Pfau: How to Manage Sequence of Returns Risk With Reverse Mortgages

High costs can still be an issue, he acknowledged, but he said it’s still worthwhile for potential borrowers to shop around. “Unfortunately, there’s no central clearinghouse type of service for comparing different options from different lenders, but the initial costs on a reverse mortgage can range from anywhere between $100 up to more than $10,000,” he said.

To qualify for a reverse mortgage, borrowers must be 62 or older, and have equity in their home. They must also prove that they’re able to pay property taxes, homeowners’ insurance and continued maintenance on the home.

Borrowers must also undergo a counseling session with an approved counselor, and an appraisal by the FHA on their home, which must be their primary residence. Assuming they meet those qualifications, borrowers can be approved for up to $625,500.

A reverse mortgage loan must be repaid when borrowers no longer meet these eligibility requirements, due either to their death or a move to a nursing home or assisted living facility.

Borrowers who take out an HECM can choose to take the payment as a lump sum; a tenure payment, which acts as an income annuity and provides a payment as long as they’re in the home and remain eligible; a term payment, which provides guaranteed payments over a set term; a line of credit; or a modified tenure or term payment, which carves off part of the line of credit for regular payments.

While interest rates are low, retirement is expensive because investments are generating lower returns. Still, Pfau identified two strategies that can use low interest rates to their advantage. One is delaying Social Security because it has a “built-in implicit rate of return of 2.9% after inflation. That’s better than you’re going to get on any sort of bond investment in today’s environment.”

The other is to open a reverse mortgage line of credit. “The amount you can borrow is essentially based on a present value calculation,” Pfau said. “The lower the discount rate, the lower the interest rate, the higher the present value.”

A lower expected rate means a larger initial principal limit that grows at a lower rate than if interest rates were higher. “To the extent that interest rates are low today, you get a bigger initial amount and then if we see any sort of mean reversion where eventually interest rates go up again, then the principal limit’s going to grow faster as well.”

Uses for Reverse Mortgages

Pfau identified four categories where reverse mortgages could be used depending on whether the client is trying to spend down credit or preserve it.

Clients can use the reverse mortgage in combination with their retirement portfolios to pay off an existing mortgage, fund home renovations to age in place or to use the HECM to buy a new home.

Clients can use the HECM to fund their retirement while their portfolios grow, but Pfau noted one risk with that strategy is that in low markets, their portfolios may not grow that much.

Clients can also use the HECM to improve retirement efficiency by taking tenure payments as an alternative to annuities, to support them while they delay Social Security benefits, or to cover taxes for Roth conversions or long-term care insurance premiums. However, “it’s important to not use it to fund a new [LTC] policy, but to keep paying premiums on a current policy,” Pfau warned.

Finally, an HECM can help preserve credit if borrowers open the reverse mortgage early but don’t access the line of credit until they deplete their retirement portfolio.

— Read “5 Critical Issues That Will Make or Break an Aging America” on ThinkAdvisor.