Unfortunately for many Americans, the dream of a comfortable and secure retirement is clouded by the reality of an inadequate level of savings, limited sources of retirement income, or potentially both. Indeed, according to a survey by GoBankingRates, 56% of Americans have less than $10,000 saved for retirement, and among those aged 55 or over, three in ten respondents reported having no retirement savings at all. While others may be better prepared for retirement, the survey found that only one in four respondents age 55 or older had savings of $300k or more.1 Furthermore, a 2015 report from the Transamerica Center for Retirement Studies found that, among Baby Boomers, 35% expected to rely on Social Security as their primary source of retirement income.2 While some can potentially close these savings and income gaps by saving more or delaying retirement, others are tapping the equity in their homes with the help of “reverse mortgages” in order to generate income.
A type of loan available to individuals age 62 or older, a reverse mortgage allows a borrower to access some of the equity in his or her home, or qualifying condominium, in the form of a lump sum payout, periodic payments, or via a line of credit. Payments from the loan may be used to supplement other sources of income, help fund home improvements or other miscellaneous purchases, or to help cover any emergency needs in the future. Payments are typically income tax free to the borrower, and how much one can borrow is dependent on factors such as one’s age – older individuals are typically able to access more equity in the home – the type of mortgage, the value of the home, and the current interest rate environment.3
Unlike a traditional mortgage or equity loan, the borrower is never required to make payments on a reverse mortgage loan. Instead, the loan is repaid, with interest, often with the proceeds of the sale of the home once the borrower has passed away, or when he or she had moved out of the residence. Over the life of the loan, however, the borrower is required to pay the property taxes and insurance on the home, and he or she is also required to keep it in good repair. In most cases, lenders will conduct a “financial assessment” of the borrower prior to approving the loan in order to ensure that the borrower has an adequate level of savings and/or income to meet these ongoing expenses.
Reverse mortgage types
When considering reverse mortgages, there are primarily three types from which to choose:
- Single-purpose reverse mortgages – Offered by some state and local government agencies or non-profit organizations, these loans are typically offered to cover the costs of specific expenses such as property taxes, insurance, or home improvements or repairs.4
- Proprietary reverse mortgages- Loans offered by private lenders, these types of loans typically allow borrowers with higher value homes to access more of the equity from the home.5
- Home Equity Conversion Mortgages (HECM) – The most common type of reverse mortgage, HECM loans are offered by individual lenders, but are insured by the Federal Housing Administration which is part of the U.S. Department of Housing and Urban Development (HUD). In exchange for a 1.25% insurance charge that is added to the loan balance annually, borrowers are protected in the event the lender is unable to make a scheduled income payment. Similarly, should the value of the home be less than the outstanding principal when the loan is due, the government will pay off the balance of the loan from its insurance fund.6
As a financial planning tool
While reverse mortgages have traditionally been used as a means of increasing income, some individuals are now using them as a tool in financial planning. For example, retirees in need of income are eligible to file for Social Security benefits at age 62, but when filing before attaining full retirement age, the benefit payments will likely be reduced. By tapping the equity in one’s home for income, a retiree may be able to delay filing for Social Security benefits until full retirement age or later, thereby increasing the amount that may be received in the future. Similarly, by accessing the equity in the home to satisfy current income needs, a retiree may be able to delay withdrawals from his or her investment portfolio, thereby giving it additional time to grow.7
To help satisfy other financial planning needs, securing a line of credit from the home may be more advantageous than taking current income payments. With a line of credit, borrowers will only owe interest on the portion of the credit line that has been accessed. As well, given that the credit line will grow over time by an amount comparable to the interest rate, a borrower may have access to a potentially larger line of credit – and larger income payments – to cover future needs.8 Additionally, during periods of market declines, the ability to generate income from a line of credit may help one avoid the need to make withdrawals from an investment portfolio when the value may be down.9
Some key considerations
While reverse mortgages can open the door to a new source of retirement income, as well as some potential retirement planning benefits, there are some things that potential borrowers may want to keep in mind before they sign on the dotted line.
For instance, as with traditional mortgage loans, there are fees and costs associated with reverse mortgages that include origination fees, closing costs and servicing fees, as well as the previously discussed insurance fee for HECM loans10, that when considered in aggregate, may be quite substantial. As well, interest accrues on the outstanding loan balance over time, thereby resulting in a growing balance that must be repaid when the loan is finally due.11 Consider as well that interest on the loan is not deductible year to year as is typically the case with traditional mortgage or equity loans. Instead, the interest is only deductible once the loan has been partially or fully re-paid.12
And what may become of a surviving spouse who was not a co-signer on the loan if the borrower passes away? In the past, the death of the borrower may have required a surviving spouse to sell the home to pay off the loan. Given some changes to the rules that have been implemented by HUD, however, a non-borrower surviving spouse may continue to live in the home as long as they continue to pay for the home’s taxes, insurance and upkeep, however no additional income will be generated from the loan. 13
Lastly, those planning to leave their homes to their heirs should carefully weigh the pluses and minuses of taking a reverse mortgage. As a reverse mortgage is a loan against the equity in the home, and must be repaid – likely with the proceeds from the sale of the home upon the owner’s passing - a large outstanding balance may leave little residual value that can be passed to one’s beneficiaries.
If you have questions as to how a reverse mortgage may be used to supplement your retirement income, or as a strategy for extending the life of your investment portfolio, please contact us. Together, we can review your individual needs, the potential benefits and shortfalls of a reverse mortgage, as well as any alternative strategies that may be available to you.
10, 11, 12, 13https://www.consumer.ftc.gov/articles/0192-reverse-mortgages
Apella Capital, LLC (“Apella”), is an investment advisory firm registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. No current or future client should assume that any discussion or information contained in this material will serve as the receipt of, or as a substitute for, personalized investment advice from Apella or your adviser. As with any investment strategy there is the possibility of profitability as well as loss. Please be advised that Apella does not provide tax or legal advice and nothing stated or implied in this material should be inferred as providing such advice.
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