Using Reverse Mortgages in a Responsible Retirement Income Plan, with Dr. Wade Pfau
Reverse mortgages are becoming more mainstream. But to benefit from using one, you need to understand how to incorporate it into a responsible retirement income plan. So exactly what is a reverse mortgage? What role should it fill in your retirement planning? And should you open a reverse mortgage early or as a last resort?
To answer your questions, we’ve invited back a special guest, Dr. Wade Pfau. Dr. Pfau is the author of Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement, and host of Retirement Researcher. He shares his significant work on retirement income planning to shed some light on reverse mortgages.
To learn how to get the most retirement income with reverse mortgages, so you can enjoy your money and your life the most… tune in now!
Table of contents
Why Retirement Income?
[4:50] “I was interested in retirement income planning, it really just evolved from research I did in grad school… There was a proposal in the early 2000s to privatize part of Social Security, and I was investigating how that might work out in practice, and that’s really translated into what I do today in terms of personal retirement planning. But then, in that regard, I really built a career around this insight that is not fully understood yet in the general population, which is when you’re retired, investment risk changes. When you’re spending from assets, you’re more exposed to investment volatility.”
This volatility in retirement means opens retirees up to a wide variety of income strategies that can increase the longevity of assets and income. However, many typical financial talking heads consider these strategies unconventional, and many people don’t know how to use them properly.
One of those misunderstood assets is home equity, and subsequently, reverse mortgages. However, when used strategically, these elements can really make your retirement income far more efficient.
What is a Reverse Mortgage?
A reverse mortgage, as Dr. Pfau shares, is when you borrow money from the home and don’t have to pay it back until the end of the loan. About 90 percent of reverse mortgages are represented by the Federal program of Home Equity Conversion Mortgages (HECM). They issued the first HECMs in the late 80s, and the government is consistently working to ensure that the program is operating as well as it can.
The amount you can borrow from your home depends on your age and the current interest rates, and reverse mortgages actually benefit from low interest rates. A HECM gives you access to a percentage of your appraised home value.
What the reverse mortgage actually does is give you a line of credit to tap into. This line of credit increases over time. And unlike a regular home equity line of credit, a HECM cannot be frozen or canceled. You have access to it for as long as you choose to remain living in the home. Once you move out of the home, the loan balance becomes due.
The benefit of a reverse mortgage is that it gives you more options for spending. That way, you don’t have to draw from certain assets during bad times. For example, if most of your retirement income is coming from equities, you don’t want to pull that income out while the market is down. A reverse mortgage is just one way to create that flexibility.
Different Strategies for Borrowing
The strategy Dr. Pfau proposes acts more like a volatility buffer by giving you discretionary power to pull out income as you see fit. However, there are other reverse mortgage strategies. For example, there are reverse mortgage options to pull out a fixed monthly income.
While this monthly income doesn’t help with a specific sequence of returns risk, it helps you to reduce what you’re pulling from your investments. This helps you to preserve those investments overall.
Both strategies reduce income risks fairly well. And ultimately, it is up to the individual to decide what works more synergistically with your assets and way of thinking.
When Should You Use a Reverse Mortgage?
Typical financial wisdom is to use a reverse mortgage as a last resort. Many suggest using it when you have exhausted all other options. The issue here is that doing so can be incredibly inefficient. Because what’s happening is you’re just waiting for the worst to happen. In some instances, this could be an event where you lose significant portions of your equities, and still have to draw an income, which locks in those losses, and ultimately hastens your race to the bottom.
On the other hand, if you were to open a reverse mortgage as soon as possible with a discretionary line of credit, you have options. You may not use that line of credit for years, all the while it’s growing. Then, if the market takes a dive, you have somewhere else to pull money from. This can actually extend the life of your account significantly because you’re giving it time to recover.
[20:20] “There are many different strategies around [reverse mortgages]. But then let’s look to see how that performs relative to the last resort strategy. And that’s where consistently–not a hundred percent of the time–the odds are really in the favor of this more strategic, coordinated reverse mortgage strategy.”
The Right Mindset
[32:40] “The great advantage of the reverse mortgage is it creates liquidity for an otherwise illiquid asset. It let’s you spend from your home equity when you otherwise would not be able to do that.”
While this is an incredible opportunity, there are situations where it might not work on an individual level. For those who cannot use this ability wisely, it might be better in the long run to avoid a reverse mortgage. If used unwisely, or without a strategy, it may be more trouble than it’s worth.
[33:15] “If you’re tempted to spend it because it’s there, you maybe want to hold off and try to prevent yourself from getting into that situation. If you can manage the responsibility of having all these funds available, but not just spending them because you can, that’s really the kind of scenario where the reverse mortgage can have the most positive impact.”
Are Reverse Mortgages Expensive?
[26:03] “[There’s] this idea that reverse mortgages are expensive. And they can certainly appear expensive. There’s certainly some sticker shock involved. That was one of the major changes of the 2017 reforms, was to increase the initial mortgage insurance premiums that provide protections…”
[36:36] “So when you set up a reverse mortgage, if you have, say a five hundred thousand dollar house, it’s not inconceivable that between the mortgage insurance premiums the origination fee, and other mortgage closing costs, it could be up to, say, twenty thousand dollars to set up the reverse mortgage.”
While this can be a pretty substantial amount, the 2017 reforms prevent reverse mortgage lenders from canceling, freezing, or otherwise blocking a line of credit. This helps to protect retirees from losing that stream of income or liquidity that they’ve paid to set up. Reverse mortgages are also non-recourse, which means that the lender cannot ask for more than the house’s appraised worth. In other words, if the house is worth $500,000 at the time the loan comes due, that’s the upper limit of the loan.
[37:55] “It’s important to emphasize when I look at all these different ways of using a reverse mortgage, I do incorporate all those costs. And so when I say that opening the reverse mortgage earlier and using it strategically gives you a better outcome, that is a better outcome net of the cost that is a part of the loan.”
Connect with Dr. Wade Pfau
- Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (3rd Edition)
About Dr. Wade Pfau
Wade D. Pfau, Ph.D., CFA, RICP®, is the program director of the Retirement Income Certified Professional® designation. He is also a Professor of Retirement Income at The American College of Financial Services in King of Prussia, PA, as well as a co-director of the college’s Center for Retirement Income. As well, he is a Principal and Director for McLean Asset Management and RISA, LLC. He holds a doctorate in economics from Princeton University and has published more than sixty peer-reviewed research articles in a wide variety of academic and practitioner journals. He hosts the Retirement Researcher website and is a contributor to Forbes, Advisor Perspectives, Journal of Financial Planning, and an Expert Panelist for the Wall Street Journal. Wade’s newest book is Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success.
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