In an advertising campaign in the 1980s, Heinz ketchup used the slogan “Good things come to those who wait.” For your clients who are in their 40s or 50s and yearn to get a Home Equity Conversion Mortgage (or HECM, commonly called a reverse mortgage) loan, well, like the slow trickle of ketchup out of a glass bottle, they are going to have to let time do its thing and wait at least until they reach the minimum qualifying age of 62.
But let’s assume you have a client who is already 62 or better and wants to leverage his or her home equity one day via a reverse mortgage — should the wait to get one continue or is acting now the optimal strategy?
Conventional wisdom is that the later in life one takes out a reverse mortgage, the better. The strategy to delay goes hand in glove with the way most borrowers used to access their reverse mortgage loan proceeds: via a single-disbursement, lump-sum payment at closing — often done to address an urgent financial need after everything else has failed.
By contrast, many retirement researchers, like Wade D. Pfau, PhD, CFA®, and financial planners now recommend establishing a HECM line of credit at the first opportunity, for strategic financial planning purposes. This mindset shift is in part due to regulatory overhauls of the HECM product in 2013 and 2015 by the U.S. Department of Housing and Urban Development (HUD). The amendments are designed to help ensure that HECMs are a sustainable solution for the borrowers over a lengthy retirement period.
Today’s borrowers who are closing on their HECMs often have no immediate need for the funds. Now more than ever, applicants tend to be closer to age 62, and some may still be working. The line of credit is there to assist with future access to home equity as a non-taxable* source of retirement cash flow.
What Is a Reverse Mortgage?
While there are various types of reverse mortgages available, the Home Equity Conversion Mortgage (HECM) is by far the most popular option and the only one insured by the Federal Housing Administration (FHA).
A HECM is a home-secured loan that enables homeowners 62 and older to access a percentage of their home equity as cash, fixed monthly advances, or a line of credit. Unlike other types of home loans, reverse mortgages do not require the borrower(s) to make a monthly mortgage payment toward the loan balance, so long as a borrower lives in the home, maintains it, and pays the property charges, like taxes and insurance.
A HECM loan generally becomes due and payable when the home is no longer the principal residence of at least one borrower (e.g., the last surviving borrower passes away or permanently moves into a nursing home). The loan is usually satisfied via the sale of the home. The due and payable status of the loan may continue to be deferred under certain conditions when an eligible non-borrowing spouse is still occupying the home.
Why Waiting to Establish a Reverse Mortgage Doesn’t Pay
If you and your aged 62+ client have been doing some research on reverse mortgages, you both may surmise that waiting two, five, or however many more years to establish the reverse mortgage is the model for maximizing HECM loan proceeds. After all, as the years pass, your client will have paid down more of his or her traditional mortgage balance (if he or she has one), your client may qualify for a larger percentage of home equity (older applicants often qualify for more principal), and your client’s home may appraise for a higher value (property values tend to rise over time).
However, before your client hits the snooze button on that reverse mortgage application, you should consider the costs of waiting and the advantages of acting now. Here are three reasons why it simply doesn’t pay to wait:
- Waiting Longer Doesn’t Mean Your Client Will Have a Higher Principal Limit
The amount of money a borrower can borrow from a HECM is called the principal limit. Your initial principal limit, determined during the loan approval process, is a calculation based on three factors: 1) The age of the youngest borrower [or eligible non-borrowing spouse, if applicable]; 2) The expected rate on the loan; and 3) The lesser of the home value or the HECM limit (currently $970,800). The HUD provides HECM lenders with a HECM Principal Limit Factor (PLF) calculation table, which is used to calculate HECM proceeds based on the above factors.
Generally speaking, a younger borrower, a higher expected rate, and a lower-value home will have a lower principal limit than an older borrower, a lower expected rate, and a higher-value home.
So, increasing borrower age — achieved through the passage of time — is the only factor in the equation the borrower can control. What both the expected rate and the home value will be months or years down the road are two big unknowns that are driven by external market factors. If your client decides to wait and expected rates rise and/or home values fall, your client might not end up with that larger principal limit he or she desires.
Consider expected rates. On a fixed-rate HECM (only available for the single-disbursement, lump-sum payment option), the expected rate is the same as the interest rate. With the HECM adjustable-rate mortgage (only available for the fixed monthly advances and/or the line of credit payment options), the expected rate is 10-year Constant Maturity Treasury (CMT) plus the lender margin.
As you know, the interest rate environment changed dramatically in 2022. Higher inflation, which has been the Federal Reserve’s enemy in 2022, tends to mean higher interest rates. And, at least in the short term, the Fed appears poised to continue to raise rates in an effort to tamp down inflation.
If your client were to have delayed establishing a HECM line of credit in March 2022, he or she would have missed out on opportunity lock in his or her expected rate when the CMT rate was below 2.5 percent — the CMT rate has more recently trended above 3.5 percent.
