The Problems With Reverse Mortgages

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1 The Problems With Reverse Mortgages On Monday, we discussed the nuts and bolts of reverse mortgages. On Wednesday, Josh Mettle went into more detail with some of the creative uses for a reverse mortgage. Today s post is going to be more critical about them. Now, you need not assume by this post that I have anything against you using a reverse mortgage or that I think they are a bad product and those who sell them should get some cement shoes. If you truly understand how a reverse mortgage works and still want to use one, I don t have a problem with that. But one of the best ways to understand something is to see the problems with it. Then you can decide if those issues are a big deal to you or not. Home Equity Isn t Doing Nothing Perhaps the thing that bothers me the most about the reverse mortgage thing is the same thing that bothers me with those who advocate carrying a mortgage long into retirement and

2 using HELOCs for various purposes during your career. They like to sell this concept that home equity isn t doing anything. It s just sitting there being useless. I vehemently disagree. The home itself provides dividends. That dividend is saved rent. Technically, that home provides the same dividend whether the home is paid off or if you have a 100% LTV mortgage on it. So what the home equity itself is really doing is reducing your interest cost for that home. All the other expenses are precisely the same. If the home is 100% paid off, there is no interest cost. If you only have a little home equity, there is a substantial interest cost. The rate for that depends on your tax situation, but the return on your investment is your after-tax mortgage interest rate. Sure, that might not be a very good rate of return in comparison to the expected long-term return on riskier investments, but it certainly isn t zero and it is probably better than the guaranteed return on many low-risk investments. In addition, the paid off home eliminates a risk in your life- the risk of the home being foreclosed on if for some reason you can no longer pay the mortgage. That risk might not be very high, but it isn t zero. Bottom line: Home equity isn t doing nothing. A Reverse Mortgage is a Loan An important thing to understand about a reverse mortgage is it is a loan. With that loan, comes (almost) all of the problems with owing money to somebody else. These include having to pay interest, carrying the psychological burden of debt, and reduced future options. For example, if you borrow against something now, you can t borrow against it later.

3 In addition, a reverse mortgage isn t a particularly attractive loan. Not only is the interest rate 1-2% higher than a typical mortgage, but you can t even deduct the interest. You see, the IRS rules are that you can only deduct interest you actually pay. Reverse mortgage interest isn t paid until the home is sold. To make matters worse, the interest rate is generally variable. Now that doesn t seem like a big deal in times of low interest rates, especially for a short-term loan. But a reverse mortgage is not short-term (you hope). It s for the rest of your life. So when you signup for a reverse mortgage, you are committing to a highinterest rate, non-deductible, variable rate loan. That sounds kind of bad when you put it that way, doesn t it? A Reverse Mortgage is an Annuity In some ways, a reverse mortgage is also an annuity. Except it isn t a very good one. It doesn t really care about your gender or health status. It also doesn t guarantee to make payments until you die, even if you choose the tenure option. It only guarantees to make payments while you are living in your house. Want to move? Forget it, no more payments. Need to go to assisted living? There goes your house (unless you or your heirs pay off the loan) and your annuity payments. If you re not a big fan of loans, and you re not a big fan of annuities, you might not be a big fan of reverse mortgages, which combines the two concepts.

4 Reverse Mortgages Are Complex I m not a big fan of financial products I can t explain to a seven year old. Complexity generally favors the issuer and those who sell them. If you re going to bring me a complex product, its advantages better be so overwhelming that it makes up for the fact that I need an actuary to tell if I m getting a good deal or not. Mixing insurance and investing is usually a bad idea. Mixing home equity, an annuity, and insurance sure makes it hard to tell whether it is a good idea or not. You Only Get To Use Part of Your Home Equity Reverse mortgage- one way to spend home equity One of the things that bothers me about a reverse mortgage is that you only get to use part of your home equity. Given expected rates around 5%, that amount is 52%. But the expectation is that on average you will lose all or almost all of your home equity in exchange for it. If you really want to use your home equity to its maximum, sell the house, buy a SPIA, use part of the SPIA proceeds to pay the rent on a similar (or even the same) house and spend the difference on

