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The robust appreciation in the housing market, coupled with the decreased returns of most investment portfolios, has created a conundrum for many retirees who find themselves in the unique position of being house rich and cash poor. Many strategies can appear overwhelming and may not satisfy your client's most basic desires, so financial planners have revisited an old, abandoned strategy that has recently been updated for a new era of retirees: reverse mortgages. Today, the Federal Housing Authority has eliminated many undesirable provisions and created a much more balanced product. Although a relatively high cost should cause you to proceed with caution, under proper circumstances a reverse mortgage can provide the necessary cash flow and financial flexibility for your clients who are looking to remain financially independent in their own home, sweet home.

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The robust appreciation in the housing market, coupled with the decreased returns of most investment portfolios, has created a conundrum for many retirees who find themselves in the unique position of being house rich and cash poor. These retirees may have insufficient cash flow to meet their high monthly expenses, such as property taxes, and fear losing the family home. Their limited options include realizing their fears of having to sell the family home, transferring their home to their children, or using a home equity line of credit. Many of these strategies can appear overwhelming and may not satisfy your client's most basic desires, so we have revisited an old, abandoned strategy that has recently been updated for a new era of retirees: reverse mortgages.

Is a reverse mortgage the right option for your client? Let's take a look at the benefits and drawbacks.

Reverse mortgages were certainly a strategy we had removed from our tool kits. In the pre-government sponsorship days they were not an attractive option since the lender would receive most of the benefit, including closing costs, interest on the loan, frequently sharing in whatever appreciation occurred during the loan, and, in some situations, simply ended up owning the home. Today, the Federal Housing Authority (FHA) has eliminated many of these undesirable provisions and created a much more balanced product. In fact, we believe the improvements to reverse mortgages not only have made them an important option for the retiree wanting to save the family home, they can also be a useful strategy to replace income lost due to low interest rates, to provide additional income so as to avoid having to sell depreciated stock, to pay for long-term home care, and to buy long-term care insurance.

General Provisions

Our analysis will focus on the FHA-sponsored home-equity conversion mortgage (HECM) program, since many private and state government lenders will have different provisions that need to be considered on an individual basis. Portions of our discussion will be true of all reverse mortgage programs, but we recommend carefully studying each program to weigh its strengths and weaknesses.

A feature of the HECM program we find particularly attractive is that it provides financial independence for our clients, allowing them to retain ownership of the family home. Most retirees, particularly people from "the greatest generation," are not interested in receiving a hand-out. Many strategies, such as an intra-family sale to a child, can make the client uncomfortable with the loss of their financial independence; generally speaking, these issues do not arise with a reverse mortgage. In addition, in many reverse mortgage situations, they can keep the family home for their heirs, which is often a primary concern of retirees.

Perhaps the most substantial benefit is that the HECM program docs not require loan repayment until the last surviving borrower dies, the home is sold, or the borrower permanently moves out of the home. Thus, there is no increased risk of missing payments, or defaulting on the loan and losing the home, though the loans provide for default for circumstances such as failing to pay property taxes or failing to maintain the home. Another significant provision is that the HECM loans are non-recourse and, under certain payment options, the borrower can receive payments in excess of the home's value, though the borrower will never owe more than the home is worth.

Withdrawal Options

The HECM program offers borrowers several draw-down options that provide significant flexibility as to how they would like to access their cash. The withdrawal feature includes a lump sum, monthly payments, or credit-line option. The ability to opt in or out, or to combine any of these payment options, creates enough flexibility to satisfy any client's need.

Generally, we recommend the credit line to our clients since they can draw down on their credit limit only when needed. Another significant benefit of the credit line is that the amount available for borrowing grows over the life of the loan; it is increased by the interest rate charged on the outstanding loan balance. For example, if you started with a credit line of $100,000 with a 6 percent interest rate and withdrew $10,000, leaving a $90,000 balance, the balance would grow monthly by the 6 percent interest rate so that at the end of the next year, assuming no additional withdrawals, the new available balance would be $95,400.

The monthly payment option is an alternative for some who are looking for steady cash flow. It has two distinct payment options: tenure or term payment. The tenure payment is used much more frequently than the term payment and is very similar to a lifetime annuity. The FHA guarantees payments for the life of the surviving borrower, regardless of loan balance or home value. Thus, the borrower can receive payments in excess of the home value, a particularly comforting provision for most cash-strapped retirees. Note that when the last borrower dies, the loan becomes due and the amount received must be paid back by the estate, including closing costs and interest.

