NEW YORK (MainStreet) — It’s hard to miss the celebrities touting reverse mortgages on TV. And, indeed, what they say is right: These loans can be a great way for retirees to use home equity for living expenses when other assets aren’t enough.
But what about getting one before you actually need it? Though experts generally say the home ought to be the last asset tapped, one urges applying now and borrowing later to lock in today’s low interest rates. In the long run that would permit a much larger loan, and less debt over time, than if the homeowner waited to apply until after interest rates were higher.
“It is urgent to act now because the window for doing these deals will begin to close when interest rates begin their inevitable rise,” says Jack M. Guttentag, emeritus professor of finance at the Wharton School.
Writing on his website, Guttentag explains that the loan, in the form of a line of credit, could be held in reserve for later use — or never used at all if the homeowner didn’t need it. Once the homeowner did start to tap the loan, the interest rate would be fixed at the level set when the mortgage was approved. Also, the loan limit would grow automatically over time due to the assumed appreciation of the property.
The approved but untapped loan would thus serve as a low-cost insurance policy against the danger of running out of money. Though there would be upfront fees, there would be no interest charges until the homeowner began to borrow. As with all reverse mortgages, there would be no monthly payments. Instead, any debt – the amount actually borrowed plus interest – would be paid off after the borrower left the home. Typically, that’s after the homeowner moves or dies, though the borrower can offset the loan with other assets.
To act on this opportunity, a homeowner has to be 62 or older and have equity in the home, which means owning a home worth more than any debt against it, such as a mortgage or home equity loan. Because borrowers make no payments on reverse mortgages, there is no income requirement for approval.
As Guttentag describes the process, the homeowner would take out a Home Equity Conversion Mortgage, opting for a line of credit rather than a lump some or fixed monthly income. A line of credit works like a credit card, allowing the borrower to take as much or as little cash as desired, up to a limit. Until the credit line is tapped, there are no interest charges. With a credit card, the interest rate can rise or fall as prevailing rates change. But the rate on an HECM is fixed at the start.
By holding this credit line in reserve, the borrower can benefit from two features of HECM loans, Guttentag says.
First, the initial borrowing limit on a home of a given value is higher if the mortgage rate is low at the time the loan is approved. That’s because the debt will grow more slowly if interest charges are small, improving chances the home will eventually sell for enough to pay off the debt.
With a mortgage charging 5%, a rate obtainable today, a 62-year-old borrower with $200,000 in home equity could get a credit line of $97,800, Guttentag says. If the loan charged 8%, a rate fairly common in the past, the same homeowner could get a line of only $40,200. And at 10% the limit would be a mere $19,000. An older homeowner could borrow more, since there would be less time to build up interest charges, but would face the same drop in borrowing power if rates were higher when the loan was taken out.
Second, the credit line would grow, on the assumption the home, which serves as collateral, is getting more valuable from normal appreciation. But instead of using the home’s actual value to recalculate the credit line, the HECM uses a formula based on prevailing interest rates. The more rates rise, the faster the credit line increases.
If the prevailing mortgage rate remained at 5%, the borrower above who started with a $97,800 credit line could see the limit grow to $381,400 after 20 years. But if the prevailing rate were 8% over that period, the line would grow to $592,100.
At first glance, benefiting from low rates now and higher rates later looks like some sort of loophole, but it’s not. A low borrowing rate and high property appreciation reduce the lender’s risk of loss — the chance the home would not be worth enough to pay off the debt.
Guttentag’s strategy does have costs, such as upfront fees for getting the loan. In his example, they might come to around $7,000 for a home with $200,000 in equity. Also, the borrower could run into trouble, and even lose the home, by failing to maintain the property or pay property taxes. Of course, any debt against the property would reduce the value of the estate passed to heirs.
But if you think a reverse mortgage credit line might make sense at some point, it could pay to get it sooner rather than later.
— By Brian O’Connell for MainStreet