5 something else. When you move out, you still get the SPIA payments. In Pfau s excellent Reverse Mortgages book, he shows how the tenure payment for a reverse mortgage is calculated. On a $500K house owned by a 62 year old, he calculates out a monthly payment of $1,498, assuming the upfront mortgage costs are paid from other resources. If you reduce the value of the house by 6% to account for realtor fees, a SPIA for a 62 year old male on $470K is $2,431, or 62% more. Now, granted the reverse mortgagee also gets to stay in the house, and that s worth something. However, he is also still responsible for the insurance, taxes, and maintenance that the renter would have covered by a landlord. A reasonable rule of thumb used by real estate investors is that the non-mortgage expenses on a rental property will be about 45% of the rent. Tricky comparison, right? Most 62 year olds aren t going to be able to do the math to really know which option comes out ahead, right? So they re not going to make this decision based on math. But guess who has done the math? The actuaries that work for the lender, and you can bet they re not going to lose money on the deal. High Interest Rates Make Reverse Mortgages Much Less Attractive

6 Platinum Level Scholarship Sponsor But wait, there s more. In Pfau s example, expected rates are quite low, so low in fact that the 62 year old was able to borrow 52% of the home equity as a reverse mortgage. At higher effective rates, such as 9.5%, that percentage falls to 15%. It s a lot less attractive to reverse mortgage your $500K house when all you get out of it is a loan for $75K. I think part of the interest in reverse mortgages the last few years is that the structure of a reverse mortgage makes it much more attractive in a period of low interest rates. While annuities become less attractive, reverse mortgages become more attractive with low rates. Conversely, as rates rise, you re probably much better off with a paid off home than a reverse mortgage. If your expected rate is 9.5%, a 62 year old can only borrow 15% of the home s value. Yet the estate might lose the entire value of the home at death. Does that sound like a good deal to you? I think I d rather give granny some spending cash myself and get 100% of the home s value when she passes. The Lender Can t Lose Another aspect of this that I don t like is that it is set up so the lender can t lose. The lender isn t making a bet that you re going to die soon. He doesn t come out any more ahead by you keeling over the year after you take out the reverse mortgage than 30 years later. His profit comes from the upfront fees, and if you include the investor in the securitized note in your definition of lender, from the years of interest. His downside is covered by the federal insurance fund. Guess who pays for that insurance? You did with the mortgage insurance. The reason you either put 20% down or used a physician mortgage when you bought your home was to avoid mortgage insurance. Yet now you want to buy it in retirement? Seems odd.

7 You want to know why lenders are so big on these? Higher fees, higher interest rate, higher closing costs, losses covered by mortgage insurance it is all good and no bad for the lender. In fact, there is so much potential bad in this for you that the federal government requires you to go to a counseling session provided by someone besides the lender before you can buy one. What other consumer products out there do you have to go to a government-mandated counseling session before you buy? A child? No. A firearm? No. A primary mortgage? No. A Roth IRA? No. Whole life insurance? No. But you do for a reverse mortgage. If that doesn t say Caveat Emptor I don t know what does. At any rate, when the lender can t lose in this deal, someone else has to, and that someone is you. (Okay, that s a little harsh. It could be a win-win deal, but it certainly isn t going to be a lose-lose deal, I can tell you that.) Be Realistic About Taxes Something that bothered me in Pfau s book was that he consistently used an example of a $500K paid-for house and a $1M investment portfolio. Yet he used a 25% marginal tax rate for that retiree. While I do not dispute it is entirely possible for a retiree with a $1M portfolio considering a reverse mortgage to have a 25% marginal tax rate, it seems rather high to me. The RMD on $1M at age 70 is $36K a year. That portfolio is likely not all tax-deferred. Some of it may be Roth and some of it is probably taxable. Let s say $500K is tax deferred. That s an RMD of $18K. Maybe they get another $30K in Social Security. But with only $18K in taxable income aside from Social Security, they don t pay taxes on Social Security. And they re in a low enough tax bracket that their dividends/capital gains rate is 0%. So how much federal income tax is this couple really going to pay? Nothing. 0%. Certainly not 25%. Now, I m ignoring state taxes as well, but even together it s pretty tough to get to 25% when your federal tax is so low.

