Reverse mortgages, which reportedly have been in use since Deering Savings & Loan issued one to Nellie Young of Portland, Maine, in 1961, have long been viewed with suspicion. Evoking images of late-night infomercials and disreputable loan agencies, the reverse mortgage is the product of last resort for many CPA financial planners.
But while detractors characterize reverse mortgages as a quick fix that decreases borrowers’ net worth and the value of their estate, traps them in their homes for the rest of their lives, and subjects them to high upfront costs, this view may be outdated. The Financial Industry Regulatory Authority “softened its stance about the use of reverse mortgages in a comprehensive retirement plan after reviewing research published in the Journal of Financial Planning in 2012,” said Wade Pfau, Ph.D., Professor of Retirement Income at the American College of Financial Services. “Research has consistently demonstrated that, when employed wisely, the reverse mortgage can serve as an effective personal financial planning tool.”
A reverse mortgage is a loan against a home-equity line that can be issued as a lump sum, fixed installments, or a line of credit. Unlike the traditional forward mortgage, a reverse mortgage does not necessitate loan payments by the borrower. To qualify for a reverse mortgage, borrowers must be 62 years old or older, which makes this banking product attractive to older Americans who wish to supplement their retirement income. The loan balance becomes due when the borrower dies, moves away, or sells the home, and reverse mortgages are structured so that the loan amount does not exceed the property’s value.
Most reverse mortgages on the market are FHA-backed home-equity conversion mortgages (HECMs). HECM terms are often better than those of private reverse mortgages, but the loan amount is fixed, and borrowers are required to pay mortgage insurance premiums, for instance. Private reverse mortgages are more flexible and are often favored by borrowers with high-value homes.
Be sure to advise clients who are considering taking out a reverse mortgage to be careful to avoid entrapment by scammers who specialize in targeting older Americans. Some unscrupulous home-improvement vendors and contractors try to persuade homeowners to take out a reverse mortgage to cover the costs of repairs. Some scammers convince unsuspecting homeowners to take out a reverse mortgage as part of a house-flipping scheme. Encourage your clients to be wary of anyone who approaches them about taking out a reverse mortgage and to consult with a trusted financial adviser before proceeding. Note that meeting with an HECM counselor is mandatory before taking out an HECM.
When reverse mortgages can be a reasonable choice
The following conditions can indicate that a reverse mortgage might just be the right product for your client:
Your client plans to stay put: Reverse mortgage borrowers are required to pay off the loan if they move out and must therefore carefully consider future housing plans. “Anyone considering a reverse mortgage should be sure they have no short-term plans to move,” advised Benjamin Dorsey, CPA/PFS, director of Tax Strategies at Cassaday & Company. “The reverse mortgage is geared towards people who are certain they want to remain in their home.”
Your client can afford the upfront costs: Reverse mortgage borrowers can incur significant upfront expenses. “Just like a traditional mortgage, reverse mortgage borrowers must pay appraisal and closing costs,” explained Rob Premselaar, CPA, a tax manager at Mach & Associates PA. “That said, since a reverse mortgage is essentially a loan payment, it is not a taxable event and won’t impact your taxable income or tax bracket.”
But Premselaar warns of a catch in the event the home is later sold: Reverse mortgage borrowers are more likely to be subject to a capital gains tax because, if the loan amount exceeds the value of the property, the difference between the loan balance and the sale price is forgiven and thus counts as additional proceeds on the sale.
Your client can coordinate with other investments: Any homeowner considering a reverse mortgage must be prepared to take a responsible and strategic approach to the use of the funds. Clients can accomplish this by coordinating the reverse mortgage payment with their existing investment portfolio. “Borrowers can balance their home asset against their other assets and only draw on reverse mortgage funds during a bear market,” Pfau said. “When your portfolio is doing fine, however, spend from there.”
Other options that should be considered
A reverse mortgage is not the right choice for every individual, and it is important to educate your clients about possible alternatives. “The reverse mortgage is often the product of choice for individuals in a tight financial spot who aren’t aware of other options,” Dorsey said. “People who find themselves in this situation should be working with a fiduciary adviser in order to chart the best course of action” based on a clear understanding of all their options.
Some alternatives to a reverse mortgage that should be considered include:
Downsize: Sometimes, financial concerns are just a matter of too much house. If your client is willing to move, consider advising the client to sell the house, buy or rent a cheaper home, and use the proceeds to supplement his or her income. “Selling your home and moving somewhere more affordable is an effective way to preserve your net worth and maximize what you leave to your heirs,” Dorsey said.
Refinance: If your clients have another income source, such as from Social Security or a pension fund, it might make sense to consider a traditional home refinance, Dorsey advised. “Reverse mortgages typically do not reflect a home’s fair market value,” he said. Indeed, reverse mortgage companies ordinarily adjust for a potential decline in value and for transaction costs that would be part of a potential future sale.
“If you can demonstrate some income and refinance your home, you can draw down a large lump sum and use that to supplement your income,” Dorsey said, adding that a home refinance is a nontaxable event and as such will not affect your client’s tax bracket.
Open a line of credit: Dorsey further suggested the possibility of using a home asset to open a short-term line of credit at the bank. Dorsey appreciates the flexibility a line of credit affords. “Optimize your home’s value by locking in a rate for five to seven years,” Dorsey advised. He added that an interest-only home-equity loan will allow your clients to stretch their money as far as possible. Interest-only loans enable homeowners to borrow money, repay it, and borrow again as needed during their draw period.
The main takeaway
“Risks change in retirement,” Pfau explained. “Don’t look at the reverse mortgage in isolation but as one part of a larger strategy.” Your client’s home may very well be his or her greatest asset. Educate clients about the various ways to leverage this asset to help them maximize their income. For certain sensible and judicious borrowers, a reverse mortgage may be a tool to help them spend their golden years with dignity and financial security.
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