Replacing Your Mortgage with a Reverse Mortgage
Originally published at Forbes
After my recent overview of potential uses for a reverse mortgage, I want to go deeper on each item. The first set of options for a reverse mortgage uses the available credit more quickly, either to pay off an existing mortgage or to purchase a new home. With these strategies, it is possible to look at using outside resources to avoid borrowing more than 60% of the initial principal limit during the first year of the loan. Using outside sources could mean the difference between paying a 0.5% initial mortgage insurance premium, and a 2.5% premium. For a $500,000 home, that difference means $10,000 of additional costs for exceeding the limit.
With regard to using a reverse mortgage primarily as a way to pay off an existing mortgage, the general idea is that doing so will create more flexibility for distribution needs from the investment portfolio by removing a fixed expense from household budgeting. During pre-retirement, it is common to not pay off the mortgage more quickly than may otherwise be possible because of the hope that investment returns can outpace the borrowing costs on the mortgage.
Those with sufficient risk tolerance may wish to continue with this approach post-retirement, but this proposition becomes riskier due to the heightened sequence risk that amplifies the effects of investment volatility when retirement begins. As well, a changing tax situation with the loss of wages and the dwindling size of the remaining mortgage balance in retirement may mean that any potential tax deductions for mortgage interest may be lost, resulting in less being saved on taxes. Meanwhile, reduced pressures on withdrawals from the portfolio help to reduce exposure to sequence of returns risk.
With the reverse mortgage used to pay off the existing mortgage, one could voluntarily proceed with making the same monthly payments on the loan balance of the reverse mortgage to reduce it and increase the amount of growing credit line for future use. But this is not necessary, and these repayments could be made more strategically at times when markets are performing well and then stopped at times when it would be necessary to sell assets at a loss to make payments. With a traditional mortgage, stopping payments in this way is not allowed, and it can trigger foreclosure for a reason which is not possible with a reverse mortgage.
The benefit of replacing a mortgage with a reverse mortgage, then, is the reduced exposure to sequence risk. However, it is also important to note that the growth rate on the reverse mortgage loan balance could exceed the interest rate on the pre-existing mortgage, especially if interest rates rise from their current levels. You would have to balance the tradeoffs between the increased flexibility and reduced cash flows to be supported earlier in retirement, against the possibility that the final legacy value for assets could be hurt if the HECM loan balance is not repaid for many years.
Whether the final legacy increases or decreases with the reverse mortgage used in this way would also depend on the performance of the investment portfolio, which required less distributions, leaving assets with more time in the market. This is an area which remains ripe for further research.
Related to housing, another potential use for the reverse mortgage is to make home renovations which can better allow for aging in place. This can reduce the need to move to a more institutionalized setting, or to at least delay this move, later in retirement. Home renovations made with a reverse mortgage could include many of the ideas mentioned before, such as adding a walk-in bathing facility on the first floor of the home or creating a ramp entrance to the home.