A reverse mortgage is a powerful financial tool because it brings home equity into the retirement planning picture. In this article, I want to lay out my own reverse mortgage retirement plan.
If you’re like many people, you may be surprised that I’ve included a reverse mortgage in my retirement plan. After all, aren’t reverse mortgages just for broke and desperate people? Aren’t they just a loan of last resort for those with no other options?
Fortunately, the reverse mortgage is not what it used to be. It has evolved significantly over the years, but the negative perception remains.
When people learn how today’s reverse mortgage works, they’re often pleasantly surprised. They’re surprised that many of the negatives they’ve heard are overblown or simply aren’t true. They’re also surprised when they see how a reverse mortgage can positively impact their retirement lifestyle and financial security.
The problem with home equity
According to US Census Data, the average American 65-year-old in 2019 had a household net worth of $268,700. Of that, $182,000 was home equity. As you can see, home equity is a significant part of the average retiree’s net worth.
Now, think about your home equity for a moment. How much does it impact your day-to-day life? Probably not much, right? After all, home equity isn’t liquid. You can’t trade it for a vacation, home upgrades, or critical medical care.
Whether your home equity equals $5 or $500,000, it’s just a number on paper. Here’s a case in point: there are seniors living paycheck-to-paycheck in the San Francisco Bay Area with free and clear homes worth over a million dollars. They’re technically millionaires, yet they’re barely scraping by on a meager Social Security check.
Yes, home equity is a good thing, but it has no practical impact on your retirement lifestyle unless you can convert it into cash.
In the past, there were just two ways to convert home equity into cash: 1) sell your home, or 2) do a “cash out” refinance. The first option obviously makes no sense if you want to continue living in your home. The second option sometimes makes sense, but it comes with the downside of a monthly payment.
Fortunately, there’s a third and better option: the reverse mortgage. A reverse mortgage enables retirees to tap into home equity without the pitfalls of selling or taking on a mortgage payment. As we’ll see, this adds a powerful weapon to the retirement planning arsenal.
Reverse mortgage basics
Before I lay out my strategy, let me first cover the basics and dispel a few common misconceptions. The reverse mortgage is a highly misunderstood product.
The most popular reverse mortgage in America is the FHA-insured home equity conversion mortgage, or HECM. If you’re at least 62, a HECM enables you to convert a portion of your home’s value into cash.
No mortgage payments are required as long as you live in the home and pay your property taxes and homeowners insurance.
You always remain the owner of your home, which means you’re free to leave it to your heirs. Your heirs will inherit any remaining equity in the home.
The HECM is a non-recourse loan. FHA covers the shortage if you owe more than the home is worth at the time of repayment.
HECM proceeds have no impact on income taxes, Medicare, or Social Security retirement benefits.
My reverse mortgage retirement plan: the home equity retirement “account”
The HECM line of credit is similar to a HELOC but without the pitfalls and risks. HELOCs can be risky for retirees because they’re typically interest-only, have adjustable rates, and can be taken away with little notice. Even worse is the recast, which can cause payments to double or triple when the draw period ends.
The HECM line of credit lacks the risks of the HELOC. Again, you don’t have to make payments and you’ll never lose your credit line as long as you remain in good standing. But here’s the best part: the available credit grows and compounds over time with no limit, unlocking more equity automatically.
Basically, my reverse mortgage retirement plan is this: maximize growth by getting the line of credit early in retirement and leaving it untouched for as long as possible. This strategy works best for retirees who are at least reasonably financially stable, owe little to nothing on their homes, and don’t need the proceeds right now. This is not a strategy for the broke and desperate.
To see how the growth works, let’s assume a retiree named Tina is 62 and has a free and clear home worth $450,000. Let’s also assume Tina qualifies for a total of $191,000 from the HECM.
Closing costs vary significantly, but let’s assume they add up to $16,000 for this example. Yes, that’s a significant chunk of money! But it’s also far cheaper than selling and moving or paying a mortgage payment for the next 30 years.
The largest portion of the closing costs is usually the FHA initial mortgage insurance premium, or IMIP. IMIP is important because it helps make the HECM non-recourse.
The good news is this: you don’t typically have to pay the closing costs out of pocket. Most lenders are happy to roll them into the starting loan amount.
Ongoing costs include interest and the 0.5% annual mortgage insurance premium (MIP) charged by FHA. MIP also helps make the HECM non-recourse.
Let’s assume the interest and annual MIP add up to a total of 5%, which is reasonable for today’s market. If you don’t make any payments (the whole point, right?), interest and MIP simply accrue onto the loan balance.
Once the closing costs are paid, Tina is left with a HECM line of credit starting at $175,000. The growth rate on the line of credit always equals the interest rate plus the MIP, so it too is 5%. Interest and growth rates can change over time, but we’ll assume they stay the same for simplicity.
If Tina leaves the line of credit untouched for one year, it will grow to $183,953 – an increase of almost $9,000. The loan balance would grow to around $15,636 because of the accrued interest and MIP.
If Tina leaves the line of credit untouched for five years, it will grow to $224,588 – an increase of almost $50,000. The loan balance would grow to around $19,170.
After a decade, Tina’s line of credit would grow to $288,227. That’s over $288K of tax-free cash available with no mortgage payment for home maintenance, travel, or expensive long-term care. Her loan balance would be just $24,602.
As you can see, the HECM line of credit essentially turns a portion of Tina’s home equity into a liquid and growing retirement asset. Tina now has more money to live on, which helps protect her lifestyle and financial security.
A powerful retirement planning tool
A reverse mortgage can powerfully enhance your retirement plan by adding home equity to the picture. Home equity no longer has to be a nice-to-have, but mostly unusable, asset. Thanks to the reverse mortgage, you can use your home equity to increase your financial security and preserve your other retirement assets for longer.
My reverse mortgage retirement plan is pretty simple: do exactly as Tina did. My goal is to pay off the house by my early 60s, set up a HECM line of credit, and leave it alone to grow and compound for as long as possible.
If you’d like an estimate of how much you can get from a reverse mortgage, check out our reverse mortgage calculator.