With more baby boomers moving into retirement every day, the wealth locked up in their homes seems ripe for the picking. And a relatively new way to put that wealth to work–the standby reverse mortgage strategy–is garnering increasing attention. Some researchers say the strategy can increase the longevity of a retiree’s portfolio by opening the door to an income source to tap in an emergency.
The standby strategy puts to use some of the reverse mortgage’s quirky features to provide a flexible pot of money to help manage cash flow. First, the retiree takes a reverse mortgage as a line of credit. Any unused balance grows at the same rate being charged on the line of credit.
If a borrower receives a $100,000 line of credit at a 5% interest rate but doesn’t tap the funds, that line of credit would grow to $105,000 after a year and then about $110,000 the next year, and so on. “The idea is to set up the line of credit early and let it start to grow,” says Wade Pfau, a professor of retirement income at the American College of Financial Services and author of Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (Retirement Researcher Media, $20).
This effectively allows you to create a ready source of cash if you need it. The money isn’t taxable, so you can cover a major expense with no ill effect on your tax bill. That might protect some of your Social Security benefits from being taxed or prevent you from going over the income threshold that triggers Medicare premium surcharges. If you tap the line in an emergency, you can pay the loan back without penalty when you are able to restore your borrowing power.
The reverse mortgage can play a role in the bucket approach to retirement portfolios, the strategy that calls for keeping a couple of years’ worth of income needs in cash, with two or more buckets holding more volatile investments. The idea is that you routinely sell assets from the other buckets when it’s time to replenish the cash.
But what if the market has taken a beating just when you need to sell? Tapping your reverse mortgage to refill the cash bucket could give your stocks time to recover. When stocks are back up, you could pay the line of credit off, to use for another rainy day.
Experts applaud the way a standby reverse mortgage strategy can provide retirees the flexibility to handle emergency costs. “The concept is to use it judiciously,” says Peter Bell, president of the National Reverse Mortgage Lenders Association.
You could use the line to pay off lumpy expenditures, such as a car repair bill or a large medical bill. “It’s a little bit like a home equity line of credit, which is good for cash flow management,” says Steven Sass, a research economist for Boston College’s Center for Retirement Research. “But you don’t have to pay it back. You do have to pay back a HELOC.” That gives you flexibility if you run into a cash crunch and can’t pay back the amount you borrowed right away.
You must be age 62 or older to get a reverse mortgage, and the amount you can borrow is based on several factors, including your home’s value, your age and current interest rates. The younger you are, the lower the percentage of the home’s value you can borrow, but the more years your line of credit could grow if left untapped.
The line can remain untapped for as long as the borrower likes. “It’s possible for the line of credit to exceed the value of the home,” Pfau says. Federally backed Home Equity Conversion Mortgages are “nonrecourse” loans–borrowers never owe more than the home is worth. No payments are due while the borrower is living in the house. The loan comes due in full when the borrower moves out for 12 months or more, sells the house or dies.
Rates Ripe for Reverse Mortgage Borrowing
Low interest rates are generally a negative for retirees seeking income. But “the reverse mortgage is the only retirement strategy where you’re better off when interest rates are low,” says Pfau. The lower the rate, the more of your home’s value you can borrow.
Perhaps counterintuitively, impending rate hikes actually boost the attractiveness of the standby reverse mortgage strategy because lines of credit carry variable interest rates that will climb as interest rates rise. And, the higher rate will apply to your unused balance to boost your borrowing power. The ability for the credit line to grow is a key advantage of the strategy. Interest rates for a reverse mortgage recently ranged from 3.38% to 3.53%.
The costs of taking a reverse mortgage have come down in recent years, which helped the standby strategy gain traction with retirement experts.
When shopping, ask about the origination fee, which the government limits to a maximum of $6,000. You may find loans with zero to little origination fees, but the interest rate will be higher in that case. That’s a trade-off: You’ll get less proceeds up-front with a higher interest rate, but the unused line of credit will grow at a faster rate. Other typical loan closing costs generally run about $2,000 to $3,000.
You will owe the annual insurance premium of 1.25%, as well as an up-front premium of 0.5%. (If you have to access more than 60% of your proceeds to pay off an existing mortgage, that up-front premium jumps to 2.5%.) But the annual premium is based on how much you actually borrow from the credit line, not the full line of credit.
Of course, any loan means you’re putting your collateral at risk. You must maintain the home and keep up with property insurance and property taxes. Fail on those fronts, and you risk a loan default, which could lead to foreclosure. If you use up all the proceeds from the reverse mortgage, you won’t be able to tap the home for cash again unless you’re able to pay off the line of credit. This strategy “needs to be part of an overall responsible plan,” Pfau says. “If the person will spend anything they have, it could be a problem.”
Copyright 2017 The Kiplinger Washington Editors
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