The HECM reverse mortgage is a fantastic home loan product, but it’s not the right solution for everybody (nor does everybody qualify, anyway).
What does the ideal reverse mortgage candidate look like? Who is the program most ideally suited for? I’ve helped many seniors get reverse mortgages over the years and I’ve concluded that the ideal candidate fits one of two profiles.
But before I dig into what an ideal candidate looks like, let me first cover a few basics about what a reverse mortgage actually is. There is a lot of misinformation floating around about reverse mortgages, so I want to cover a few of the basics first. If you’re already familiar with the basics, feel free to skip farther down into the article.
How a reverse mortgage works
The reverse mortgage is probably the most misunderstood mortgage product out there. Even financially savvy people often get the basics wrong.
The most common reverse mortgage product in the United States today is the home equity conversion mortgage, or HECM (often pronounced heck-um by industry insiders). If somebody you know recently got a reverse mortgage, it’s likely they got a HECM.
The HECM program was signed into law by President Reagan as part of the Housing and Community Development Act of 1987. Today, the program is overseen and regulated by the Federal Housing Administration (FHA) under the authority of the Department of Housing and Urban Development (HUD).
The HECM is designed to give homeowners aged 62 or older access to a portion of their home’s value without a mortgage payment or giving up ownership of the home. As long as at least one borrower is living in the home and paying the required property charges, no mortgage payments are required.
You always remain the owner of the home and you’re free to leave it to your heirs, who will inherit any equity remaining in the home.
Because the HECM is a home loan, interest accrues on the money borrowed. If no mortgage payments are made (which is the whole point, right?), interest simply accrues onto the loan balance over time.
HECM interest rates are usually pretty comparable to 30-year rates for traditional “forward” mortgages.
The HECM is a non-recourse loan, which means the most that will ever have to be repaid is the value of the home. If the home isn’t worth enough to settle the entire balance, FHA will cover the shortage out of the mutual mortgage insurance fund.
Reverse mortgage proceeds can be received as a line of credit, lump sum, monthly term or tenure payments, or some combination of all. The HECM is very versatile and can be tailored to your financial goals.
HECM borrowers commonly use the proceeds to eliminate existing mortgage or other debt payments, finance home improvements, or supplement retirement income and/or assets.
Non-ideal reverse mortgage candidates
Before I dig into what an ideal HECM candidate looks like, let me first address who the non-ideal candidates are. In my opinion, there are four:
- Those who lack financial discipline. The reverse mortgage can be a hugely beneficial life raft for seniors who have run into hard times through no fault of their own. However, it’s not a good solution for those who lack financial discipline. The financially undisciplined senior may reap some benefit from the reverse mortgage – at least for a while – but they’ll likely just end up back in the same bad spot later. And they’ll have less equity in their home to boot.
- Those who want to leave the maximum amount of equity to their children. If you want to leave the most equity you can to your kids, then a reverse mortgage obviously is not the right solution.
- Those who plan to sell the home in the near future. If you plan to sell the home in the next few years, it’s better to avoid the reverse mortgage for now. You can always get a reverse mortgage when you’re permanently settled in your new home.
- Those who have a disabled relative living with them. A reverse mortgage may not be a good fit if you have a disabled relative living in the home who can’t care for himself. Remember, once the last borrower passes away, the reverse mortgage has to be paid in full. If that particular individual doesn’t have the means or ability to pay off or refinance the reverse mortgage balance, they’ll have to move out of the home.
The ideal reverse mortgage candidate
Though a HECM reverse mortgage can help a wide range of people, the ideal candidate fits two profiles in my opinion:
- Profile #1: Homeowners who owe little to nothing on their homes and don’t need the money right now.
- Profile #2: Homeowners who have mortgages they’ll likely never pay off and don’t care about leaving equity to heirs.
Let’s dig a little more into how a reverse mortgage can help both of these candidates.
Profile #1: Owes little to nothing on the home and doesn’t need the money right now
In my opinion, this is the ideal reverse mortgage candidate. They’re financially stable, don’t need the money right now, and owe little to nothing on the home. For this candidate, the reverse mortgage supplements existing retirement assets and/or provides a safety net.
For this candidate, I usually recommend taking proceeds in the form of a line of credit. The beauty of the line of credit is that it essentially turns a portion of the home’s value into a tax-free retirement “account” that automatically grows larger over time.
