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Informed Investor: New safeguards making reverse mortgages more attractive

Recent changes in federal law have made reverse mortgages more attractive for senior homeowners. This week’s column explains what a reverse mortgage is, how a homeowner can receive the proceeds from a reverse mortgage, and some potential uses of reverse mortgage proceeds—and examines some of the recently passed safeguards that prevent homeowners from losing their homes.

A few years ago, most financial advisors would have rolled their eyes at the mention of a reverse mortgage—a loan that gives homeowners an advance on their home equity. Unfortunately, reverse mortgages were used by some homeowners as an inappropriate means for preparing for retirement. This column discusses in more detail what a reverse mortgage is, which individuals may want to consider a reverse mortgage, and the new federal safeguards on reverse mortgages.

Reverse mortgages first appeared in the 1980s. A Home Equity Conversion Mortgage (HECM) is a relatively new type of reverse mortgage. An HECM allows a homeowner age 62 or older to tap into the equity of his or her home as a cash distribution and spend the cash for any purpose. For example, the money could be spent to pay off the existing mortgage of the house, to make capital improvements, to invest, to spend on a vacation, or to pay medical bills.

The money is paid out to the homeowner in one of three ways: (1) a lump sum; (2) a monthly payment; or (3) a line of credit. The cost of a reverse mortgage includes mortgage insurance, which is usually bundled into the mortgage interest rate. The mortgage interest is added to the loan balance each month and the balance grows over time.

Taking a Lump Sum

Borrowing enough of the equity in a house in a lump sum to pay off an existing mortgage is one of the most frequent uses of a reverse mortgage. In more than 60 percent of reverse mortgages, borrowers have used the proceeds for this purpose.

While paying off an existing mortgage is certainly a worthy goal for individuals nearing retirement, lump-sum reverse mortgage borrowing has some disadvantages. For example, using a lump sum as a down payment on a second or vacation home can be risky. The risk is “overleveraging”—taking on more debt that a homeowner can afford to pay off.

Opening a Line of Credit

Many financial advisors are suggesting that senior homeowners establish a line of credit through an HECM program, whether they need the money immediately or not. The line of credit can be used in case the homeowner has an immediate need for cash. For example, a reverse mortgage line of credit could be used as a way of protecting retirement funds such as the Thrift Savings Plan. When the stock market is down, for example, a TSP participant could minimize the amount he or she withdrawing from the TSP account and instead draw from the reverse mortgage line of credit.

An HECM line of credit can also be used as a source of income for those individuals who want to delay applying for Social Security benefits in order to earn delayed retirement credits (DRCs) of 8 percent per year. DRCs result in an increase a Social Security recipient’s monthly retirement benefit when  the recipient starts receiving benefits. After the recipient applies for his or her Social Security benefit, the recipient can stop taking money from the reverse mortgage line of credit and, if he or she wants, start paying the loan back.

Since income from a reverse mortgage line of credit is not includable in income, it can be used in place of taxable withdrawals from retirement accounts such as the TSP. This avoids “tax bracket creep” as well as higher Medicare Part B premiums that can result from higher income.

Another use for a reverse mortgage line of credit would be to pay taxes due on a Roth IRA conversion. In the Roth IRA conversion process, distributions from traditional IRAs are taxed in the process of being converted to Roth IRAs. Tax professionals often recommend paying the taxes due with funds outside the IRA because using money from the IRA for that purpose results in additional taxes due.

Some Things to Beware Of

The Consumer Financial Protection Bureau warns consumers not to be misled by the numerous advertisements about reverse mortgages found on radio and television. Spokespersons tout the benefits of reverse mortgages without mentioning the risks. Some common myths about reverse mortgages that have emerged are:

A reverse mortgage is a federal government-sponsored benefit. In fact, a reverse mortgage is a home loan with fees and interest that must be repaid.

• A reverse mortgage owner cannot lose his or her home. Homeowners who fail to pay property taxes or homeowner’s insurance or stop meeting the requirements of the reverse mortgage can trigger a loan default.

New safeguards are in place for HECM reverse mortgages. The Reverse Mortgage Stabilization Act of 2013 prevents homeowners in most cases from receiving all their equity at once. Roughly 40 percent of the total amount that can be borrowed is unavailable until a year after the initial loan. Other more recent regulations require homeowners to demonstrate they are able and willing to pay their property taxes and home insurance. There are also new protections for the non-borrowing spouse.

 

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