To give some color to the effect of a rising rate environment, let’s plug in a hypothetical example. Let’s say Jane, a prospective 67-year-old borrower, in March 2022 started the HECM application process but decided to wait until July 2022 to move forward with it — when her age would round up to 68, to potentially secure more loan proceeds (based on the HECM PLF calculation). For simplicity, we’ll say that Jane’s home value of $500,000 stayed the same but the expected rate jumped a full percentage point, from 5.0% to 6.0%.
PLF (Expected rate is 5.0%)
AGE 67 44.50% of $500,000 home value = $222,500 principal limit
PLF (Expected rate increased to 6.0%)
AGE 68 40.20% of $500,000 home value = $201,000 principal limit
If Jane had waited to take out the reverse mortgage until her age rounded up to 68, she would receive a 4.30% lower principal limit than if she had taken the reverse mortgage out back in March 2022.
NOTE: Story is for illustration purposes only. The persons depicted herein are fictional and any resemblance to actual persons is a coincidence.
In short, if rates continue to go up, new applicants who wait to age may have access to less of their home equity.
Now let’s consider home values. Nationwide, on average, home prices have risen substantially over the past few years, which is wonderful news for today’s reverse mortgage applicants. It’s a safe bet that home values will continue to rise over the long term. But with mounting pressure on affordability posed by recent interest rate hikes and worries about a slowing economy, is the prospect of a near-term big drop in home prices on the horizon? Nobody knows for sure, but when your client locks in the current home value today via a reverse mortgage, your client can hedge against future falling home values and secure the principal limit.
- Waiting Sacrifices Compounding Line of Credit Growth
If your client takes out a reverse mortgage line of credit, he or she is not required to borrow any of the available funds — ever. Your client is not charged interest or fees on the available funds he or she doesn’t draw from the line.
Better yet, the unused portion of the line of credit actually grows over time. That means your client will have greater borrowing capacity as the months and years pass, regardless of swings in the value of his or her home. The unused portion of the line of credit grows at the same compounding rate (the interest rate plus 0.50%) as the loan balance. And any voluntary prepayments your client makes toward the line of credit loan balance increases his or her borrowing capacity dollar-for-dollar. That’s right, your client can borrow the paid-down amount again or leave it alone in the line of credit and watch it grow. When your client establishes a line of credit early and defers, or limits, its use, a rising interest rate environment can work to your client’s advantage, as his or her borrowing capacity will increase at a faster rate.
The sooner-than-later strategy with the HECM line of credit can give your client greater financial flexibility and security over a lengthy retirement.
- Enhance Your Client’s Cash Flow and Financial Strategies Sooner
A good retirement-income strategy combines the best retirement-income tools for meeting one’s goals while protecting against risk, like healthcare costs and downturns in the equity markets.
People are living longer, and retirees, without the stability of earnings by employment, must find a way to convert their financial resources into a cash flow stream that lasts for the remainder of their lives.
A reverse mortgage line of credit is ideal for financial planning purposes. It’s an additional cash flow stream that is not subject to income tax*. The available line of credit is liquid home equity — it can be borrowed, paid back, and borrowed again. And it is secure — it cannot be capped, reduced, or eliminated due to market conditions. And, as previously mentioned, the unused portion of the line grows over time.
Here are some ways you can help your clients to use a reverse mortgage line of credit:
- Work with your clients to coordinate between spending from their investments and their reverse mortgage — potentially better protecting their investment portfolio from market volatility. For instance, your clients could draw needed cash flow from the line of credit during market downturns instead of selling investments at depressed prices. This may give the portfolio time to recover and help you to extend the life of your traditional investments*. It can also help you to keep more of their assets under your management for a longer period.
- Use as a tax management tool to receive deductions when needed, to pay for Roth conversion costs, or to withdraw less from IRAs and other taxable sources*
- Use to pay for long-term care insurance (LTCI)
- Use to pay for aging-in-place home renovations to create a safer, more comfortable living environment
- Use to pay for health insurance while waiting for Medicare (62-65)*
- Use to free your client from the burden of fixed monthly mortgage payments by refinancing their traditional mortgage into a HECM
- Use to establish a rainy-day fund or to close gaps in their retirement cash flow
Is a Reverse Mortgage Right for Your Client?
With household budgets across the country being squeezed by inflation, rising interest rates, market volatility, and more, your clients may be worried about having to sacrifice the quality retirement they worked so hard for. Strategic use of home equity via a reverse mortgage, as part of a sound retirement plan, could put your clients on the path to a more flexible and satisfying retirement. With reverse mortgages in your financial planning toolkit, you can more fully serve the needs of your mature clients.
If you are interested in learning more about reverse mortgages, please reach out to a Fairway Independent Mortgage Corporation retirement mortgage specialist today.
*This advertisement does not constitute tax and/or financial advice from Fairway.
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