By Doug Buchan, CFP®
Fifteen years ago, I was as cynical of reverse mortgages as I was of annuities.
With respect to annuities, I had the strong opinion that all annuities were bad, some were downright evil, but none were good, as their costs and lockups and tax inefficiencies far outweighed any perceived benefit that the highly commissioned salesmen pitched.
But, over the years I’ve worked hard on practicing Shane Parrish’s mantra of “strong opinions held loosely.” I’ve read objective research papers and analyses on annuities with an open mind, and I have graduated to the opinion that arguing all annuities are bad is the same sort of thing as saying all drugs are bad. In my opinion, some annuities are indeed like heroin. They are dangerous and oversold, and I maintain the strong opinion that – like heroin – they should be illegal. But, there are other annuities that I would argue are akin to, say, Lipitor. And, for the right person or couple, these annuities can enhance or even save their lives (financially speaking). The challenge, of course, is knowing which annuities are heroin and which are Lipitor, but that is a conversation (or article) for a different day.
Much like my former disdain for all annuities, I was also opposed to reverse mortgages, mostly due to the horror stories I heard or read about unsuspecting seniors getting swindled and losing their homes at the eleventh hour of life. Like any good narrative, pockets of this reflect fact, but also like many popular narratives, exaggeration and misinformation abound.
I’ll combat some of the misinformation in a moment, but first, what is a reverse mortgage?
In a nutshell, a reverse mortgage – technically called a Home Equity Conversion Mortgage (HECM, pronounced “heckum”) – is a special kind of Home Equity Line of Credit (HELOC). Just like a traditional HELOC, you can open up a HECM and pull out tax-free cash from the equity in your home. And just like a HELOC, you can open up this line of credit for “just in case,” not tapping it at the outset. (Technically, per several reverse mortgage companies, you are required to maintain a $100 balance on your reverse mortgage line of credit. And, yes, that $100 balance will grow at an interest such that – if interest rates stay the same* – you’d owe about $320 on your house in 20 years. This seems like a worthy tradeoff.)
But, there are also some stark differences. Unlike a traditional HELOC, if you do tap the HECM, you are not required to pay any of the loan back (as long as you live in the home). And, while that’s a lovely benefit, the biggest – and most powerful – difference is that, unlike a HELOC, the amount of money you can borrow from your home grows every single year at a compounded rate. It’s this increased borrowing power that makes this strategy special. More on that in a moment, but first, let’s address some of the most popular preconceived notions about reverse mortgages.
1) Reverse mortgages are for poor people. Couldn’t be further from the truth. While the reverse mortgage could serve as a last-minute stopgap for folks who are quickly running out of money, it’s the people who have ample money today that can take the fullest advantage of this solution.
2) The bank can take your home from you toward the end of your life. Now, just like any mortgage, if you don’t pay your property taxes or homeowners insurance, the bank may come calling. Other than that, I simply don’t see a cause for this concern. In fact, a HECM can actually protect you from losing your home by funding a bucket for future property taxes and homeowner’s insurance.
3) HECMs have exorbitant fees, making them a bad deal. I shared the same concern. As I have dug into the various illustrations for several clients, all-in fees range from 3%-4.5% (with the exception of Florida, which has very high state fees) of the value of the home. This is significantly higher than a traditional refinance, but there’s good reason for this. Two percent of this upfront fee is a mortgage insurance premium. Mortgage insurance? More on that in a sec.
As we know, there are many risks out there in life. As a financial planner, I focus on the financial risks. Risks such as market risk, inflation risk (or purchasing power risk), long-term care risk, longevity risk and even deflation or disinflation risk. We need weapons to combat such risks.
The HECM is fabulous at protecting not just one but two of the above risks: longevity risk and potential home deflation or disinflation.
The required insurance cost that I referenced above is a key piece to this whole thing, as this insurance – which is backed by the federal government through the Department of Housing and Urban Development (HUD) and the Federal Housing Association (FHA) – guarantees a growth rate to your home (more accurately, a growth rate to what you can tap from your home).
What if your particular area of the U.S. suffers a prolonged recession, thus driving down home values? What if a sinkhole destroys your neighbor’s home and plummets the value of the homes in your community? What if rising state taxes drive down values in your particular community? What if, what if, what if?
Let’s look at how this guaranteed growth rate could play out:
A 63-year-old couple lives in New Jersey, their home is worth about $650,000, and they have no mortgage. They are in solid shape financially, but it’s possible that things might get a little dicey for them if one spouse is still on this planet into their mid-90s. They both would like to stay in their home forever, they feel it’s suitable to growing old, and if it came to it, they’d prefer help be brought in to them versus going into assisted living.
They could take out a HECM today, and – assuming interest rates don’t change* – at age 93, when they’re starting to feel that money might be getting tight, they can tap over $1.2 million from their home, tax free, no questions asked. They have zero obligation to pay it back, either (while living). If they wanted to tap their line of credit at age 87, they’d be able to draw over $900,000, and even at age 80, seventeen short years from now (time flies), they could tap more than their home is worth today.
Now, it’s very likely that their home will be worth far more than $650,000 in 17 years. Likely, but certainly not guaranteed. Just ask anyone who bought a home in many of the high-end burbs in the northeast 13 years ago. Thirteen years is a pretty long time. And, in many of these towns, real estate values are less than they were in 2007.
You may never need to pull this arrow from your quiver. And, if not, hooray, it’s most likely because you didn’t need to exercise it to do all the things you dreamed of doing.
But, if things don’t go exactly as you hoped, if the luck factor of your financial plan rolls craps over the next couple decades, then this one extra arrow may be the one that saves you.
* Well, that’s a silly assumption, but we’ve got to assume something. Here’s the thing though. If rates rise, they can actually borrow more, not less. Rates in this illustration are based on LIBOR plus 4%. The 4% is guaranteed. LIBOR is currently at 0.41%. In theory, LIBOR could go negative, but the floor is 0% for this product, so the downside is 41 basis points but the upside is far greater than 41 basis points. That risk/reward is skewed in the borrower’s favor.
About the author: Doug Buchan, CFP®
Doug Buchan, CFP® is a Wealth Advisor with Buckingham Strategic Wealth. He works to help his clients make smart choices with their money so they can live the life that is most important to them.
Important Disclosure: The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. While reasonable care has been taken to ensure that the information contained herein is factually correct, there are no representations or guarantees as its accuracy or completeness. No strategy assures success or protects against loss. Individuals should seek advice from a qualified professional based on their own individual circumstances. IRN-20-1120