Making optional payments on a reverse mortgage may be strategically wise. Academic research since 2012 suggests that the delayed and gradual use of a reverse line of credit can be extremely helpful in prolonging the longevity of an investment portfolio.*
Some people want to make monthly payments for emotional reasons or out of habit. New research shows there may be other advantages to making payments on a reverse mortgage when doing so is part of a larger financial strategy. Maximizing the unique feature of a reverse line of credit can be accomplished by making optional payments.
Previously, we discussed the danger of a conventional home equity line of credit in retirement – namely that the bank can change the rules and pull it away when it might be needed most. This happened to thousands of people during the great recession and many never regained their footing. A reverse mortgage line of credit can be a better, safer alternative for retirees.
Benefits of a Reverse Line of Credit
Three key advantages with a HECM (Home Equity Conversion Mortgage or reverse mortgage) line of credit:
- A reverse mortgage line that cannot be cancelled, reduced, or modified
- Reverse line of credit growth occurs independent of home value
- The unused portion of a reverse line of credit grows over time
New research on the strategic use of home equity as part of an overall retirement income plan points to significant improvement in the likelihood of not running out of money when a home equity conversion mortgage is used to:
- Minimize sequence of returns risk from portfolio (IRA) withdrawals
- Create an income stream as an annuity alternative
- Minimize lifestyle disruption in divorce
- Maximize social security benefits
With a conventional home equity line of credit (a bank HELOC) the borrower usually makes a minimum payment to cover interest. However, after a set period the required payment amount increases substantially (called recasting) to a monthly amount large enough to pay both interest and repay the principal balance.
This ‘recasting’ can happen at the most inopportune time. And if payments are not made every month the home can be foreclosed. Most people who get a HELOC would like to make an interest-only payment indefinitely but that is not an option with a conventional HELOC. During the last recession, people who wanted to refinance their HELOC just before recast were unable to do so because: (a) they no longer qualified, or (b) their home’s value dropped.
Flexible Payment Feature
Home equity conversion mortgages are different. They have a flexible monthly payment feature allowing the homeowner to pay as much or little as they wish. They even have the option to make no payment for a month, a year, or however long they remain in the house (so long as one borrower lives in the home and keeps up with property taxes, insurance and home maintenance).
HECM Line of Credit Growth
The reason having flexibility around making payments with a reverse mortgage is valuable is because of the growth feature that is unique to the home equity conversion mortgage line of credit. The unused portion of the reverse line of credit grows at the same rate (known as the accrual rate) that the loan balance would grow if the line were drawn upon.
Consider an example where a borrower has $200,000 of unused available line of credit on their reverse mortgage. Assume the accrual rate is 5.73%. That is: 1-year Libor rate (1.73%) + margin (2.75%) + FHA insurance (1.25%) = 5.73%.
This is the rate that the available credit line will increase each year. Look at how significantly the $200,000 available line increases when not used.
End of year 1
$200,000 x 5.73% = $11,460
$200,000 + $11,460 = $211,460
End of year 2
$211,460 = 5.73% = $12,116
$211,460 + $12,116 = $223,576
End of year 3
$223,576 + 5.73% = $12,810
$223,576 + $12,810 = $236,386
In just three years the homeowner has over $36,000 more to work with. This is like getting a letter from your credit card company saying they’ve increased your limit – except if you use it you don’t have to make a minimum payment or any monthly payment. The numbers above illustrate the concept and power of having the line of credit growth feature.** With a conventional home equity line of credit, the amount the homeowner can access (borrow) never goes up. With a reverse line of credit, it is technically possible that left alone for enough years…
The available line of credit can grow larger than the home’s value.
FHA insurance protects the homeowner’s ability to access that larger value and the lender cannot reduce it. This is why the HECM is described as having a longevity (living a long time) insurance characteristic. A homeowner could withdraw the entire line limit (more than the home's value) the day before moving out of the house and be within their contractual rights.
As Wade Pfau, Ph.D., CFA notes, "strategies that open a line of credit and leave it unused run counter to the objectives of lenders and the government's mortgage insurance fund. Though they still exist today, one day these opportunities may become more limited."*
Actual results may vary because any interest rate index (like Libor) will vary over time. What is guaranteed by the federal government (HUD/FHA) is the fact that the line of credit cannot be taken away, reduced, or curtailed.
