Ideally, a person would finance their retirement through a combination of fixed income (social security or pensions), individual retirement accounts (401k, IRA) and, if necessary, supplementary income from working, or even family support. However, as many retirees saw in the recent stock market downturn of 2008 & 2009, things don’t always work out this way. Fortunately, other options exist that provide retirees with ways to close the income gap (other than ‘starving’, an unpopular method.)
Home, sweet home
Most Americans have at least 50% of their wealth in their primary residences. Wouldn’t it be nice if, after working hard to pay down that mortgage, there was a way to use the value of your home as income? The simplest way is to ‘down-size’ by selling your home and moving to a less-expensive one, investing the difference to pad your retirement funds. While this may be great for a purely financial point of view, the obvious downside is the hassle and the emotional or practical undesirability of moving.
Home equity lines of credit (HELOC) are a way to use your home equity without selling your home. A private bank will loan you the money as an interest-bearing loan taken from your home’s equity (the difference between the house’s worth and the mortgage principal you owe.) You can then use that money for pretty much whatever you want, paying back the loan according to its terms. One drawback is that you can unwittingly take out too much, then have to either pay it back at an inconvenient time, go without income, or lose your home if you default on the HELOC. Additionally, your lender could freeze or reduce your line of credit if your home value declines. For the financially savvy (you!) there’s another way to get at that home equity in a less-risky fashion.
Enter the reverse mortgage
If you’re at least 62 years old, reverse mortgages, called Home Equity Conversion Mortgages (HECM) when sponsored by the Federal Housing Authority (FHA), allow you take either a lump sum, a line of credit, or fixed payments for a specified term or for as long as you live in your house. This last payment option, called ‘tenure’, seems the safest and most attractive from a retirement income perspective since your payments come monthly, keeping you from spending the lump sum too fast. However, all the HECM options keep you from losing your house as long as you stay in it. The loan is also ‘non-recourse’ which means the bank can only collect what is received from the sale of the home, and not any other parts of your estate, even if the loan is more than the value of your house when it’s sold.
From the FHA HECM site:
“A borrower cannot be forced to sell the home to pay off the mortgage, even if the mortgage balance grows to exceed the value of the property. A HECM loan need not be repaid until the borrower moves, sells, or dies. When the loan must be paid, if it exceeds the value of the property, the borrower (or the heirs) will owe no more than the value of the property, if they sell the property to repay the loan.”
Wait as long as you can, and take note of high fees
The positive from the fixed payment reverse mortgage option is that you receive constant income for life that can supplement social security and your (cracked?) retirement nest egg. The more equity you have built up in your home, and the older you are, the higher this reverse mortgage income will be. This is one reason why you should wait as long as possible before taking out such a reverse mortgage. Another is that you want to be sure you actually need to take out the loan. Reverse mortgages come with very expensive upfront fees, about 6-12% of the value of the loan.
Also, the amount you’ll receive will be much less than the total equity you’ve built up. This amount is usually a little more than half of your home equity. (The limit for FHA reverse mortgage loans is $625,000, even if your home is appraised much higher.) Using this calculator, a 75-year-old Seattle couple who owns their $400,000 house free and clear (no mortgage debt), could take out a lump sum of $202,424, or receive a fixed payment of $1,467 per month. They would also pay over $16,000 in fees (not to mention the interest that’s factored into the loan amount.) Remember: a reverse mortgage should only be used after other retirement options fail.
Note that the above numbers are based on current interest rates, and will vary over time. But, when a person actually initiates the fixed payment option in a reverse mortgage, that monthly dollar amount IS fixed over time, just like the payments you make on a regular fixed mortgage. Keep in mind, though, that the payments are NOT adjusted for inflation, hence the real value of your received payments will likely decline by about 3% per year on average due to rising costs of living.
The FHA HECM site on fees:
“Two mortgage insurance premiums are collected to pay for HECM: an upfront premium (2 percent of the home’s value), and a monthly premium (which equals 0.5 percent per year of the mortgage balance).
A lender can charge an origination fee up to $2,500 if the home’s appraised value is less than $125,000. If the home is valued at more than $125,000, lenders can charge 2% of the first $200,000 of the home’s value plus 1% of the amount over $200,000. HECM origination fees are capped at $6,000.”
Another negative is that your heirs will receive less due to the decrease in your home equity. If your kids are already set up independently by the time of your death, this may not be a big concern.
A reverse mortgage can keep your retirement moving forwards
The bottom line is that if you end up struggling in retirement, a reverse mortgage might be the best unconventional alternative to meeting your income needs. Fixed ‘tenure’ payments (or any combination of the other payment options) can be made to you for life without risking foreclosure on your home. Wait until you really need the costly loan before taking it. That allows you to build up equity (pay off your mortgage before reversing it for best results) and get older, both of which increase your monthly payments.
Of course, the best retirement solution is to avoid taking out expensive loans for your retirement. Instead, invest as much as you can for retirement before you get to it, defer retirement a few years if needed, find other (or increase) income sources, and live beneath your means.
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In addition to the FHA site linked above, here’s another handy reverse mortgage FAQ if you want to learn more.
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