A Better Way to Turn a Major Asset into Retirement Income

My mother-in-law lived in her very modest home until the day she died just a few months after her 88 birthday. In fact, thanks to hospice care, Helen quietly passed away there, a place she had literally known her entire life.

We tried a couple of times to convince her (once while she was recovering from hip surgery) that she ought to consider moving. Western Pennsylvania is hilly. She had to go up steps to get from the garage to the three-story house. But she would hear none of it. Even after knee surgery she insisted that climbing all those steps helped keep her in shape.

I understand. Her Ukrainian immigrant parents had built that home: essentially, just a cellar dug into a hill. Later, they added another floor containing kitchen, dining and living spaces. Another floor was added on top of that to create three bedrooms for her and her seven siblings. Over the years, various upgrades were made.

My husband grew up in that home. It was the family gathering place we happily crowded into during holidays and general get-togethers. You could walk in unexpected at any time (she never locked the doors) and be welcomed.

Helen didn’t just have family memories tying her to that home. A few blocks away is the church her grandparents had helped construct and she was a lifelong, active member (singing in the choir, directing the pierogi-making team, treasurer, etc.). She knew everyone for blocks around (she grew up with many of them) and everyone seemed to know her. If you were sick, you could always count on her to show up with homemade soup.

There’s No Place Like Home

Like Helen, most people want to remain in their own homes for as long as they are physically able. The familiar has a very strong pull. This is why many retirees find “reverse mortgages” so attractive because they allow owners to convert some of the value that has built up in a home into cash.

“People don’t save. They are living longer, facing large medical costs. They only thing they can tap is their house,” says Alicia Munnell, director of the Center for Retirement Research (CRR) at Boston College.

In theory, reverse mortgages make a lot of sense. Like a traditional mortgage, a reverse mortgage is a loan that uses the value of the property as collateral.(1) But instead of the homeowner making payments to the bank, the bank pays you- either in a lump sum or via a series of regular payments. The loan does not have to be paid off until you move from the home or die.

In turn, the homeowner agrees to continue to maintain the home, as well as pay property taxes and home insurance.

You are only eligible for a reverse mortgage if you are at least age 62, and most are guaranteed through the through the federal government’s Home Equity Conversion Mortgages (HECM) program. The lender is insured against the risk that the property could be worth less by the time it is sold, and the homeowner is insured against the risk that the lender might run into financial difficulty and not be able to continue making its promised payments.

Though I’m a big fan of the concept of reverse mortgages, they've come under scrutiny recently with critics complaining they were expensive. There have also been cases where homeowners have been forced out of a home because they couldn’t afford to keep it up.

The Perfect Storm

The problems inherent in reverse mortgages hit critical mass when the housing market collapsed and led to the Great Recession. In the run up to 2008, real estate values were skyrocketing. Low interest rates meant homeowners could borrow more of the equity in their homes. As you can see from the chart below, the number of reverse mortgages soared.

When the financial markets collapsed, so did seniors' retirement accounts. High unemployment also hurt. According to analysis by the Center for Retirement Research, reverse mortgages continued to climb through 2009 because “the deteriorating economy forced some people to turn to their home as a source of income.”

Unfortunately, many who had taken out a reverse mortgage found that they could not afford to pay their taxes or home insurance. By 2012, the default rate was 10%. Banks were foreclosing on homes worth less than the amounts they had loaned out. The government insurance fund had to make up the difference, depleting its reserves.

The New and Improved Reverse Mortgage

This month the federal government rolled out revised guidelines for its reverse mortgage program. For those of us who have filled out reams of documents to substantiate that we are financially able to afford a traditional mortgage, perhaps the most shocking change is that, prior to approving a reverse mortgage, the lender now has to evaluate the borrower’s finances!

“Before, there was no underwriting,” says Munnell. “All you needed was the house.”

Yes, folks, you heard it right: Until now, lenders were not required to consider whether a borrower could afford a reverse mortgage. Now they have to perform an income analysis, look at credit reports and determine whether the homeowner can afford to keep up their side of the bargain, i.e. pay property taxes, continue to keep the home in good repair and maintain their homeowner’s insurance.

This step alone should weed out a lot of candidates for whom a reverse mortgage is simply not practical. “Requiring residual income as a criteria for granting the loan” will result in fewer foreclosures, according to Munnell. In addition, a review of their finances will give the borrower “a sense of how much money you need to have as a buffer before you can take out these loans.”

This exercise should also make seniors pause before they cash in on the value of their home equity. Before paying the upfront fees on a reverse mortgage, Munnell says homeowners ask themselves "will you still want to be there in 15 years?” Is there a chance you might need wider halls or doors to accommodate a wheelchair?  Are there too many steps? Is the yard going to be too large for you to keep up?

The re-designed reverse mortgage program will have one option instead of two:

• Based upon current interest rates, the maximum percent of your home’s value that you can potentially borrow will be identical for everyone who is the same age. 
• The maximum amount that you can draw out in the first year is limited to 60%. If you meet one of the exceptions to this limit and wish to borrow more, you will pay a stiff price- your lump sum insurance premium goes up by 2.5%.

As Munnell sees it, these changes are aimed at “trying to place the loans with the right people and get the money taken out in a sensible fashion.”  She considers the reserve mortgage re-design a positive step for all parties involved- retirees, lenders and the federal government. Reducing the amount of income you can borrow right away “is a good step forward. You’re more likely to have people in decent shape down the road.” Because fewer defaults are expected with these changes costs are dramatically reduced.”

1. Even if a home is worth more, the maximum value that a loan can be based upon is currently $625,500. This is tied to FHA rules.