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Reverse Mortgage to Avoid Poverty

Retirement has become a frightening prospect for millions of Americans who haven’t made adequate financial preparation for it, yet face the likelihood of living much longer than any prior generation of retirees. The Center for Retirement Research at Boston College reports that more than half of all households will not be able to maintain their standard of living in retirement.

The home equity conversion mortgage, or HECM reverse mortgage, is a partial solution to the crisis. It is partial because it is feasible only for homeowners who have significant equity in their homes on retirement. But that is a very sizeable chunk of the retirees who need help. Let’s focus on three seniors whose problems differ in severity but each of the three is typical of millions of others.

∎ John retires at 65 with few financial assets, is largely dependent on Social Security for income, and still has a balance on his mortgage.

∎ Mary is in the same position as John, except that her mortgage is paid off.

∎ Leslie has no mortgage debt and significant financial assets from which to draw spendable funds, but faces the risk that the funds will run dry while he is still alive.

The received financial wisdom of my generation was that your mortgage should be paid off by the time you retire. John, like so many others in his age cohort, did not follow this principle. He has a mortgage balance of $50,000 on a house worth $110,000 and is obliged to pay $540 a month until the balance is paid off, which won’t happen for seven years.

But John can use a reverse mortgage to pay off the balance now. This makes the best of a bad situation by replacing debt that John must repay in monthly installments with debt that doesn’t have to be repaid until he dies or moves out of the house permanently. Being relieved of the burden of paying $540 a month is the equivalent of having that much additional monthly income.

The unavoidable downside is that by using most of his reverse mortgage capacity now, he retains little capacity to draw spendable cash in later years. After repaying his mortgage balance, only about $13,000 remains, which he can draw in cash, or leave as a credit line for future use.

There are a lot of Johns out there, but many are in the less populated parts of the country, where reverse mortgage loan originators and counselors are hard to find. Getting the word out about the availability of the reverse mortgage option is a challenge I will be discussing in another column.

Mary has the same balance sheet as John except that at 65, when she retires, her mortgage will be paid off. This means that Mary has more options than John in how she uses a reverse mortgage. The principal options are a credit line for about $63,000, which grows over time if not used; a monthly “tenure” payment, which will pay her about $331 a month for as long as she lives in her home; or some combination of the two. She could also select a monthly term payment, which would be larger than the tenure payment but cease when the term was over.

Since Mary wants to supplement her income permanently, by as much as possible as soon as possible, she will take the tenure payment. But this doesn’t commit her forever, since a tenure plan can be modified at any time for $20 paid to the servicer. For example, if Mary finds after 2 years that the monthly tenure payment won’t be needed for awhile, she can switch to a credit line of about $59,000. The line will grow in size from that point on, and if she swings back to a tenure payment after a few more years, it will be larger than the one she had originally.

In the opposite case, where she needs a larger monthly payment for a limited period, she can switch to a term annuity, with the option of switching back to a tenure payment or to a credit line any time before the expiration of the term. The HECM reverse mortgage is marvelously flexible.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.