What the Critics Get Wrong About (HECM) Reverse Mortgages

by Wade Pfau, 4/15/19

Press coverage around reverse mortgages has grown more positive in recent years as new research has helped to explain how they can improve the prospects of an overall retirement income plan. However, a lingering question remains about the costs of reverse mortgages. Costs can be high, which leaves people wondering how their benefits can be justified.

In isolation, reverse mortgages can look expensive, and one might question the motivations of those researchers who argue that reverse mortgages can add value. But reverse mortgages should not be viewed in isolation. They are a piece of a larger puzzle that retirees are trying to solve. Reverse mortgage costs can be offset by gains elsewhere in the overall financial plan. To show this, I’ll create an example to illustrate how a reverse mortgage, by protecting the investment portfolio in retirement, creates a net positive result despite its costs.

The power of a reverse mortgage to help preserve an investment portfolio in retirement can be viewed in any number of ways. For instance, a reverse mortgage could be used to refinance a traditional mortgage to avoid making mortgage payments in the key early years of retirement; it could be used to build a bridge to support the delay of Social Security benefits without taking excess distributions from an investment portfolio; or it could be used to coordinate distributions from an investment portfolio to avoid creating greater pressure on the portfolio when markets are looking bleak.

I’ll show an example of the last point, as this is where most of the research about reverse mortgages has focused, starting with Barry and Stephen Sacks’ seminal article1 on reverse mortgages published in 2012.

For the example, I’ll assume a 65-year old retiree who has $1 million in an IRA and a home worth $200,000. The home is fully paid off. She uses a 50/50 asset allocation, rebalanced annually and divided between the S&P 500 and intermediate-term U.S. government bonds. I’ll use historical market returns from 1966 to 1995. This is a valuable series of data to use because it was the years that gave the financial planning world the 4% rule-of-thumb for retirement spending. Over those years, one could withdraw just 4.038% of their retirement date investment assets and sustain that level of spending with inflation adjustments for 30 years without depleting the assets. I’ll also assume that the home’s value grows at the Case-Shiller Home Price Index returns over that period.

The idea is to treat the retiree as retiring at present and facing current rules and costs for IRAs and reverse mortgages, but we test their retirement with a market return sequence from the historical data. On the reverse mortgage side, because LIBOR rates are not available for this period, I will approximate them using one-year constant maturity Treasury rates and 10-year Treasury bond yields. The historical data for stocks, bonds and inflation are provided by Morningstar; the one-year Treasury rates are from the Federal Reserve; and the Shiller-Case home price returns and the 10-year Treasury yields are provided by Robert Shiller’s website.

In the first scenario, the retiree does not use a reverse mortgage. She takes a $40,388 dollar distribution from her $1 million IRA balance in the first year of retirement and adjusts those distributions for inflation in subsequent years over a 30-year retirement period. As this was the historical sequence that triggered the 4% rule, her IRA balance is reduced to $396 (effectively $0) after 30 years. Her home value has grown over retirement to be worth $992,270 at the end. The combined net worth she has created for heirs at the end of retirement is $992,666. The full details are provided in the Scenario 1 table below.