Beware of Free Lines of Credit with No Initial Draw
Financial planners need to be aware that some lenders promote a no-cost HECM line of credit when the borrower needs no money at closing. In the fine-print one learns that it is based on a 1-month Libor index, usually with a higher margin; and most important, the lifetime interest rate cap can be twice as high as a HECM based on the 1-year Libor.
The net effect is the borrower takes on considerable interest rate risk to save a little money at the beginning of the loan. If rates go up significantly, something all retirees remember in the early 80s, the no-cost, no-draw option would have been a poor trade. When the initial draw is less than 60% of the available line, the upfront FHA insurance is only 0.5% instead of 2.5%. Therefore, setting up a low-draw reverse line of credit is not that expensive.
Personally, I expect interest rates to tend toward the low side in the future because of demographics; i.e., aging populations tend to accompany deflation - older people spend less than younger people who are buying houses and starting familes. This view is supported by a recent paper from the Federal Reserve Board. However, if rates do rise considerably, having a lifetime interest rate cap of 5% versus 10% could make a big difference to legacy wealth (the amount that heirs will receive). The small additional up-front expense is worthwhile insurance.
Admittedly, differences between loan products can get complicated. It’s wise to talk to a Certified Reverse Mortgage Professional (CRMP) or seasoned professional to get educated on the differences between loan products and when one is preferable to another. One thing everyone agrees on is the power of the compounding growth feature that is unique to the government-insured reverse mortgage line of credit.
Coordinated Retirement Income Planning
Retirement income planners love the line of credit growth feature because it enhances their ability to leverage house wealth to support other components of their client’s retirement plan.
One, it gives them more money to use as a portfolio shock absorber when the stock market is down. Two, it provides more money to fund unexpected expenses like temporary in-home care after a medical event, without having to dip into the retirement portfolio at a time when the market is down.
Optional Repayment for Personal or Strategic Reasons
To recap, one of the many benefits of a reverse mortgage is that is does not require borrowers to pay monthly mortgage payments. In most cases this helps the family budget and it is one of the main reasons for borrowers to obtain a reverse mortgage.
Some borrowers emotionally prefer to make regular monthly payments, even when they are not required to do so. There are a few different ways borrowers can make monthly payments such as the ability to pay just the accrued interest. This method of payment is a more affordable option that keeps the balance of the mortgage loan from growing – thereby allowing the unused balance on the line of credit to continue to grow.
Since there is no required monthly payment with a reverse mortgage, those with unstable income may also chose to pay when they can, but have the option of skipping a month or two, or more, when their income doesn’t allow for mortgage payments at those times. This is a major benefit of a reverse mortgage over a cash-out refinance or a conventional line of credit, both of which require on-going monthly payments.
If you have a reverse mortgage and are planning to leave your home to your beneficiaries in the event of your passing, making regular monthly payments can help reduce the remaining balance of your loan, which will allow your heirs to purchase the home for a much lower price should they wish to keep the home. Remember, reverse mortgages have interesting tax advantages when they're paid off.
Financial advisors and CPAs may suggest using unexpected windfalls (inheritances) to pay down a reverse line of credit to accelerate its rate of growth going forward.
As an Orange County reverse mortgage expert, I understand eliminating monthly payments is the primary reason most borrowers obtain a reverse mortgage. If you have the ability to make regular payments, even just to cover the interest, or you can make additional payments occasionally, doing so may positively affect your long-term ability to meet financial obligations and enjoy the lifestyle you desire.
Complimentary Strategic Planning
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*Pfau, Wade. “Reverse Mortgages, How to use Reverse Mortgages to Secure Your Retirement.” The Retirement Researcher’s Guide Series. 2016.
**This article is not intended to be a substitute for or to provide tax advice. You should review these strategies with your own tax legal and estate planning professionals. Interest rates and loan programs change frequently.
About the Author
Kent Kopen earned his Reverse Mortgage Specialist credential in March 2007. In 2016 Kent earned the CRMP (Certified Reverse Mortgage Professional) designation. There are less than 150 CRMP designees in the United States. Mr. Kopen also provides education, tools, and strategies to professionals who offer financial and legal advice to others. "Our resources help financial advisors, CPAs, and estate planning attorneys help seniors optimize their home equity to provide greater security and peace of mind."