousands of dollars, money that can't otherwise be touched until after you're dead; why not do this?

A more interesting case is for those who want to leave a legacy; in this case, the value in their home would be part of that. However, I would argue that in most cases, a reverse mortgage still makes sense.

This is because your legacy consists of the value of the home plus the value of your investments. In general, the value of your home is expected to grow at the rate of inflation. Your investments, on the other hand, are expected to grow significantly faster than that. So why not spend money from the asset that will grow slower, leaving more money in your (faster-growing) investments, and thus a larger legacy?

Moreover, a reverse mortgage can help reduce the probability of a reverse legacy -- your kids having to take care of you in retirement because you spent down your portfolio, rather than you leaving something for them! Speaking of which:

How to effectively use a reverse mortgage

Once you've decided on a reverse mortgage, the question then becomes: how do you use it? Pull out as much as possible and invest it? A line of credit, only to be used in emergencies? A tenure payment?

There are many different ways to skin this cat, depending on your particular situation, but the research consistently shows that a tenure payment is one of the most efficient ways to use a reverse mortgage. It's also quite simple, very much a "fire and forget" sort of situation.

Why do tenure payments work so well? One answer goes back to Monte Carlo simulations. By pulling a set amount from your home's equity each month, you're reducing the amount you have to pull from your investments; this in turn reduces the negative impact of a market downturn at any given time.

Now, if you want to get a little fancier, you might consider term payments -- just like it says, a set of payments that lasts for a certain number of years, rather than for life. The advantage here is that you can customize it to your particular situation. For example, you might be retiring at 62, but waiting to take Social Security until 70 and RMD's at 72. In this case, you might set up a 10-year term payment, which would greatly reduce the impact of a market downturn during the just-after-retirement "danger zone", when you would otherwise be taking the largest chunk out of your retirement assets.

However, tenure payments also work as longevity insurance -- like an annuity, they last until you die, as long as you don't move out of the home. So keep this in mind before going the term payment route!

Hopefully you see that reverse mortgages aren't a Hail Mary pass at all; rather, like investments, they're a financial planning tool that fits with just about everyone's goals, if used properly. Of course, also like investments, you should be careful how you use them -- handle with care, and be sure you know what you're doing!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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