All of this may sound too good to be true, and it probably is to some extent. Perhaps this is why it is difficult to grasp the concept of line of credit growth throughout retirement. I’ve already noted that unused lines of credit work for borrowers to the detriment of lenders and the government insurance fund. Such use of a reverse mortgage still exists today and would be contractually protected for those who initiate reverse mortgages under the current rules. At some point in the future, I expect to see new limitations about line of credit growth, especially as more people start to follow the findings of recent research on this matter.
I had written the above paragraph in the first edition of my book on reverse mortgages (page 72). So it goes with government-administered programs; financial planners use their acumen to find uses and strategies that government policymakers do not anticipate.
It happened with Social Security in November 2015, when sophisticated claim strategies were phased out in response to financial planners catching on about how to obtain additional spousal benefits.
And then it happened following a series of rule changes to the reverse mortgage program in October 2017. Based on a series of articles published in the Journal of Financial Planning since 2012, financial planners saw how setting up a growing line of credit with the home equity conversion mortgage (HECM) program offered invaluable options for building more efficient retirement-income plans. The rule changes throttled the value of those strategies.
The updated rules about this prompted a need to write a second edition for my book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement, sooner than I expected. That second edition was released earlier this year and is available from the link on this page.
For those who initiated reverse mortgages prior to rule change, the old rules still apply. However, the situation changed significantly for new loans after that date.
Where do we stand one year removed from these changes?
Overview of the rule changes
The new HECM rules reduced some of the momentum and value from reverse-mortgage line of credit uses. Under the new regime, it is a tougher psychological hurdle to open a reverse mortgage before it is needed in order to begin the line of credit growth process. Up-front costs are higher with the increased initial mortgage-insurance premium, and the line of credit now grows more slowly due to a smaller ongoing mortgage insurance premium. More specifically, the new reverse-mortgage rules include:
- The initial-mortgage insurance premium when opening a reverse mortgage is now 2% of the home value up to the $679,650 (as of January 1, 2018, and subject to change) lending limit. This has changed from a previous dueling-premium approach that depended on the amount borrowed in the first year; it was 0.5% if less than 60% of the allowed borrowing amount was taken in the first year and 2.5% if more than 60% of the allowed borrowing amount was taken in the first year.
- The ongoing mortgage-insurance premium on the loan balance has been reduced to 0.5% from the previous 1.25%.
- A new table of principal-limit factors was issued, and these generally result in a reduced initial borrowing amount with the reverse mortgage, at least when interest rates are low.
- The floor on the expected rate used to calculate initial borrowing amounts on a reverse mortgage was reduced from 5.06% to 3%, which does have some interesting implications in our low-interest-rate environment.
Are reverse mortgages still a viable planning option?
The line of credit does indeed remain as a viable option and use for a reverse mortgage. I determined that as a part of updating my Monte Carlo analyses about reverse mortgages uses when revising my book to account for these new rules.
Actually, as a part of updating my book, I also shifted the focus and emphasis slightly. Setting up lines of credit for future use was never the most popular way to use a reverse mortgage. People generally open reverse mortgages because they wish to spend the proceeds sooner rather than later.
Refinancing a traditional mortgage into a reverse mortgage to reduce the fixed payments in the early years of retirement has been the most popular use for a HECM reverse mortgage. Arguably, the new rules have made using a reverse mortgage in this way more attractive, especially when the remaining mortgage to be refinanced is a larger percentage of the available reverse-mortgage proceeds. The initial mortgage insurance premium actually decreased from 2.5% to 2% in those higher utilization cases, and loan balances will now grow at a slower rate with the lower ongoing insurance premium. Borrowers are also aided through the fact that the changing rules have pushed lenders to lower their margin rates within the loans.
Most of the research about reverse mortgages, though, has focused on coordinating retirement spending with a reverse mortgage used as a buffer asset. Buffer assets are resources not correlated with financial markets that can be drawn from on a temporary basis to avoid selling assets at a loss as part of funding a retirement spending goal at times when markets are down in value.
In updating simulations for the new book edition, I found that these coordinated strategies can be made to work. A spending goal can be supported with a higher probability of success using coordinated strategies with a reverse mortgage, compared to leaving home equity as a last resort to consider when all else has failed and the investment portfolio is depleted. This is true net of reverse mortgage costs. Legacies are protected through the synergies created by preserving the investment portfolio through stressful market events.
More generally, there are numerous potential ways that a HECM reverse mortgage can be used within a retirement-income plan, which I have vetted through Monte Carlo simulations. In thinking of an organizational framework, strategies may be ordered from those that spend available credit more quickly to those that open the line of credit as a type of insurance backstop that may never need to be tapped. Accelerated uses include a tool to coordinate retirement housing, such as by refinancing a traditional mortgage or by funding home renovations to support aging in place. Again, for these types of uses, the new reverse mortgage rules may actually lead to better client outcomes.
Next, one can use the HECM to reduce portfolio distribution needs by using the reverse mortgage as a buffer asset to spend from when the portfolio is down in value. As for strategies to enhance retirement efficiency, a reverse mortgage could be used to support delaying Social Security benefits, to manage the marginal tax bracket, to pay the taxes on Roth conversions or to maintain long-term care insurance policies after premium increases. Finally, a reverse mortgage can be used as a source of liquidity and reserves to support spending shocks or if the investment portfolio depletes late in retirement.
The bottom line
Conventional wisdom is to treat the home as a reserve asset that can be sold to support long-term care needs. Otherwise it is the source of legacy. Through Monte Carlo simulations focused on meeting financial goals in retirement using the available client assets, I have provided quantitative assessments to compare this conventional wisdom to other reverse-mortgage strategies to view of the overall impact on the retirement-income plan.
I find that financial advisors who maintain the conventional wisdom about reverse mortgages as only being worthwhile as a last resort should instead give them a second chance by updating their due diligence. The conventional wisdom is changing. This is outlined in greater detail in the second edition of my reverse mortgage book.
Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D. program in financial services and retirement planning at The American College in Bryn Mawr, PA. He is also a principal and director at McLean Asset Management and the Chief Planning Scientist for inStream Solutions. He actively blogs at RetirementResearcher.com. See his Google+ profile for more information.
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