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By Barry Sacks

Many retirees, at some point in retirement will sell their family home and buy their retirement home. This can be for several reasons -- to downsize from a larger home to a smaller one, or to move closer to children and grandchildren, or to move to a more hospitable climate or to an area with a lower cost of living. Some retirees "up-size" or "same-size" when purchasing a new home.

And for many retirees, a primary concern is having the cash flow available for ordinary expenses. In the context of buying a new home, a reverse mortgage used to pay part of the purchase price can provide a significant increase in available cash flow.

Here's a brief summary of the features of reverse mortgages, both of home equity conversion mortgages, or HECMs, and of proprietary reverse mortgages.

Downsizing Without Existing Mortgage

Consider a retiree whose home is worth $800,000 and has no existing mortgage debt against it. The retiree would like to downsize to a home worth $500,000. If the net amount received from the sale is $740,000 (after real estate commission and other expenses of sale), the retiree could purchase the new home for all cash, and still have $240,000 remaining to invest for cash flow. If the annual earnings rate of the investment is 5%, the increase in available annual cash flow resulting from the investment would be $12,000 (5% x $240,000).

On the other hand, if the retiree were to make a down payment of $270,000 and use a HECM for purchase for the remaining $230,000 of the purchase price, he or she would have $470,000 remaining to invest for cash flow. If the annual earnings rate of the amount invested is 5%, the increase in available annual cash flow would be $23,500. (5% x $470,000). The retiree would have no mortgage payments to make as long as they live in the home as their principal residence.

Downsizing With Existing Mortgage

Consider the same situation as in the previous example, with the sole exception that the retiree's current home, worth $800,000, has a $150,000 mortgage on it, with 10 more years to run. (Assuming that the interest rate on the existing mortgage is 4%, the monthly payments are approximately $1,519. On an annualized basis, these payments amount to $18,224.) When the home is sold, the net amount received is $740,000, and after the existing mortgage of $150,000 is paid off, the amount remaining is $590,000. If the full amount of the $500,000 purchase price of the new home is paid from this remaining amount, $90,000 will remain to invest for cash flow. Thus, the increase in available annual cash flow would be $4,500 (5% x $90,000) plus approximately $18,224 (from no longer having to make mortgage payments), which equals a total increase in available annual cash flow of $22,724.

On the other hand, if $270,000 is used to make a down payment on the new home and a reverse mortgage is taken to pay the remaining $230,000 of the purchase price, the cash remaining from the sale of the existing home would be $320,000. If this amount is invested for cash flow, the increase in available annual cash flow would be $16,000 (5% x $320,000) plus approximately $18,224 (from no longer having to make mortgage payments), which equals a total increase in available annual cash flow of $34,224.

What About 'Up-Sizing'?

There are data indicating that a significant portion (although a minority) of retirees who purchase new homes buy larger or more expensive homes. Reasons given for larger homes include the desire to have room for visits from adult children with their families; reasons given for more expensive homes include the desire to be closer to adult children and their families who happen to live in more expensive locations.

For a simple example, consider the situation of a retiree who has an existing home of value $500,000 that is fully paid for, and who would like to purchase a new home of value $700,000. In this situation, the retiree could sell the existing home, and net $470,000 after payment of real estate commission and other costs of sale. The $470,000 could be used as the down payment on the new home and a reverse mortgage could be obtained for the remaining $230,000 of the purchase price. Thus, the larger home is obtained with no outlay of new cash. Also, no mortgage payment is required, and therefore there is no new burden on the retiree's cash flow.

Tax Considerations

There are several interesting tax aspects of the reverse mortgage for purchase:

The reverse mortgage amount used for purchase is a loan, and therefore is not treated as taxable income.

The interest on the reverse mortgage loan accrues and compounds over time, and does not have to be paid until the loan itself is paid off, which only becomes necessary when the borrower leaves the home permanently. And because the reverse mortgage for purchase is treated, under the Internal Revenue Code, as "acquisition indebtedness," the interest is deductible when paid, to the extent that the initial indebtedness does not exceed $750,000.

(There is some uncertainty in the law on whether the deductible interest is simple interest or compound interest. This uncertainty is discussed in an article in the April, 2017 issue of the Journal of Taxation.)

In the second example above, the amount of cash flow burden that was reduced by downsizing from a home with an existing mortgage to a new home without a mortgage was specified. The figure specified, however, did not consider a related additional cost to the borrower if the money to make the mortgage payments came from a tax exempt retirement account (such as a 401(k) account).

That additional cost is the tax cost on drawing the money from the retirement account. To illustrate, the annual mortgage payments set out in the example were approximately $18,224. If the retiree's marginal tax rate is, for example, 25%, the additional cost of continuing to make the mortgage payments would be approximately $2,200 (based on the assumption that, on average, one-half of the payment is deductible interest and the other half is non-deductible principal).

In situations where the homes are of substantially higher value than those considered in the foregoing examples, proprietary (so-called "jumbo") reverse mortgages can be used.

Features of a Reverse Mortgage

Most reverse mortgages are home equity conversion mortgages or HECMs, which are FHA-insured and subject to HUD regulation. There are also proprietary reverse mortgages (also known as jumbo reverse mortgages), which differ from HECMs in certain features.

Features of HECMs

Most advisers are familiar with HECMs, but five key features should be emphasized:

    A reverse mortgage is, in substance, a loan secured by the borrower's principal residence, with required repayment deferred until the borrower permanently leaves the residence.

    The loan can be taken on a home currently owned by the borrower or for purchasing a new home.

    The loan proceeds can be taken as a lump sum, a line of credit, an annuity, a lifetime or term or monthly payments, or any combination of these forms.

    The loan is available only to borrowers age 62 or greater.

    The maximum home value that can be taken into account for a HECM is $679,650, and the maximum loan to value ratio is about 50 to 60%, depending on the borrower's age.

    Different Features of Proprietary Reverse Mortgages

    The features numbered 1, 2 and 4 above for HECMs are also applicable to proprietary reverse mortgages. However, unlike feature No. 3 for HECMs, the proprietary reverse mortgages currently available can only be taken as a lump sum. But, of course, as noted in the examples, a lump sum is precisely the way a reverse mortgage is taken when used for purchase. And unlike feature No. 5 for HECMs, the maximum home value for proprietary reverse mortgages is up to $5 million or more, but the maximum loan to value ratio tends to be closer to 40%.

    Although reverse mortgages had a questionable reputation in the early years of their use, since then changes in the structuring of HECMs and recent research leading to better uses of the product have resulted in its current acceptance by many advisers and planners as a useful and flexible financial tool for retirees.

    About the author: Barry H. Sacks is a tax attorney specializing in pension law. He also has a Ph.D. in theoretical physics from MIT. He published the pioneering research paper modeling the use of reverse mortgage credit lines to mitigate the effects of adverse sequences of investment returns in retirement accounts. While developing his model for the use of reverse mortgages in retirement income planning, Barry became aware of other needs of retirees (or soon-to-be retirees), including those who are moving to new homes and those who are in the process of divorce. As a result, Barry has published papers demonstrating various uses of reverse mortgages to address these retirees' needs.