Reverse Mortgages: A Valuable Financial Planning Tool

Home equity can play a vital role in a financial plan. Home equity is commonly categorized as a future cash lump-sum resulting from a home downsize later in life. The lump-sum is then earmarked as an emergency fund or converted into retirement income. This binary approach to home equity involves potentially extreme lifestyle changes and the necessity for weighty decisions at older ages. An alternative is the Home Equity Conversion Mortgage (HECM), which adds a broad array of solutions to retirement planning.

 

Home Equity Loan and Line of Credit

 

One option for a homeowner needing supplemental funds is to borrow from accumulated home equity. A home equity loan is usually a fixed rate over a set term and is distributed in a single lump-sum. Monthly repayments include both principal and interest. This type of loan is ideal for large one-time expenses, such as home improvement. The predictability of a fixed rate and monthly payment can be budgeted easily into monthly cash flow.

Conversely, loans that are second mortgages tend to have higher rates with less flexibility. Once the loan is issued, the entire loan must be repaid before additional funds can be borrowed. A significant risk of home equity loans is home collateralization. If payments are not made, the home will be foreclosed.

A home equity loan can also be taken as a line of credit (HELOC). The HELOC is a flexible borrowing option in which funds are drawn as needed. Interest is assessed only on the amount borrowed and the cost of securing the HELOC is low. This is attractive for a retiree who has concerns about large expenses, such as long-term care. Payments reduce the outstanding line of credit, providing renewed funds for borrowing. A HELOC that has not been used, however, is subject to being pulled by the lender if the home value declines.

 

Downsizing

 

At younger ages, larger homes are often bought to raise children or for entertaining. A large home or yard may become too maintenance-intensive later in life, motivating an elderly homeowner to downsize or move to a retirement community. Ideally, the substantial home sale proceeds allow the homeowner to buy a retirement home outright with a residual cash balance. The homeowner then spends the rest of their life in a comfortable, manageable home without a mortgage payment. This strategy's setback involves difficulties of leaving a home filled with family memories, adapting to less space, or having to build a new social and medical network.

 

Reverse Mortgage

 

An approach to home equity borrowing is the Home Equity Conversion Mortgage (HECM), also referred to as reverse mortgage. Reverse mortgages allow homeowners age 62 or older to borrow home equity as a cash lump-sum, line of credit, monthly income for a specified number of years, a guaranteed lifetime monthly income, or a blend of these options. The homeowner maintains occupancy and title to the home during their lifetime. Unlike Home Equity Loans or HELOC, repayments are not made until the home is sold or the borrower dies. The provision of receiving funds or income without required immediate repayment positions the reverse mortgage as an attractive retirement planning tool for the right client.

Available strategies using reverse mortgages are extensive. Retirees with limited cash flow can eliminate monthly mortgage expenses by drawing from equity via a reverse mortgage. Once the mortgage is paid in full, cash flow frees up. If additional liquidity is needed, the remaining credit line can be taken as a lump-sum or income stream. For retirees with sufficient cash flow who have concerns about unknown future expenses, a HECM line of credit can be established. Whether the line is used or not, the retiree has peace of mind if portfolio assets are depleted due to devastating unexpected expenses. Origination costs are higher than a HELOC, but a HECM line of credit differs in that it is non-cancellable by the lender upon a home value decreases. HECM line of credit amounts increase over time.

Income strategies using HECM can be beneficial to retirees. One of the more common uses of a reverse mortgage in retirement planning is the monthly income generation to supplement Social Security. If lifetime payments received exceed the value of the home when the homeowner dies, the excess debt is forgiven (p. 86). Also, monthly payments from home equity provide a level income stream, shielding from negative stock market returns (p. 88). Distributions from investment portfolios fluctuate with market movement and are at risk of depletion, while HECM income is fixed and guaranteed for a specified period, or life.

Reverse mortgages have inherent risks that must be considered. The costs are higher than traditional mortgages. The estate value may be reduced or eliminated for the heirs. A client who chooses against downsizing may have challenges aging in a home that requires much maintenance or has stairs. Thus, it is imperative that the client thoroughly understand the benefits and the risks clearly before engaging in a reverse mortgage.

Paul and Christine's home is paid off in eleven years. Upon retirement, a HECM line of credit could be considered for future unexpected expenses or portfolio losses. The cost is minimal to establish, is non-cancelable, and the available credit line will increase over time. Their retirement income will come partly from their investment assets, which are subject to market volatility. Establishing an income stream from a HECM line of credit provides predictability and safeguards against future financial pitfalls. If they end up not needing the funds, they can stay or move to a new home.

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