Will financial planners resuscitate the reverse mortgage?
New loan originations have fallen sharply since their peak year in 2008. Reforms put in place by the federal government several years ago have led the reverse lending industry to target more affluent potential borrowers—the households that tend to work with planners. And some retirement researchers have been making the case that planners should revisit Home Equity Conversion Mortgages (HECMs) as a key component of client retirement plans.
But it’s going to be a tough putt. A recent survey shows that older homeowners don’t understand the product well and are not comfortable with it. What’s more, the new regulations have increased HECM fees and reduced the size of initial drawdowns for larger loans.
Most reverse loans are administered and regulated by the U.S. Department of Housing and Urban Development (HUD). In 2013, HUD clamped down on HECMs, issuing new rules aimed at reducing defaults on loans. Defaults had become a problem in the industry—especially when newspapers started publishing stories about seniors losing their homes in certain cases. Although the loans have no payments, borrowers must keep their homeowners insurance and property taxes current and maintain the property.
The changes reduced total loan amounts, raised fees and, importantly, introduced a required financial assessment to make sure borrowers had the capacity to meet their obligations and terms under the HECM.
HECM volume peaked in 2008 at just over 115,000 loans, according to John Lunde, president of Reverse Market Insight, which tracks industry statistics. That’s not a huge number by any measure, and Lunde expects loan volume around 50,000 this year, down a bit from 56,363 in 2015.
Lunde points to the housing market downturn during the Great Recession as a key factor depressing loan originations—the drop in home values decreased the amount of home equity available to consumers. And, many of the large banks and insurance companies participating in the market exited during the downturn, which has squeezed distribution.
But Lunde agrees that the tighter HUD rules also play a role. “The new HUD rules have lowered volumes in the short run, while hopefully setting the stage for more sustainable growth moving forward,” he says.
Consumer interest remains low. Just 14 percent of Americans ages 55 to 75 have considered a reverse mortgage, according to a recent survey by The American College of Financial Services. The survey queried more than 1,000 people ages 55 to 75 with at least $100,000 in investable assets and $100,000 in home equity. The number one reason (44 percent) people did not enter into a reverse mortgage was they did not need it because of sufficient income. Other reasons, in order, were “too young” (18 percent), “not ready” (10 percent) and “too risky” (9 percent).
“Americans don’t understand the reverse mortgage product,” said survey author Jamie Hopkins, professor of retirement income planning at the college.
The American College advisor training program includes curriculum on reverse loans and home equity. “Most advisors come into the program with a somewhat negative viewpoint on reverse loans,” Hopkins says. “Very few, if any, have recommended them—but honestly, most aren’t doing any home equity planning at all.”
At best, he says, advisors are taking a look at their clients’ mortgage rates and discussing refinancing. Few consider home ownership and equity from the perspective of taxes, how much clients are spending on housing and where it fits into their budget, the length of their mortgages and whether pre-payment makes sense. “Will the home be used as a legacy for the kids?” he adds. “Is it there to fund your long-term care needs? There’s a need for a broader incorporation of home equity strategies in retirement plans.”
Hopkins thinks that the U.S. Department of Labor’s new fiduciary rule will push the planning profession in this direction as it adopts a more comprehensive approach. There’s nothing specific in the DOL rule addressing home equity or HECMs, but Hopkins argues that a “best interest of the client” approach should incorporate consideration of home equity in the retirement plan.
“If we see research over and over showing that considering home equity as part of the overall portfolio can make an IRA last longer and help with total returns, are you really doing what a prudent investment advisor would do by ignoring that? The fiduciary rule also doesn’t specify that you need to consider taxes when you make recommendations, but if you ignored that and recommended a Roth conversion at the wrong time, we’d all say that fails the test under the rule.”
The research Hopkins references includes several papers published in academic journals over the past five years exploring the uses of HECMs in retirement plans. Numerous studies have argued in favor of HECM credit lines—not lump-sum drawdowns—as backup resources in lieu of large cash reserves, and as a way to generate income in lieu of portfolio drawdowns during market downturns.
