Home equity is destined to become an important source of funds for retirement, and the reverse mortgage is a product designed for this purpose. In this article, I’ll evaluate the reverse mortgage as a product for generating lifetime income, either directly or in combination with an immediate annuity.
The Need to Use Home Equity
For many older Americans, the equity in their home is their largest asset. Data from the Federal Reserve’s Survey of Consumer Finances shows that for individuals over the age of 65, home equity averages about 2 ½ times the amount of financial assets.
The Center for Retirement Research at Boston College has estimated that without tapping home equity, 61% of Americans are at risk of not being able to maintain their standard of living in retirement, and the trend is worsening. In a recent study they conclude:
“Not tapping home equity may be a luxury that future retirees can ill afford as Social Security replaces a smaller share of pre-retirement incomes and people rely increasingly on meager 401(k) balances rather than on traditional pensions.”
Retirees can generate funds from home equity by downsizing, or by borrowing against their home’s equity value. The reverse mortgage is a product specifically designed for retirees who wish to stay in their home and have access to its equity.
So far, reserve mortgages have been used by only about 2% of eligible homeowners. They have generated quite a bit of press coverage—some positive because the product meets a growing need, and some negative because of the high fees.
Reverse mortgage lenders offer a number of different ways to utilize home equity. Homeowners may take the loan in any of the following forms: as a lump sum advance, as a credit line account, or as a regular monthly payment that lasts as long as the owners remain in the home.
As a rule, the borrower is not required to make any repayments until he or she vacates the home. Proceeds from the sale of the home may used to pay off the loan balance. Any excess of realized sale value over the value of the loan goes to the homeowners or their heirs. Because the loan is non-recourse, the borrower’s obligation cannot exceed the home value, regardless of how long the homeowners continue to occupy their home.
|Quote from 3/20/10|
|Age of Youngest Owner||75|
|Advance or Credit Line Available||$162,915|
|Monthly Funds Available||$1,120|
|Variable Loan Interest Rate||2.73% + .5% mortgage insurance fee = 3.23%|
Here is a sample quote (3/20/10) from Wells Fargo, currently the largest reverse mortgage lender in the United States.
The “Advance or Credit Line Available” is significantly less than the home value because the loan balance grows over time with interest. Amounts available will vary inversely with current interest rates, and directly with the age of the owner.
The “Monthly Funds Available” is the annuity-like payment that owners can choose to receive as long as they remain in their home. The “Variable Loan Interest Rate” in this quote is based on a spread over Libor.
(Note: in examples that follow, I’ve used a projected 6.00% borrowing rate instead of 3.23%. Current rates are at historic lows, so I’ve based the examples on a rate more in line with past averages.)
Now for the scary news. Here are typical fees based on the above example.
|Origination Fee—paid to lender||2% of first $200,000 of home value, 1% above $200,000||$5,000|
|Closing Costs—paid for legal, appraisal, and other services||Similar to a conventional mortgage||$2,500|
|Mortgage Insurance Premium—Paid to FHA/HUD for guarantees||2% of home value + .5% of loan balance||$6,000 + .5% of loan balance (included in the 6.00% projected borrowing rate)|
|Servicing Fee-paid to lender for monthly servicing||$35 per month|
|Total Up Front Fees||$13,500|
The total fees are much higher than for conventional mortgages. Fortunately for borrowers, most of these fees can be financed and do not require up-front cash. One way to understand the impact of the fees is to look at the effective loan interest rate as a function of how long the homeowner stays in their home and keeps the reverse mortgage. This calculation is based on the cash the borrower receives and the loan amount paid back at maturity.
|Duration of Reverse Mortgage||Effective Interest Rate—Monthly Pay Mortgage||Effective Interest Rate—Lump Sum Mortgage|
|20 years (example when home value limits loan amount)||5.61%||5.56%|
The effective interest rates show the impact of the up-front costs. For example, a homeowner taking out a monthly pay reverse mortgage and keeping the mortgage for five years, would be effectively borrowing at a rate close to 15%.
However, for borrowers who stay in their homes for longer durations, the rates look much more attractive. The rates shown in the last line of the chart are based on an example where home prices increase 2 ½% each year and loan balances eventually bump up against home values, effectively lowering the borrowing cost.
