Why Larry Kotlikoff Changed His Mind on Reverse Mortgages
The retirement expert was skeptical of these loans but now thinks retirees should give them a second look.
Reverse mortgages are a controversial source of retirement cash flow. The loans come with high fees, can place a burden on heirs and can be a vehicle for unscrupulous lenders to defraud seniors.
But others liken it to an annuity that provides free rent long after the house is paid off. This group includes economist Larry Kotlikoff, who was a guest on a recent webinar discussing reverse mortgages.
A onetime opponent, he now has changed his mind.
“I was always very skeptical, probably because [RMs] seemed complicated and I always worried about the issue of people having to move and having to pay back what I thought was going to be a big bill,” Kotlikoff said in the webinar. “[However] the median home equity of people 65 and older is about $150,000 [and] that’s a big number compared to their net worth.”
With a RM, that “trapped” home equity can be utilized.
Morningstar’s director of retirement research, David Blanchett, was equally positive: “Conceptually, they (obviously) make a lot of sense,” he told ThinkAdvisor in an email. “The home is one of the largest assets for many retirees, and therefore being able to utilize that asset to fund retirement spending is something that should be considered, especially since it enables the retiree to live in the house” for the rest of their life.
Only about 3% of retirees currently use reverse mortgages and 5% plan to in the future, making them the least common source of retirement income, Blanchett says, citing the Society of Actuaries 2015 Risks and Process of Retirement Survey. (Those numbers barely budged in the 2019 survey.)
Pros and Cons
To do an RM, clients must be 62 or older and have 50% equity in their home (for a government-protected RM). Yet they still own their home, and they must pay taxes, insurance and upkeep on the home.
Tom Dickson of Financial Experts Network, who hosted the webinar, pointed out some other positive RM aspects.
- An RM allows a client to convert that home equity, or “trapped equity,” into tax-free cash.
- The most popular form of RMs (99%) are those backed by federal government. For couples, only one partner must be 62 or older to qualify. Those age 60 and older can qualify for proprietary reverse mortgages (or jumbo RMs).
- Single-family homes, condos, townhomes and 2-4 unit apartment buildings (with owner occupying one unit) are eligible. The home must be a primary residence.
- No monthly payment is required.
- This is the only residential loan that comes with non-recourse protection, usually a factor in commercial loans. For example, a couple lives in a home until they die. When their heirs sell the home for more than what it costs to pay off the RM, they keep the proceeds of the sale. If the RM is larger than what they can sell home for, the heirs (or even homeowners if still living) would not be responsible for making up that deficit — that’s where the Federal Housing Administration comes in.
Also, RMs come with some safeguards:
1) If the client wants to repay the loan at any time, there is no additional cost;
2) Neither owner or their children will ever owe more than the house is worth;
3) Those considering RMs must receive counseling from an unbiased, FHA-approved third-party counselor;
4) The lender evaluates borrowers’ ability to pay taxes and insurance;
5) Origination fees are regulated by the government.
How Much Can a Reverse Mortgage Borrower Get?
How much a client is qualified for depends on multiple factors:
- Appraised value of the home (the FHA lending limit varies by county but tops out at $822,375), multiplied by the principal limit factor (derived from the age of the youngest borrower) multiplied by interest rate (determined by margin plus CMT, or constant maturity Treasury, index). Owners should get at least three interest rate estimates.
- For example, a 62-year-old with a $400,000 home could borrow about $191,763, depending on interest rate. In this case it was 2.32%.
- In today’s low interest rate environment, there is an inverse relationship between interest rates and how much clients qualify for.
How do Reverse Mortgage Payouts Work?
Payouts can happen in four ways: monthly payments for life, lump sums, monthly payments for a fixed period, or as a line of credit.
Also, the owner will always get the original value of the loan, even if the home value declines — for example, if the neighborhood starts to go downhill due to location or climate change (fire or rising sea level) .
Further, after the loan is paid out, the owner still can live in the home rent-free.
Blanchett noted that “Considering [RMs] as a potential asset will obviously improve any kind of retirement scenario (free money!), but many retirees view the home as an asset of last resort (e.g., for health care expenses) and a bequest to pass down to heirs, so effectively ‘selling it’ isn’t something many are interested in considering.”
(Pictured: Larry Kotlikoff)