Are Reverse Mortgages Expensive— Especially For Those Who Don’t Need Them?
MAR 31, 2021 11:13AM EDT
Whenever the subject of reverse mortgages come up, invariably one of the objections that are cited is the perceived high cost of originating a reverse mortgage. Virtually every news media article about reverse mortgages cites the high cost and how it eats away at equity. That is why so many advisors recommend they only be used as a “loan of last resort” when there is no other option.
The opposite is actually true. When all costs are considered, reverse mortgages became the loan of first resort. The fact is that they actually cost considerably less when used as a source of income as compared to a portfolio or continuing to make payments from a portfolio once past the age of 62. Let’s investigate the concerns that both consumers and advisors have about the actual fees and closing costs that are the subject of concern.
First, we should establish that the cost of anything should never be the sole issue in making any decision for an investment or purchase. The most important consideration is value. Is $10,000 too much for one pill that would cure cancer? Of course, that would be considered an inexpensive thing when compared to other treatments and the value of life itself. In the investment world, the important objective is for the costs of any financial tool to be outweighed by a greater value received by employing the tool.
Let’s establish the actual costs first. Most everyone is aware of the costs involved with a traditional “forward” mortgage. Those costs vary by state, but are broken down by lender fees, third party fees like appraisal and title costs, origination fees, PMI and other miscellaneous costs depending on loan and location. All those costs are very similar in a reverse mortgage except for one difference that gives a reverse the reputation of being expensive. The difference is a Mortgage Insurance Premium (MIP). This is a 2% fee based on the home value which goes to the Federal Housing Administration (FHA)— the entity responsible for insuring the loan.
So, if you are insuring a $400,000 house, part of the closing costs— usually simply deducted from the equity— would be an $8000 fee for the insurance cost. (If a reverse loan is proprietary and not an FHA loan— this fee is not charged but interest rates are typically higher). Even though a reverse mortgage only pays out about 50-70%— what does that insurance fee get you? Why is it required?
Mortgage insurance on a forward mortgage encourages the lender to lend to a borrower with a lower credit score or a small down payment so they are insured by the mortgage insurance company if there is a default. Reverse MIP is much more powerful than forward PMI. It not only insures the lender, but also the borrower AND the borrower’s heirs. The reverse is a non-recourse loan that requires no payments until the borrower turns 150 or moves out of the house permanently. That is a rather generous guarantee and a considerable risk for the fund.
No one really knows the value of the home next year - say nothing about 30 years into the future. But, with this MIP, the borrower can live a very long time, and even pass away in a year like 2009 when home values plummeted and balances on the loans continued to negatively amortize. If the balance on the loan is more than the value of the house, the fund pays out the loss and the lender, the borrower, or the borrowers’ heirs are completely absolved of responsibility without fear of collection or tax liability.
It is important to note that most of the time there is equity left to pass on to the children because the home value has increased faster than the loan balance, and thus no insurance claim. However, without this insurance, the loan would be quite risky for those with a lot of longevity in their genes! The mortgage insurance fund is evaluated annually, and actuarial experts adjust the premiums as necessary to cover the costs. There is no profit motive with this insurance as this is planned to be revenue neutral by FHA as a government agency. In reality, the borrower is really just paying the actual cost of the risk on an overall basis. And be reminded, that the borrower can actually “pay” the insurance with their equity and not with cash— meaning all the closing costs can technically be paid a year after death— if there is enough equity. That is the ultimate “time value of money” advantage.
By now it is clear that this is a fair non-profit fee that truly insures against actual losses. But is it worth it to the borrower and homeowner? What kind of value does a reverse mortgage provide when compared to a familiar “forward” mortgage which has less expensive costs and sometimes lower interest rates? There are 3 major value propositions when using a reverse mortgage as part of a financial plan early in retirement. Remember, a reverse mortgage is available as soon as a borrower turns 62 and is then eligible to create liquidity for about 50% of the home value.
The first value is the biggest benefit in most cases - eliminating a mortgage payment so that cash flow is freed up to invest or use for other purposes. Currently 44% of seniors reaching the age of 62 are still making a mortgage payment. Most can easily afford it, but it is not the best use of that money.
When anyone thinks of investing money, the ROI always comes up as a measurement. It is amazing that many financial advisors don’t consider the very low ROI on paying off a mortgage. Every dollar deposited into paying off a home mortgage gives a return of less than 3% and all the dollars are illiquid with no guarantee of the future value. This is where the reverse mortgage really shines. If a payment is $2000 a month ($24,000 per year) it would require 4% investment cash flow withdrawal from $600,000 in total investments. That saps a tremendous amount of most client’s portfolios for a payment that is not required. For the last 100+ years the investment portfolio has been more productive than the mortgage cost regardless of how high or low the interest rate was.
Quite frankly stopping the withdrawal from the investment bucket is simply a wise thing to do, whether there is a little or a whole bunch in the asset bucket. One of the worst rates of return is paying off a low rate mortgage and creating lots of illiquidity.
The second major value is for those who are wealthy, have “plenty of money” and have their homes paid off. There is always, always a need for cash flow because there is something called the “cost of living!” That cash needs to come from active income, or from passive income with investment assets. If you consider the reverse mortgage as another source of income, it is usually the most efficient and cheapest income available to a senior past 62. It also allows an advisor to keep his/her senior client fully invested in longer term risk portfolios because the cash reserve is in the reverse mortgage line of credit. It eliminates the need for a cash reserve in the investment account that serves as a big drag on returns. That line of credit —unlike a traditional line of credit which has cheaper closing costs— is guaranteed never to be canceled or closed as long as the borrower pays HOI and real estate taxes.
It requires no payments and is guaranteed to increase every year that goes by even if the house value does not. Liquidity is one of the top rules of retirement and to not create liquidity for at least half the value of the home is quite frankly foolish. The cost of not having that source of tax-free income available is much higher than simply having the liquid collateral readily available. By being willing to pay the costs, you may have less equity at the end, but your net worth will be higher and the inheritance greater because of what you have in more versatile, and more efficient, liquid investments.
The third major value really cannot be measured in dollars and cents. What if some of your clients suddenly saw their required mortgage payment eliminated? Some will continue to make it, which is fine because every payment they make on a reverse mortgage is available for future spending. That is something that can never be done with a forward mortgage or for those having no mortgage at all. Again, liquidity is such a vitally important issue in retirement. But what if you want to give your money away, or spend it on family, or vacations with the grandchildren, or a hundred other uses that create memories that are savored on one’s death bed. What is that worth? I have never seen on a tombstone or on a plaque on a casket any reference to dying with a certain amount of home equity.
The ROL or Return On Life perhaps is a value that is worth more than bragging about a “free and clear” home. As we make plans for the wealth in our homes and our client’s homes if we are an advisor, we should consider the tangible and intangible high cost of NOT having a reverse mortgage so equity can be intentionally and carefully used for a better retirement, for a better life, and for a better inheritance
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.