The Retirement Safety Net You’ve Foolishly Dismissed
Managing Editor’s Note: Reverse mortgages are a touchy subject. Many retirees see them as a viable income solution… but not all experts agree. Marc Lichtenfeld railed against their costs and consequences a few weeks ago. He thinks they’re too big to ignore. But Steve McDonald disagrees. He says a reverse mortgage can be a “lifesaver” should things head south. Check out Steve’s rebuttal below. And watch Marc and Steve face off on the matter next Thursday in a special edition of Wealthy Retirement.
If you’re a longtime reader, you probably know that I never recommend taking on debt in retirement. Just a few weeks ago, in one of my Two-Minute Retirement Solution segments, I highlighted the benefits of paying off your mortgage early.
Reverse mortgages may be the one exception to my rule. In fact, for a rising number of baby boomers, they offer a viable solution to retirement funding problems.
For years, reverse mortgages were ignored by most financial advisors. They were considered only as a “last resort” for folks who didn’t plan or save for retirement. But new regulations have put a whole new face on this income idea.
Reforms implemented thanks to the Reverse Mortgage Stabilization Act of 2013 educate and protect borrowers so they can make more informed decisions. These changes could very well move reverse mortgages from “poor cousin” status to the forefront, as a retirement funding tool.
A Major Overhaul
The biggest change is the amount of equity borrowers can access in the first year. It is now limited to 60%. It’s a safety valve.
This change was likely driven by the incredible amount of second mortgage borrowing we saw prior to the 2008 collapse.
The other key change driving popularity is that borrowers must demonstrate their ability to pay the taxes and insurance on their homes. This measure should help prevent folks from defaulting on loans they cannot afford.
If used properly, the cash from a reverse mortgage can be a lifeline for those caught between zero interest rates and monthly bills that just don’t go away. Reverse mortgages aren’t for everyone, but in some situations they’re a safe option that makes a lot of sense.
For example – this one’s a huge eye-opener – you can use the equity in your home to pay off an existing mortgage or make your monthly mortgage payment. Sixty percent of reverse mortgages are used to pay off existing mortgages.
Weigh the Benefits
If you’re carrying a mortgage into retirement, you know what a burden that monthly payment can be. So getting out from under it can be a big relief.
A reverse mortgage allows you to use the equity in your home to pay off the balance you owe. That way you have no monthly payment. And you don’t settle up with the lender until you sell the property (or until your family sells it after you’ve passed away).
It also makes perfect financial sense (to me) to use a reverse mortgage as a line of credit. In this case, it can back up your investments during down market periods.
If you rely on your investment returns to pay your bills, an extended bear market can turn your retirement plan on its head. Having to withdraw money when your holdings are down locks in losses and leaves less money to generate income and grow when the market rebounds. It’s a double whammy you must avoid, if possible.
Instead, use the cash from a reverse mortgage to avoid selling in a down market. Once the market turns around, you can withdraw from your investment account (without locking in losses) to pay back the amount you used from the reverse mortgage. Or you can let it ride and settle up when you sell the house.
In this third scenario, you use the income from a reverse mortgage to help pay your bills while you delay taking your Social Security benefits.
Delaying until full retirement age allows you to claim your maximum Social Security benefit. But most boomers can’t afford to delay because they don’t have the cash to pay their bills.
A reverse mortgage may not be the whole answer, but it could help. The income it provides could help you delay until age 70, in which case you’d receive 75% more monthly Social Security income than you would at age 62.
A Disciplined Approach
But what’s most surprising is that reverse mortgage income is not taxable because it’s considered a loan. So you can also use the cash from a reverse mortgage to delay taking taxable distributions from your retirement accounts.
And most borrowers (those who take out a government-backed Home Equity Conversion Mortgage) will never end up on the hook for negative equity. If the balance on your reverse mortgage grows to exceed the value of the home or if your home’s value drops, the federal insurance covers the difference.
But, as with all loans, you have to be disciplined about how you use the money. If you’re not careful, this solid solution can create a lot of problems.
You shouldn’t use a reverse mortgage to buy another home, take a vacation or purchase a new car. You also shouldn’t use it to invest or finance more debt.
Keep in mind that reverse mortgages aren’t cheap. As with all mortgages, you’re charged interest on the total loan amount and you pay an insurance premium.
A reverse mortgage offers you the unique ability to use equity from your home without selling it. And you can think of the insurance requirement as a safeguard against surprises.
You have to weigh the costs and benefits in order to determine whether a reverse mortgage works for your situation. If it does, and if you have the discipline to manage the cash wisely, it can be a lifesaver.
If you haven’t saved enough or can’t get by in this low-yield environment on your investment returns alone, a reverse mortgage may be the lifeline you’re looking for.