You’ve spent a good portion of your life investing in what many consider part of the American dream: your home. Now, as retirement draws near, learning how to properly leverage your home equity could become an important part of a secure plan to help sustain you through your golden years.
A reverse mortgage is one way to tap into one’s equity, however, it’s not necessarily the right financial strategy for each retiree. Fortunately, new rules were implemented this April to help prevent previous mistakes often associated with reverse mortgages, which can get complicated and pricey, depending on one’s situation.
Let’s break it down: If you’re age 62 or older and worried about outliving your retirement, a reverse mortgage can help you obtain a loan and tap into your home equity without losing your home in the process. The amount of the loan depends on your home’s value, your age, and the prevailing interest rates. If used the correct way, this strategy can significantly reduce the risk of outliving your retirement nest egg.
Payment options available for reverse mortgages
- Tenure option payment: receive a monthly payment for as long as you live in your home
- A lump sum: receive the full amount of the loan all at once
- Standby line of credit: borrow as you choose.
Benefits of reverse mortgages
- You will not be required to repay the loan for as long as you live in your home.
- The bank entering into the reverse mortgage will only receive the value of your loan, even if your home value exceeds that price.
- The homeowner does not own anything more than the value of the home, even if the loan value exceeds it.
In recent years there have been concerns about homeowners with reverse mortgages experiencing “technical default,” a condition that affects about 10% of reverse mortgages, according to a recent Forbes article. This condition, which can cause one to lose his or her home, occurs when the homeowner can’t pay property taxes, home insurance premiums, and/or other homeowner fees.
To help prevent the scenario above, the government recently created a financial assessment screening test to help determine whether a particular homeowner is financially able to enter into a reverse mortgage. The new rules, which apply to the Home Equity Conversion Mortgage (HECM) program, will require potential borrowers to prove their ability to pay property taxes, fees, and insurance premiums based on their income and available credit. While the rules will disqualify a substantial number of people that were able to qualify for a reverse mortgage just a few months ago, they will also likely save many from technical default.
Uses of reverse mortgages within your retirement income strategy
1. Standby reverse mortgage line of credit
This strategy can help reduce market risk, along with other risks associated with retirement planning. It can be more beneficial to draw from a reverse mortgage at the beginning of one’s retirement rather than at the end. For example, if you use a reverse mortgage in its entirety during the first few years of retirement, it will enable you to initially avoid taking large withdrawals from your investment portfolio (especially if the market is on a decline), thus allowing it to continue to grow and multiply.
The reverse mortgage line of credit can also be used as a complement to the returns of your retirement fund, and you could mainly live off its line of credit in the years following a negative return on your investment. Either way, there’s a possibility you could prolong your retirement investment assets by reducing the risk of withdrawing from certain accounts during a down market. When the market goes back up, you could then use the extra income you earned on your investments in those years to repay the reverse mortgage loan and retain the value of your home.
2. Draw from home equity to postpone claiming Social Security benefits or defer employer-sponsored retirement plan
With this strategy, you will spend a significant portion of your equity early in retirement instead of depending on it later. This option can be especially beneficial for delaying Social Security benefits, as they increase an average of 7% to 8% for each year after age 62. For example, if you’re able to draw from home equity funds in order to delay collecting Social Security benefits until age 70, you could receive roughly 78% higher benefits than you would had you began collecting them at age 62.
You can also draw first from your home equity if you wish to defer taking withdrawals from your 401(k), IRA, or pension plan, thus continuing to grow those accounts in the meantime.
3. Exchange debt for income by replacing a traditional mortgage payment with a reverse mortgage
This could be a good option if you’re entering into retirement with an outstanding mortgage. Instead of withdrawing large amounts from your investments in order to pay the mortgage each month, consider using a reverse mortgage to pay off your traditional mortgage while simultaneously creating a line of credit or generating additional income. The biggest benefit of this strategy is reducing the amount you withdraw from your retirement portfolio during the early years of retirement, thus potentially increasing its longevity.
The bottom line
Reverse mortgages are no longer for those that are low on cash but have home equity. Instead, when used the right way, they can serve as a valuable tool in one’s retirement income plan to help reduce investment risk, increase Social Security benefits, and/or reduce the loss of investment funds to traditional mortgage payments. Since there are certain risks and complications behind them, however, it’s wise to consult a financial professional before deciding if it’s the right move for you.