The term payment provides for a fixed payment over a specific term such as 10 or 15 years. We almost never recommend a term plan and, through our research, have found this to be an unpopular choice nationwide. Simply put, since a reverse mortgage is intended as a possible lifetime income solution and term payments have a "doomsday" date, the need to find a new source of cash upon expiration of the term would effectively rule out term payments. In theory, however, as discussed below, term payments can be combined with other payment choices to create a practicable option.

At first glance, the lump-sum option is attractive to retirees since it would provide them with the necessary capital for large expenditures such as vacations, remodeling, and weddings. But we discourage the use of a reverse mortgage for this type of expenditure as it is likely to create a cash shortfall for the retiree in the future, the very situation they are trying to avoid. On the other hand, this feature may become a necessity when the retiree is using the reverse mortgage to pay down existing debt on the home, as the FHA requires that the reverse mortgage be the senior debt on thehome. Therefore, all prior existing mortgages must be paid in full with proceeds from the reverse mortgage.

The borrower's ability to opt in and out of the withdrawal choices, coupled with the ability to combine the different options, is the feature that creates the greatest amount of flexibility. For example, a combination frequently used by retirees is a tenure payment with a credit line. This strategy permits retirees to have a monthly cash flow and a safety net of available credit to use for unforeseen expenses. Granted, the amount of monthly cash flow would be less than if the entire loan balance were put into the tenure plan, but the additional flexibility typically outweighs the downside. Another frequently used strategy is to initially start with a credit-line option to minimize the drawdown of credit. If over time it is determined the retiree needs a more constant stream of cash flow, a change could be made to a tenure plan or a tenure plan coupled with a credit line.

One alternative worth considering before deciding to engage in the reverse mortgage strategy is a traditional home equity line of credit (HELOC). A major benefit is that there are substantially lower closing costs (typically 1-4 percent) than reverse mortgages, while retaining some of the same flexibility. Certainly, a major risk of using a HELOC is that the borrower may use up all of the equity in their home and need to find an additional source of cash flow. But if over time it appears that the line of credit does not meet the client's needs, the client could then explore the reverse mortgage option.

Drawbacks

The most significant drawback of any reverse mortgage is the relatively high financing cost. Upfront cost for the FHA program can range from 6 percent to 12 percent of the amount borrowed; private loans can be even more expensive. Currently, the FHA requires the lender to provide a Total Annual Loan Cost (TALC) to the borrower to alert the borrower of the annual cost of the loan. But the TALC disclosures often can be more confusing than helpful when trying to determine the true cost of the loan. Generally, these calculations will be affected by the amount of time the retiree remains in the home and the value of the home over time. Obviously, as the amount of time spent living in the home and the value of the home increase, the annual cost decreases. The TALC calculations need to be carefully scrutinized in order to feel comfortable with the true cost of the loan.

Another drawback is the artificial limit that the FHA creates regarding the value of the borrower's home. Currently, the FHA creates a cap on home value of $312,895 in urban areas and $172,632 in rural areas. Thus, many borrowers will not be able to use the fair market value of their home in determining the loan amounts. Retirees whose home values are well above the FHA limits might consider a private loan in order to free up additional equity that may be used for borrowing. In addition, it should be noted that the youngest borrower must be at least 62 years old to qualify for the FHA program. But borrowers under age 62 might want to consider a private loan, as this age restriction may not apply.

Are these drawbacks significant enough to rule out reverse mortgages as a planning tool? Although the relatively high cost should cause you to proceed with caution, under the proper circumstances a reverse mortgage can provide the necessary cash flow and financial flexibility for your clients who are looking to remain financially independent in their own home, sweet home.

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[Author Affiliation]

William J. Supper, CFP®, is the director of financial planning for Massey, Quick & Company in Morristown, New Jersey. He is responsible for developing wealth strategies for high net worth individuals and can be contacted at bill.supper@massey quick.com.

Christopher R. Cocozza, CPA, J.D., LLM., is an assistant professor of business at DeSales University in Center Valley, Pennsylvania. His primary professional focus is providing tax planning strategies for retirees. He can be reached at crc0@desales.edu.