8 Pfau also uses that same figure in his analysis of how using a reverse mortgage can make your retirement income spending more efficient, which obviously casts at least a bit of doubt onto those results as well. But instead of including the tax bill as part of the 4% withdrawal as I would expect, he adds it to the 4% withdrawal. So in those examples, the person without the reverse mortgage is withdrawing 5.33%. No surprise that there are a fair amount of scenarios where it doesn t work out well without tapping into additional resources like home equity. At any rate, when running your own scenarios when deciding to use a reverse mortgage, make sure you re being realistic about taxes. Taxes in retirement can be ridiculously low- no payroll taxes, much less income than during your peak earnings years, some of that income is taxed at capital gains rates, some (Roth) isn t taxed at all, and a progressive income tax system. The lower your effective tax rate, the less benefit you re going to have swapping interest for taxes. Tax-free sounds awesome, but just like with whole life insurance, taxfree but not interest-free isn t nearly as cool. The Cap Is Too Low To Move The Needle The other problem I have with a reverse mortgage for a doctor is the relatively low cap on the amount you can borrow. The maximum home value is $625K. And at best you re going to be able to use 52% of that, or about $325K. I don t know about you, but I plan to have so much money to retire on that $325K isn t going to move the needle for me. Most financially savvy docs I talk to project a financial independence number in the $2-5M range. At $2M, $325K is only 16% more money. At $5M, it s only 7%. At a certain point, it s no big deal to just have the house be part of my legacy. When you only have a $1M nest egg, that $500K home is a big part of your assets. When you have a $5M nest egg, a $500K house is not a big part of it, and even if you have a $2M house, you re only going to be

9 able to use $325K of it using the HECM program. The House Isn t Staying In The Family Platinum Level Scholarship Sponsor While technically you (and your estate) get to keep the title to the house, upon your death (or worse, your moving out before death) the loan becomes due. On average, that loan is going to be the vast majority of the value of the home. If the family wants to keep this house, they re going to have to come up with a lot of money in a hurry to do so. Now, if using this reverse mortgage really did make your retirement income strategy more efficient, maybe that can be paid out of your estate, but more likely, the family is going to have to give up a significant benefit such as a stretch IRA in order to keep the house. I would suspect that most of the time the house isn t going to stay in the family. That s not necessarily a big deal; I don t want my parent s house for instance, but if it matters to you, try to see the end from the beginning. Malincentive to Move Out An overlooked aspect of a reverse mortgage is the creation of a malincentive that otherwise wouldn t be there. Sometimes the

10 right thing to do is to downsize, move to assisted living, or move closer to family. If you have a reverse mortgage, particularly if you have chosen the tenure option, you have limited your options. As soon as you move out, the loan is due. You ve given up some future freedom when you took out the reverse mortgage. The Bottom Line If you understand the downsides of a reverse mortgage, and still find it attractive for your situation, feel free to go ahead and use it. There are a lot of different ways it can be used and there is no doubt that you can increase the maximum amount of money you can spend during your lifetime by using a reverse mortgage. However, you need to realize there is precious little free lunch here. Even when using it as a put option, there is still a price to be paid for that insurance. I doubt I ll ever use one, and I suspect most readers won t either. What do you think? Did I miss any downsides of a reverse mortgage? Would you consider one for yourself or a parent? Why or why not? Comment below! Reverse Mortgages- Has Anything Changed? Like whole life insurance, reverse mortgages and those who sell them have a terrible reputation among financially savvy folks. Over the last couple of years, I have run into people advocating their use, not just for the classic use of relatively house-poor people but even for the relatively well-

11 to-do. Some of these proponents claim that things are different now, and these aren t your father s reverse mortgage. Like with whole life insurance, the biggest advocates are those who sell the product, which results in a lot of hype and salesmanship. As Upton Sinclair said, It is difficult to get a man to understand something, when his salary depends on him not understanding it. This week, we re going to attempt to cut through the hype and salesmanship, explain how a reverse mortgage works, explain the reasons why a wealthy high-earner might want to consider it, and give some reasons why that might not be such a good idea. As I started writing this post, Josh Mettle sent me a lengthy guest post about reverse mortgages and subsequently a copy of Wade Pfau s excellent Reverse Mortgages book. By the time I finished the book, I realized this subject couldn t be covered in a single blog post (even Josh s mammoth 5000 word first draft he sent me), so we decided to run three this week on the subject. Today s post will be mostly a nuts and bolts explanation of how a reverse mortgage works. The other two posts this week aren t really a Pro/Con series, since Josh and I have somewhat similar opinions of the product, but since he is slightly more positive on the topic, I asked him to focus on the really cool uses of the product and I ll focus my post Friday on some cautions and other considerations with it.

