By Keith Whitcomb, RMA®
A 2019 Philadelphia Federal Reserve study examined the influence that home ownership has on what’s called the “retirement saving puzzle.” The “puzzle” is the inability to explain why “many people die with significant savings.” Their analysis showed that owning a home has a positive impact on the preservation of assets as people age. This is partly due to what the Fed called “borrowing constraints on retirees” which limited using home equity to generate retirement income. So, if you can’t draw on the equity and you don’t sell, the full value of a house sits on your balance sheet as a long-term asset until you die. The Fed thus concluded that “housing plays a key role in accounting for the retirement saving puzzle.”
How can you avoid falling into this illiquid trap? You first need to understand the details of a Home Equity Conversion Mortgage (HECM) and then determine if and when it makes sense for you to get one. There are many factors to evaluate before using a HECM. Here are some things to consider:
What payment options do you have? Like many financial products, the HECM can be used in a number of ways. As a line of credit, it can provide backup funding for financial emergencies, or be an alternative source of income during unfavorable market periods when selling investments would monetize losses. The tenure option can generate ongoing retirement income, providing a secure floor of funding potentially supplementing Social Security, a pension, or an annuity. Term payments can be structured to fit cash flow needs over a specified time frame, while modified forms provide flexibility to meet variations on these themes. According to HUD you can even “use a HECM to purchase a primary residence if you are able to use cash on hand to pay the difference between the HECM proceeds and the sales price plus closing costs for the property you are purchasing.” Here are the HUD defined funding alternatives:
o For adjustable interest rate mortgages, you can select one of the following payment plans:
Tenure - Equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence.
Term - Equal monthly payments for a fixed period of months selected by the borrower.
Line of Credit - Unscheduled payments or in installments, at times and in an amount of your choosing until the line of credit is exhausted.
Modified Tenure - Combination of line of credit and scheduled monthly payments for as long as you remain in the home.
Modified Term - Combination of line of credit plus monthly payments for a fixed period of months selected by the borrower.
o For fixed interest rate mortgages, you will receive the Single Disbursement Lump Sum payment plan.
How much can you get? Not surprisingly, the cash generated by a HECM is largely a function of the value of your home, but a number of other factors including age also come into play. Table #1 estimates how much money a HECM will generate for 62- and 75-year-old borrowers after accounting for regulatory limitations, closing costs, and fees (based on the National Reverse Mortgage Lenders Association’s online calculator).
Is it cost-effective for you? Essentially what you want to think about here is the cost of a spendable dollar in your pocket. Table #2 looks at the initial costs of the fixed rate and line of credit alternatives.
This expense may get buried at the HECM closing given it can be netted out of the amount of money you will receive. The table illustrates how initial costs as a percentage of total borrowed can vary dramatically. Basically, the higher the home value and the older the borrower, the more economically advantageous the HECM becomes. But remember, this table is only looking at the initial cost of getting a HECM. All-in costs are also a function of how much and how long funds are borrowed, interest rates (e.g. Constant Maturity Treasury + Margin with a 5% cap), and ongoing service fees. Here is a quick analysis of the different HECM debt structures:
Fixed Rate For lower home values, the cost for fixed rate HECMs is high when compared to a line of credit. For example, it is estimated that a 62-year-old with a $100,000 home value will pay $7,124 at closing to borrow $26,340. This is like paying a 27% cash advance fee on a credit card, which you (hopefully) would never do. For the fixed rate option, this excessive cost is largely due to a 60% first year limitation on using HECM funds. However, under certain circumstances, this restriction is overridden. “If mandatory obligations are… really high (using all or nearly all of the principal limit), then the money available will usually be about the same for both HECM programs.” As a result, your personal financial circumstances could make the cost of the fixed rate option more reasonable.
Line of Credit In particular for higher home values, the initial cost to close on a line of credit is pretty reasonable on a relative basis, if perhaps not on an absolute one. And, in a unique and counterintuitive twist, the borrowing capacity of an unused line actually grows as a function of interest rates. Over time, this can further reduce your cost per dollar of borrowing capacity.
Tenure Table #3 uses a CoRI calculator to estimate the cost of an annuity that produces the same payment stream as a tenure HECM.
In many ways, tenure is an annuity purchased over time in comparison to insurance products that generally require payment in full before you receive any benefits. This makes it a very interesting retirement income option as you get much of the benefit of an annuity without the significant upfront cost. However, an annuity pays out over the lifetime of the purchaser (as opposed to the time you and/or a surviving spouse reside in your home with a HECM), and the all-in cost of the tenure (i.e., the HECM offset to your home’s value) will rise over time based on the monthly tenure payments you receive plus interest.
Timing – To qualify for a HECM, you need to be at least 62 years old (although a spouse can be younger). Once that requirement is met, you should consider the following:
Planning – According to Wade Pfau, “Financial planning research has shown that coordinated use of a reverse mortgage starting earlier in retirement outperforms waiting to open a reverse mortgage as a last resort option once all else has failed”.
Access – The Fed study found that “borrowing constraints on retirees tighten considerably as they age.” This may be a result of the general decline in financial resources over time during retirement. Given you must show adequate income to qualify for a HECM, it may be best to book the HECM while you are still earning a paycheck, before you retire.
Optimization – From a purely financial standpoint, the optimal time to book the HECM is when interest rates are low and the market value of your home is high. If you choose adjustable-rate options, you will also want low rates when you use them. However, unused lines of credit grow based on interest rates, so if you are not carrying a balance on the line, high interest rates may actually work in your favor.
The take away here is that the HECM has lots of moving parts, so there isn’t a generalized rule of thumb that can easily be applied to provide you with a simple “go/no-go” signal on this decision. And yeah, it takes a lot of money, but a HECM may make sense if you can use it advantageously when positioning your financial resources for retirement. So, if you are at least age 62, and HECM product characteristics make sense for your financial circumstances, you should seriously consider taking advantage of today’s low interest rates and booming housing markets to close on a HECM. The FHA requires all HECM borrowers to go through counseling, so a suggested first step is to contact one. Here are HUD-provided links to get you started:
· To find a reverse mortgage counselor near you, search the HECM Counselor Roster or call (800) 569-4287.
· To find a reverse mortgage counselor that provides telephone and face-to-face counseling nationwide, use the HUD Intermediaries Providing HECM Counseling Nationwide list.
About the author – Keith Whitcomb, RMA®
Keith Whitcomb, MBA, RMA®, is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience. He is Series 6, 63, and 65 licensed.