The reverse mortgage line of credit is very similar to a traditional home equity line of credit (HELOC), except that no payment is required and the money doesn’t have to be paid back as long as program obligations are met (live in the home and pay required property charges).
The best part is that the unused credit line will automatically grow and compound larger with no limit based on an annual growth rate.
To see how the growth rate works, let’s take a look at an example. Let’s assume you qualify for an initial credit line amount of $75,000 and the annual growth rate is 5%, which is very reasonable for today’s market. As you can see in Figure 1, your line of credit will have grown to over $95,000 after just five years. After ten years, it will be worth over $122,000.
Because the growth rate applies to your available line of credit, growth compounds on growth. This means that the available credit in absolute dollar terms can really add up over time.
The growth rate will also keep up with prevailing interest rates. If interest rates rise in the future, the growth rate will as well. This means your line of credit will grow even faster.
There is no limit on how much the line of credit can grow, so it’s possible it could outgrow the value of the home. Remember, the HECM is a non-recourse loan, which means the most that will ever have to be repaid is the value of the home. FHA will cover any shortage if the home isn’t worth enough to settle the entire balance.
Profile #2: Has a lot of years left on the mortgage and doesn’t care about leaving equity to heirs
Many seniors have refinanced in recent years to take advantage of low interest rates and reduce their monthly payments. The problem, however, is that they’ve reset the clock on their mortgage payoff. Most seniors looking for a lower payment usually opt for a 30-year loan, which means their mortgage probably won’t pay off until sometime in the 2040s.
This begs a few important questions: what’s the point of paying on a mortgage you may never pay off anyway? If you have no plans to sell your home and you don’t care how much equity you leave to your heirs, why not get rid of the mortgage payment and improve your monthly cash flow?
The senior who doesn’t plan to sell, has a lot of years left on the mortgage, and doesn’t care about leaving equity to heirs is also an ideal candidate for a reverse mortgage. Why not refinance the existing mortgage with a HECM and get rid of the mortgage payment? That frees up cash that can be used for more important things.
To see how this works, let’s look at an example. Let’s assume we’re working with a 72-year old borrower named David who has 26 years left on his 30-year fixed mortgage. David knows he’ll likely never live long enough to pay off the entire mortgage balance, so he wants to use the HECM to get rid of his $703/month principal and interest payment.
Let’s also assume that David qualifies for a reverse mortgage principal limit of $159,750, which is just enough to cover his existing mortgage balance, closing costs, and leave him with a few hundred dollars in incidental cash.
The interest rate on the new reverse mortgage is 5.32%. When the annual mortgage insurance of 0.50% is added, the total interest rate adds up to 5.82%. Again, this is a reverse mortgage, so no monthly payments are required. Any unpaid interest simply accrues onto the loan balance over time.
Let’s fast forward ten years and see how things are going for David. Assuming rates haven’t changed and David hasn’t made any payments on the balance (the whole point, right?), the HECM balance will have grown to $287,972. As you can see, David’s added almost $136,000 to his loan balance. This might sound awful at first blush, but don’t forget that David hasn’t made a single mortgage payment for ten whole years. He’s kept a whopping $84,360 in his pocket that otherwise would have gone to his mortgage lender.
Instead of throwing $84K at a mortgage he’ll likely never pay off, David’s been able to spend that money on grandchildren, home upgrades, cruises, etc. Yes, he’s added a lot of dollars to his loan balance, but he’s not worried about that because he has no plans to sell. It doesn’t matter how much equity he has, because he’ll never sell and cash it out. It’s more important to maximize his monthly cash flow so that he can maximize his monthly lifestyle. Getting rid of the $703 mortgage payment was like getting a $703 monthly raise. For him, that was a huge game changer!
A reverse mortgage isn’t right for everybody
A HECM reverse mortgage isn’t the perfect solution for everybody, but it’s a fantastic program for the right candidate. If you owe little to nothing on your home and don’t need the cash right now, take full advantage of the HECM line of credit. It can add potentially tens or hundreds of thousands to your liquid assets.
If you’re more like profile #2 and have many years left on the mortgage, don’t plan to sell, and aren’t concerned about leaving equity to your heirs, then get rid of the mortgage payment! What’s the point of paying on a mortgage you may never pay off anyway? Get rid of the mortgage payment and use the savings for more important things.