12 The Too Long Didn t Read (TLDR) Version However, we both felt that in the continuum of financial products, reverse mortgages fit in somewhere around here: Right for Almost Everyone Roth IRAs Index Funds 5 Year Variable Refinanced Student Loan coupled with a willingness to live like a resident Single Premium Immediate Annuities Reverse Mortgages Longevity Insurance Long-Term Care Insurance Whole Life Insurance Loaded, Actively Managed Mutual Funds Right for Almost No one Reverse mortgages can be a great thing for the right person, and the percentage of people for whom it is a good idea is certainly higher than the 1% or so of doctors that whole life insurance is right for. How A Reverse Mortgage Works A reverse mortgage is a loan with some annuity-like features. It has some guarantees, backed first by the lender and then by

13 the government. There is a price to be paid for those guarantees. The bottom line is that a reverse mortgage is a way to use home equity for something besides providing a place for you to live and leaving your heirs a valuable asset. With reverse mortgages, or the government s favored term Home Equity Conversion Mortgage or HECM, there are Four Nevers : You NEVER give up title to your home You NEVER owe more than the home s value upon leaving the home You NEVER have to leave the home so long as taxes and insurance are paid and maintenance continues You NEVER have to make loan payments in advance of leaving the home unless you choose to do so While there are some private, jumbo reverse mortgages out there, the vast majority are done through FHA and the federal HECM program. You have to be both an eligible borrower and own an eligible home. An eligible borrower is at least 62 years old, is mentally competent, has equity in her home, has financial resources to cover tax, insurance and maintenance expenses, has no other federal debt, and has attended the mandatory counseling session. An eligible property must serve as a primary residence, meet FHA standards including flood requirements, pass an FHA appraisal, and be maintained to meet FHA health and safety standards. Note that the home does not need to be paid off. In fact, it doesn t even have to be bought yet. The Terms To Understand There are three terms you need to understand in order to get how a reverse mortgage works.

14 Diagnose your financial situation carefully before reverse mortgaging your house The first is the Principal Limit Factor (PLF). This is the percentage of home value that you can borrow out of the house and it ranges from 15-75%. That percentage is determined by your age when you take out the loan and by interest rates. At current interest rates, that percentage is 52% for a 62 year old and 75% for a 90 year old. As interest rates climb, the percentages fall. The initial loan amount is determined by multiplying the Principal Limit Factor by, well, the Principal. That s either the value of the home or the maximum of $625,000. So if you have a $500,000 home and a PLF of 52%, your maximum initial loan amount is $260,000. If you have a $1 Million home and a PLF of 60%, then your maximum initial loan amount is $625K*60%= $375K. If you re rich enough that an extra $375K isn t going to make any significant difference in your life no matter how it is used, you can stop reading right here, because that s about all you re going to get out of a HECM. The second term is the Expected Rate. This is the rate which is used to determine the PLF and is essentially your cost for borrowing the money. If you were able to borrow the entire principal amount when you originate the loan, and that

15 borrowed principal grew at the expected rate between origination and your moving out of the home or dying, then the loan would theoretically equal the home s value when you moved out of it. The expected rate is the sum of the 10 year LIBOR Swap Rate + a Lender s Margin. On the day I wrote this post, the 10 year LIBOR Swap rate was 2.48%. Add on a lender s margin of perhaps 3%, and the effective rate becomes 5.48%. On the day I wrote this post, 15 year fixed mortgage rates were about 3.3% and 30 year fixed mortgage rates were 4.2%. Obviously, the interest rates on a reverse mortgage are significantly higher than a regular mortgage. The third term is the Effective Rate. This is the rate at which the amount of money you can borrow against the home grows. That s right, that amount can change as time goes on. This rate is the sum of the One-month LIBOR Rate + Lender s Margin + Annual Mortgage Insurance Premium. Today s one month LIBOR Rate is 0.94%. If you add that to a 3% Lender s Margin and a 1.25% mortgage insurance premium, your effective rate would be 5.19%. This effective rate is all that matters once the loan is originated. This is the rate at which the loan balance grows AND the overall principal limit grows. This is a key point to understand. If you don t borrow out as much as you can in the beginning, the line of credit associated with a HECM will generally get bigger over time and given a long enough time period, may even exceed the value of the house, depending on the rate of appreciation of the house. How a Reverse Mortgage Ends When the borrower, or both borrowers, die or move out of the house, the loan must be paid back. The lender always gets their money. Typically, the house is sold. Whatever is owed is given to the lender and whatever home equity is left (if any) is given to the heirs. However, the estate and heirs can certainly pay off the loan and keep the house. If the value of the loan is larger than the value of the house, the government