Scenario 1
Retiree does not use a HECM reverse mortgage

Age IRA Distribution HECM Distribution IRA Balance Home Value HECM Loan Balance Net Worth: IRA + Home – Loan
$1,000,000 $200,000 $0 $1,200,000
65 $40,388 $0 $933,846 $201,616 $0 $1,135,463
66 $41,741 $0 $1,003,574 $204,875 $0 $1,208,449
67 $43,010 $0 $1,035,488 $215,224 $0 $1,250,712
68 $45,040 $0 $944,689 $231,270 $0 $1,175,959
69 $47,792 $0 $990,489 $248,938 $0 $1,239,427
70 $50,416 $0 $1,048,322 $259,917 $0 $1,308,240
71 $52,110 $0 $1,116,456 $265,592 $0 $1,382,047
72 $53,887 $0 $1,009,175 $276,039 $0 $1,285,214
73 $58,629 $0 $851,784 $307,354 $0 $1,159,138
74 $65,781 $0 $962,972 $324,844 $0 $1,287,816
75 $70,393 $0 $1,056,412 $352,154 $0 $1,408,566
76 $73,778 $0 $954,285 $403,688 $0 $1,357,972
77 $78,773 $0 $919,506 $467,865 $0 $1,387,370
78 $85,887 $0 $927,526 $525,073 $0 $1,452,599
79 $97,318 $0 $981,016 $565,602 $0 $1,546,618
80 $109,385 $0 $891,416 $595,952 $0 $1,487,368
81 $119,165 $0 $967,284 $602,121 $0 $1,569,405
82 $123,776 $0 $969,696 $627,789 $0 $1,597,485
83 $128,480 $0 $926,558 $660,151 $0 $1,586,709
84 $133,555 $0 $1,001,127 $710,556 $0 $1,711,684
85 $138,590 $0 $1,007,487 $776,359 $0 $1,783,846
86 $140,156 $0 $902,588 $838,339 $0 $1,740,928
87 $146,337 $0 $842,880 $897,684 $0 $1,740,564
88 $152,805 $0 $844,584 $928,142 $0 $1,772,726
89 $159,910 $0 $707,131 $919,989 $0 $1,627,120
90 $169,681 $0 $661,091 $926,191 $0 $1,587,282
91 $174,873 $0 $522,344 $931,510 $0 $1,453,855
92 $179,944 $0 $378,746 $955,676 $0 $1,334,422
93 $184,893 $0 $190,141 $976,881 $0 $1,167,022
94 $189,829 $0 $396 $992,270 $0 $992,666

Next, in Scenario 2, she uses a reverse mortgage. In particular, at age 74, which corresponds to January 1975 in the series of market returns we are using, the retiree opens a reverse mortgage to cover age-74 spending. Her reasoning is that in the previous two years, the stock market dropped 15% and 26%, respectively. Her IRA balance is $851,784, down approximately 15% from its initial retirement level. With inflation, her age-74 IRA distribution would be $65,781, which is 7.7% of her remaining portfolio balance. This is getting to be on the high side and it would be nice to provide some relief for the investment portfolio during this stressful market period. I did not model the RMD, but if she does not have other IRA assets outside what we focus on, she could take her RMD and immediately reinvest it into a taxable account to keep the stock holdings intact.

Her home is worth $307,354 as she finishes her 73rd year. Her reverse mortgage will be based on the 10-year Treasury rate of 7.5% at that time, along with a 0.5% ongoing mortgage premium and a lender’s margin of 2.5%. The loan balance growth is based on the 0.5% mortgage premium, 2.5% lender’s margin and the variable one-year Treasury rate. The full retail fees to set up the reverse mortgage include a $5,074 loan-origination fee, a $6,147 upfront mortgage insurance premium and $2,500 of closing costs. This total of $13,721 in fees, which will surely create some “sticker shock,” will be financed into the loan balance of the reverse mortgage. As for spending, because reverse mortgage dollars are proceeds from a loan, they are not taxable income like her IRA distributions. Assuming a 22% marginal tax rate, she needs only $51,309 from the reverse mortgage to cover her age-74 spending, since the rest of the IRA distribution would be used to pay taxes. With fees, her total reverse mortgage spending at age 74 is $65,030. The Scenario 2 table below shows this analysis.

