Reverse Mortgage First or Last Resort

Use home equity from a reverse mortgage first or as a last resort
The flexibility of the Home Equity Conversion Mortgage (HECM) program provides seniors and retirees some different retirement income strategies using a reverse mortgage. Borrowers can choose to receive their reverse mortgage proceeds as a series of monthly payments, a line of credit, a lump sum or a combination.

One of the debates among reverse mortgage proponents is whether retirees are better off using a reverse mortgage as a last resort if they deplete their other assets or to use it upfront as a way to supplement their assets to help them last longer.

The answer to that question isn’t an easy one to answer. The better option will depend on a variety of factors, including economic factors and the individual needs of the retiree in question.

To gain a better understanding, Wade Pfau, professor of retirement income atThe American College and director of retirement research at McClean Asset Management, ran multiple simulations for a report titled “Incorporating Home Equity into a Retirement Income Strategy.” His simulations included various scenarios for future movements of 10-year bond yields, equity premiums, home prices, short-term interest rates, and inflation.

Using hypothetical retirees with a $1 million investment portfolio invested half in stocks and half in bonds and a $500,000 home, the report showed the probability of having enough money for retirement assuming a 4 percent after-tax initial withdrawal rate.

Each of the reverse mortgage strategies tested had at least a 50/50 likelihood of the retirees having enough assets to last for 35 years in retirement. However, the strategy with the lowest probability of success was using home equity from a reverse mortgage as a last resort. This is essentially the convention use of a reverse mortgage whereby retirees deplete their investment portfolio, then obtain an HECM line of credit.

Only slightly better was a strategy of using an HECM line of credit first. Under this option, a retiree would open a line of credit at the start of retirement and use those funds until they deplete the credit line.

The best choice according to this report is to open an HECM line of credit right away, but not accessing it until one’s investment portfolio is depleted.

Growth features on HECM credit line
This last strategy effectively takes advantage of a growth feature on HECM credit lines.

HECMs use a variable interest rate formula to determine the amount of interest that accrues over the life of the reverse mortgage. Lenders typically use the London Interbank Offered Rate (LIBOR) Index to determine variable loan rates. This index reflects the rate at which banks borrow money from other banks. The U.S. Treasury Index is also commonly used.

Reverse mortgage lenders will then set a margin above the index percentage to determine the variable loan rate. Once the margin is set, it cannot change for the life of the loan.

For example, a lender may set its margin at 2 percent. If the LIBOR Index is 2.5 percent, the variable loan rate charged during that period will be 4.5 percent (2 + 2.5). If the LIBOR Index rises to 5 percent, the reverse mortgage interest rate will also increase, to 7 percent.

Once the initial line of credit is determined — based on the value of the home and the age of the borrower — it grows automatically at a similar variable rate. The growth rate is equal to the lender’s margin, plus the 1.25 percent mortgage insurance premium assessed on loan plus subsequent values of one-month LIBOR rates.

So if the lender’s margin was 2 percent and the LIBOR index value was 1.5 percent, the bank would add the 1.25 percent MIP to create a credit line growth rate of 4.75 percent (2% + 1.5% + 1.25%).

In some cases, the line of credit can grow as much as 5 percent annually. That means if you started with a line of credit of $200,000, in a year that credit line would be $210,000, assuming you did not withdraw any of the available funds.

Because of this feature, many seniors with enough equity in their homes will take out a reverse mortgage line of credit as soon as they’re eligible at age 62, with the idea of only using the funds when a need arises and letting the line of credit grow.

A hypothetical example
Say you are 62 and owe nothing on your home currently valued at $300,000. Based on your age and current rates, you can establish an HECM line of credit totaling about $148,000.

Now, assume you decide you don’t need a line of credit right away and wait ten years. Also consider that your home increased in value by around 2 percent annually, which means it would be worth about $370,000. If rates didn’t change, based on your age, your line of credit would be worth about $208,000.

But what if you decided instead to take out the line of credit immediately at age 62 even though you didn’t “need it.” Based on the current rates, the growth rate on the line of credit is projected to be about 4.5 percent annually. So in 10 years, the $148,000 credit line would grow to almost $230,000.