16 insurance steps in and makes the lender right. What Has Changed? Gold Level Scholarship Sponsor There have been a few rule changes for reverse mortgages in the last few years. These have primarily been designed to help low-income seniors from being taken advantage of by unscrupulous lending agents. But they have not necessarily done much to make these products more attractive to retired high-income professionals. Here are some of the changes: # 1 Merged the higher cost product with the lower cost product. There used to be a Standard product with 2% Private Mortgage Insurance (PMI) and a Saver product with 0.01% PMI. Now there is just one product with 0.5% PMI. Unless you want more than 60% of the proceeds of your loan in the first year, in which case the PMI goes to 2.5%. But wait, you say. Why does the borrower have to pay PMI at all? The borrower doesn t have to make payments, so she can t default on the payments. PMI is supposed to protect lenders from the borrower defaulting on her payments. In reality, this is just a fee that comes out of your pocket and into the lending industry s. The theory is that it provides the money that the government uses to back

17 the lender in case your loan amount exceeds the value of the house. # 2 Financial assessment required. Apparently Congress got sick of hearing stories of people getting reverse mortgages who had no business getting them. So they made them harder to get. That s great for some, but doesn t do much for the high-income professional who wasn t going to default anyway. # 3 You can t borrow as much as you used to be able to. For a given age and interest rate, you can t borrow as much as you used to be able to. That s a bad thing if your goal was to use this as a put option on your house. # 4 Some borrowers forced to set aside part of loan in an escrow account. If your finances look sketchy to the lender, they can require you to set a bunch of the loan aside in an escrow account to pay your property taxes and insurance. Why is that a big deal? Almost 10% of reverse mortgage borrowers defaulted on their loans in 2012, despite the fact that they didn t have to make any principal and interest payments. They defaulted (and could be foreclosed on) because they couldn t pay the property taxes (not insignificant in expensive areas like New York) or the insurance (not insignificant in places where flood insurance is required like Florida.) The more money that must be set aside for taxes, insurance, and maintenance, the less you get to use for something else. That s it. Nothing else has changed. And none of those changes are beneficial to the high income professional with a nice nest egg who is now being pitched this product. The real change is in the target market. Instead of going after housepoor seniors, lenders see the opportunity to expand their

18 market dramatically by lending to financially stable folks with plenty of home equity. Larger loans = larger fees and more interest. How A Reverse Mortgage Can Be Used Gold Level Scholarship Sponsor There are lots of ways you can use a reverse mortgage. Here are some examples: 1. Buy a house for less than it s worth and never have to make a mortgage payment on it. The reverse mortgage is the mortgage. The loan amount is the difference between what you put down and what the house is worth. 2. Borrow as much equity out of the house as you can and spend it without having to worry about losing more than the house. 3. Get a reverse mortgage at age 62 but don t draw on it. Then, when markets are down, draw on the line of credit instead of selling your investments while their value is temporarily down. You can even pay the reverse mortgage back when markets are up if you want. 4. Get a reverse mortgage at age 62. Don t draw on it. If the principal limit grows to be larger than the value of your home, borrow the money out and invest it elsewhere

19 to leave more to your heirs. In this way, it functions as a put option. 5. Get a reverse mortgage at age 62 but don t draw on it. If you run out of other assets, then tap the reverse mortgage. If you never need it, you re only out the origination fees. You will likely have access to more money than if you waited until you were older to initiate the reverse mortgage. In this way, it functions a bit like an insurance policy. 6. Get a reverse mortgage and choose the term option. Like an annuity, you will get payments for a certain term of time. After that term, you can still stay in the house, but you won t get any more payments. A possible use for this is an 8 year term starting at age 62 which would allow you to delay Social Security to Get a reverse mortgage and choose the tenure option. This is a lot like an immediate annuity. It will pay you a set amount every month until you die or move out of the house. On Wednesday, Josh will discuss more of these creative uses of a reverse mortgage. On Friday, I ll issue a few cautions. What do you think? Have you ever considered a reverse mortgage? Why or why not? Comment below!