Scenario 2
Retiree uses a HECM reverse mortgage to protect investment portfolio

Age IRA Distribution HECM Distribution IRA Balance Home Value HECM Loan Balance (Amount Due) Net Worth: IRA + Home – Loan
$1,000,000 $200,000 $0 $1,200,000
65 $40,388 $0 $933,846 $201,616 $0 $1,135,463
66 $41,741 $0 $1,003,574 $204,875 $0 $1,208,449
67 $43,010 $0 $1,035,488 $215,224 $0 $1,250,712
68 $45,040 $0 $944,689 $231,270 $0 $1,175,959
69 $47,792 $0 $990,489 $248,938 $0 $1,239,427
70 $50,416 $0 $1,048,322 $259,917 $0 $1,308,240
71 $52,110 $0 $1,116,456 $265,592 $0 $1,382,047
72 $53,887 $0 $1,009,175 $276,039 $0 $1,285,214
73 $58,629 $0 $851,784 $307,354 $0 $1,159,138
74 $0 $65,030 $1,043,564 $324,844 $71,852 $1,296,556
75 $70,393 $0 $1,151,797 $352,154 $78,283 $1,425,668
76 $73,778 $0 $1,046,917 $403,688 $84,960 $1,365,645
77 $78,773 $0 $1,016,793 $467,865 $94,332 $1,390,326
78 $85,887 $0 $1,035,773 $525,073 $107,661 $1,453,186
79 $97,318 $0 $1,108,926 $565,602 $123,401 $1,551,127
80 $109,385 $0 $1,022,230 $595,952 $149,167 $1,469,015
81 $119,165 $0 $1,131,135 $602,121 $175,793 $1,557,463
82 $123,776 $0 $1,158,059 $627,789 $197,978 $1,587,870
83 $128,480 $0 $1,134,030 $660,151 $226,408 $1,567,774
84 $133,555 $0 $1,263,051 $710,556 $252,671 $1,720,936
85 $138,590 $0 $1,313,427 $776,359 $279,353 $1,810,432
86 $140,156 $0 $1,220,964 $838,339 $305,891 $1,753,412
87 $146,337 $0 $1,197,726 $897,684 $339,172 $1,756,238
88 $152,805 $0 $1,278,880 $928,142 $381,705 $1,825,317
89 $159,910 $0 $1,155,672 $919,989 $426,288 $1,649,373
90 $169,681 $0 $1,212,819 $926,191 $469,641 $1,669,369
91 $174,873 $0 $1,115,065 $931,510 $503,268 $1,543,308
92 $179,944 $0 $1,034,384 $955,676 $536,936 $1,453,124
93 $184,893 $0 $833,224 $976,881 $577,743 $1,232,361
94 $189,829 $0 $817,851 $992,270 $633,784 $1,176,336

By sourcing the age-74 retirement distribution from the reverse mortgage, the portfolio was protected from further decline at this key point in retirement. Rather than entering into a downward spiral that left the portfolio essential depleted by age 95 as in Scenario 1, the portfolio was able to recover in Scenario 2 and $817,851 remained at the end of the retirement horizon. The portfolio balance is $817,455 larger in the reverse mortgage scenario 2, and this portfolio gain has been the key benefit overlooked by those saying reverse mortgages are too expensive.

Meanwhile, the reverse mortgage loan balance does grow substantially throughout retirement. The loan balance grows to $633,784, which is nearly 10-times as large as the proceeds used. This is where opponents of reverse mortgages would step in and say they are too expensive.

However, money is fungible and we need to assess the household’s overall situation. Our retiree’s net worth is the IRA balance plus the home’s value, less the loan balance due, which is $1,176,336. This is $183,670 larger than the net worth in Scenario 1 without the reverse mortgage.

This is the key. If heirs wish to keep the home, they could repay the loan balance and still have $183,670 more left over as an additional windfall provided by this strategy.

Again, those only doing a partial analysis will focus on the reverse mortgage costs and conclude that the reverse mortgage is just too expensive. But even after repaying the loan balance, the net legacy value of assets is still $183,670 greater than in Scenario 1, which does not include the reverse mortgage. These gains are because the reverse mortgage protects the investment portfolio from incurring excessive distributions.

The reverse mortgage has helped to preserve a legacy for heirs. It must not be viewed in isolation, but rather as how it contributes to an overall plan. The value of the reverse mortgage can mostly be found in its diversifying benefits for investment assets in retirement. Taking distributions from investments can dig a hole that is hard to recover from, and wise use of a reverse mortgage protects the investment portfolio in retirement. Aside from pointing out relevant caveats, those writing negatively about reverse mortgages are treating them in isolation rather than viewing them as part of a whole financial plan. They are missing this value that recent research has clarified.

To learn more about reverse mortgages, please find the second edition of my book about them, which is available through Amazon.

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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