The chart illustrates the point made by many loan counselors: that homeowners should not consider a reverse mortgage unless they expect to remain in their home for a long time.
The Lump-Sum/Annuity Alternative
It is almost never a good idea to borrow money to buy a financial product, but it may be worthwhile to consider taking a lump sum reverse mortgage to purchase an annuity that produces lifetime income. The type of annuity could be either an immediate annuity or a variable annuity with a guaranteed lifetime withdrawal benefit.
In the following example, a hypothetical 75-year-old woman owns a house worth $300,000 (mortgage-free). She would like to generate as much income as possible from the equity in her home. Based on the Wells Fargo quote (above), she could take out a reverse mortgage that would pay her $1,120 per month for as long as she stays in her home. Alternately, she could take the maximum lump sum, $162,915, and buy an immediate annuity (with no refund at death) that, based on Vanguard/AIG rates, would pay $1,281 per month, thus increasing her monthly income by $161.
As another option, she could buy a variable annuity with a guaranteed minimum death benefit. For a 75-year-old, the guaranteed withdrawal percentage would typically be 5%. Unfortunately, 5% would only generate $679 monthly, assuming she purchased the annuity and immediately began taking withdrawals.
Impact on Estate Values
Another important consideration is the impact on amounts left to heirs. The following chart provides a comparison of the three product options in terms of the estate values at different durations.
The estate value is the difference between the home value (assumed to increase 2 ½% annually) and the loan value, for both the immediate annuity and the reverse mortgage strategies. For the variable annuity strategy, the estate value also includes a projection of the growth of the assets in the VA account. The estate value cannot be less than zero.
Not surprisingly, the strategies that produce high monthly incomes produce the low estate values.
The difference between the estate values for the reverse mortgage strategy versus the immediate annuity strategy reflects the lack of a refund feature in the immediate annuity. (An immediate annuity with a refund feature would produce substantially less monthly income.) By contrast, the monthly pay reverse mortgage is like an annuity that pays a refund equal to the home’s net equity value.
The monthly reverse mortgage strategy does better than the immediate annuity strategy up to about age 90 in this example, so it is likely to be the favored strategy if the borrower has legacy interests.
The variable annuity strategy produces the highest estate values, but that’s primarily because monthly income is drastically reduced.
Present Value Measure
It is not straightforward to judge the tradeoff between monthly income and estate value, so the next chart uses present values to combine them into a single measure.
I used the 6.00% borrowing rate to calculate the present values. Based on this measure we can see that attractiveness of the immediate annuity strategy depends on longevity-early deaths are penalized, and long lives are rewarded.
The variable annuity strategy performs the worst under this measure. It is completely dominated by the reverse mortgage. (For variable annuity product charges, I assumed a total of 2.25% annually to cover product fees, investment expenses, and GLWB fees.)
For all three strategies there’s a change in tilt between years 15 and 20, which reflects loan values bumping up against projected home values.
These results will vary depending on choice of assumptions, but, nonetheless, I feel this analysis provides a reasonable comparison of the product alternatives.
Conclusions and Future Analysis
The key conclusions I draw form this analysis are:
- Despite their high fees, reverse mortgages can be attractive for individuals who plan to stay in their home for a long time.
- Effective borrowing costs are exorbitant for shorter-term loans.*
- The monthly pay reverse mortgage provides 10%-15% less income than using an immediate annuity, but provides substantially more value in the event of an early death.
- For maximum income if estate value is not a concern, consider taking a lump sum reverse mortgage and investing the funds in an immediate annuity.
- A strategy of purchasing a variable annuity with a guaranteed withdrawal benefit with a lump sum reverse mortgage does not appear competitive.
* Most reverse mortgages offered currently are under the HUD/FHA Home Equity Conversion Mortgage program, and fees are based on maximum allowances. If the market grows and become more competitive, products may become available with reduced up-front fees that will make them more attractive for shorter durations.
This article offers a start at analyzing the reverse mortgage as a retirement income product, but more research is needed. This analysis was done on a before-tax basis, and a more refined evaluation needs to consider tax effects.
It would also be useful to look at examples where the client has both housing wealth and other savings, and therefore more options in creating retirement income. This analysis can also be improved by developing stochastic forecasts to compare the risks in various strategies.
Such additional research can lay a foundation for incorporating the reverse mortgage product into financial planning software.
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