By Shelley Giordano
Americans who are retiring or retired are increasingly aware that they may be living longer than planned. To finance these extra years from savings is further jeopardized by the increased risk posed by both market volatility and unexpected spending shocks that these extra years will bring. With senior home equity approaching $7.82 trillion, according to NRMLA/RiskSpan Reverse Mortgage Market Index in Q3 2020, using some home equity to ease retirement threats seems like a reasonable approach.
The problem with relying on home equity in retirement is that there are just two options. Either the homeowners can move and downsize, or they can borrow against their home value.
Moving is both emotionally and financially expensive and many homeowners dismiss a move outright. Yet borrowing against the home is fraught with income and credit constraints and puts the borrower at risk if they’re unable to continue making monthly principal and interest payments, keep the house maintained and insured, and stay current on property taxes.
Despite these limitations to borrowing in retirement, seniors are turning to home equity to finance retirement spending. In a paper written for the Wharton Pension Research Council, the authors report that seniors are using relatively high loan to value (LTV) loans of 57-65%. This is especially high considering that many of these mortgages “require payments lasting decades into retirement” that “rise” in relation to declining assets as the borrowers age.
For those with assets, the traditional approach in retirement was to access a home equity line of credit (HELOC) to be used only in times of need. This safety valve proved unreliable in the Great Recession. Just when homeowners needed liquidity, the banks did, too. Existing HELOCs were cancelled, frozen, or reduced. And again in March 2020, when markets were unstable, many banks stopped offering HELOCs altogether.
What goes unsaid, however, is that HELOCs, even for borrowers with significant assets, require monthly interest and principal payments since interest-only lending is moribund. Obligatory debt service puts the homeowners right back in the penalty box if they cannot make the payments. And fundamentally, trying to leverage home equity with a mortgage that requires monthly payments “deleverages” what the homeowner wants to leverage in the first place. In other words, retirement cash flow suffers whether from a mortgage or a HELOC.
No wonder that the market has responded with retiree lending strategies that do not require a monthly payment. One hybrid approach is to borrow enough via a “cash-out” refinance so that a borrower can make the payments for a certain term by borrowing more than he needs. Again, this is can be an unreliable strategy as lenders curtail cash-out mortgages in bad economies, especially for those without premium credit and income profiles. And, of course, the borrower runs the risk of outliving the term and having to begin the mandatory debt payments from savings. These payments could be an uncomfortable ratio of the aging household’s remaining monthly income. This strategy also increases the costs of borrowing the money needed. Example – to borrow $75,000 and the payments together, the homeowner could expect to actually borrow $100,000 to reserve $25,000 for payments over a 10-year period.
In recent years homeowners in states with higher or more reliable home values have been offered a “home equity sharing partnership.” The idea with these products is to share in the increasing home value with the lender in return for not having to make monthly interest and principal payments.
Like any new financial product, there are a variety of versions while the market experiments with what might appeal to the most users, and be profitable for the lender. The lenders in this configuration tend to call themselves “investors” to signify that they do not take ownership of the home, although a deed of trust and a sort of “memorandum of option” is executed to secure current and future interest in the home.
The term within which the loan must be repaid varies by contract. Some lenders specify 10 years and others 30 years. When the loan matures, the borrower must either sell to repay the money advanced plus a percentage (varies) of the equity increase since the inception of the contract, or refinance to cover the principal plus equity share.
The selling point for this type of transaction is that the lender will share in both the appreciation and depreciation of the property for a set time. For example, one lender specifies that the loan must be repaid in 10 years, but if the home value drops within 3 years, the lender will not participate in the property devaluation. One lender’s website specifies that they will advance 17.5% of the home value while another may lend much more. Other websites require the homeowner to provide property information before revealing the loan proceeds. Some lenders specify that the lending amount will be based on a discounted home appraisal value to protect the lender against falling home values.
The providers of home-equity sharing loans often take care on their websites to compare their loan terms to reverse mortgages. In the past, there were equity-share reverse mortgages, now discontinued. These were unpopular and resulted in a famous lawsuit when the borrower’s estate objected to the lender taking a large equity share when the borrower died unexpectedly early on the eve of a huge run-up in her home value. Also, in the past, banks would take ownership of the borrower’s home in return for advancing money without monthly debt service.
This all changed three decades ago when Congress created the home equity conversion mortgage (HECM), a new reverse mortgage. The HECM is used by American retirees in greater than 90% of cases and does not include bank ownership. The HECM is insured by FHA and allows homeowners to borrow without monthly principal and interest payments yet maintain control of their title and future home appreciation. Likewise, the FHA insurance provides downside protection should the home value drop – neither the borrower nor his estate will ever be required to pay back more than the fair market value of the home when the last borrower dies, moves, or sells. There is no borrowing term because the borrower has the right to stay in his home regardless of its future value. Credit capacity is not limited at the outset of the reverse mortgage and grows in borrowing power as the homeowner ages.
Although it is dangerous to draw comparisons with new and varied product offerings, this chart is offered in the spirit of helping consumers select what home equity release product best suits their needs, if only to help guide research and ask good questions. Also, it is hoped that this attempt to compare and contrast will usher in greater discussion among lenders, policy wonks, financial planners, and consumers – all in the spirit of collaboration to help seniors enjoy greater peace of mind in retirement.
|Product Type||Eligibility||Term||Foreclose for Monthly Payment Delinquency||Debt Limited by Future Home Value||Cancellable by Lender|
Credit score, debt to income, loan-to-value is lender specific
Usually 15-30 years.
Credit score, debt to income, loan-to-value is lender specific
10 years to borrow, 20 year term (possible payment shock at recast)
Cash-Out Mortgage (borrow monthly payments)
Credit score, debt to income, loan-to value is lender specific (usually 80%)
Usually 15-30 years.
Borrow more to make 10 years of payments.
Home-Equity Share “Investment”
Credit score, income possibly, loan-to-value is lender specific
Variable - 10 years, possibly 30.
Reverse Mortgage (HECM)
Demonstrate tax and insurance payment willingness and capacity, loan-to-value specified by FHA of 45-75%
No maturity date other than when the last homeowner dies, moves, or sells.
About the author: Shelley Giordano
Shelley is the author of What’s the Deal with Reverse Mortgages? In 2012 she co-founded the Funding Longevity Task Force, now known as the Academy of Home Equity in Financial Planning at the University of Illinois. She currently directs Enterprise Integration at Mutual of Omaha Mortgage where she mentors an elite group of loan officers whose focus is on helping the financial planning community integrate the housing asset into the retirement planning process.
Jim Krueger, Todd Schwartz and Mary Jo Lafaye, mortgage specialists at Mutual of Omaha Mortgage, contributed to this article.