Most recently, Wade Pfau, who also teaches at the American College, explored six different ways of incorporating reverse loans into retirement income plans in an article for the Journal of Financial Planning. Reviewing recent research literature, he writes that the recent HECM research “could very well lead to the strategic use of home equity in a retirement income plan to become the next hot topic for client and advisor education, similar to how Social Security claiming strategies have been ubiquitous in recent years.”
David Blanchett, head of retirement research at Morningstar, has also been studying the role of home equity in retirement plans. In a working paper that has not yet been published, he argues that many households are overweight in real estate as an asset and that they would do well to diversify (the paper does not deal specifically with reverse mortgages).
“Many Americans think of their home as being a safe asset, but it is actually quite risky,” he says. “Even a home owned outright has a standard deviation that is approximately equal to a portfolio that is 50 percent stocks and 50 percent bonds. The risk of owning a home (i.e., the home equity) is significantly amplified with a mortgage, and for many younger households the home might actually be the riskiest asset they own.”
“A key driver of the risk of homeownership,” he adds, “is the fact that households generally own a single home; therefore, the risk associated with that home can’t generally be diversified. Thus, the ability to effectively 'diversify' the home would be appealing for a retiree, since it allows the household to maintain ownership but diversify the investment aspect of homeownership.” Will planners buy these arguments?
Lunde says he is seeing “early signs that a new segment of borrowers is entering the reverse mortgage market.” Specifically, he says:
- Less than 30 percent of borrowers are utilizing the HECM principal (available cash to borrowers), suggesting that borrowers are motivated at least as much by planning purposes as immediate cash needs.
- The age of borrowers is falling, suggesting that borrowers are incorporating home equity into their retirement plans earlier, rather than as a last resort (HECMs are available only to homeowners age 62 or older).
- Borrowers have higher levels of assets outside their home equity at the time of HECM origination—although Lunde says data on this point is tentative because the industry only recently began collecting this information comprehensively as a result of the newly implemented financial assessment requirements.
Jack Guttentag, a professor of finance emeritus at Wharton School of the University of Pennsylvania who runs a mortgage consumer information website, also perceives changing attitudes toward reverse loans. “I have noticed that the literature, and media in particular, has been much more favorable to idea of a reverse mortgage than they used to be.”
The question is: Where is the sweet spot for the industry? Guttentag points to the large number of households reaching retirement without resources to maintain their pre-retirement lifestyles—a point that is born out in annual surveys such as the Employee Benefit Research Institute’s annual Retirement Confidence Survey.
But the recent HECM reforms require the industry to sell to households with higher asset levels; they are by definition more likely to have saved for retirement.
Borrowers go through a financial assessment to make sure they can cover tax, insurance and maintenance expenses. The amount that can be borrowed depends on the borrower’s age, the margin tacked on by the lender and prevailing interest rates. Fees include a 0.5 percent upfront mortgage insurance premium (MIP) payment when first-year borrowing is less than 60 percent of the line of credit. The MIP is calculated against the home’s appraised value—$3,125 on a home valued at $625,000. A higher 2.5 percent MIP is charged on loans where first-year borrowing exceeds 60 percent of the credit line—$15,625 on that $625,000 home.
For the adjustable-rate HECMs that now dominate the market, payments can be taken as a large lump sum, a fixed monthly payment or as a line of credit. The upfront costs for credit lines can be quite low; Reverse Mortgage Funding, for example, will extend a credit line with lender credits that cover all of the upfront closing costs (including the MIP), except for the counseling fee, which is $125 in most states. (In Florida and Maryland, the borrower also is charged for recording taxes/fees.)
Still, the HECM reforms create some barriers to their usefulness for affluent households, argues Michael Kitces, director of research for Maryland-based Pinnacle Advisory Group and publisher of the Nerd’s Eye View blog.
They have become more expensive—the 0.5 percent MIP is higher than the 0.01 percent charged on the old HECM Saver that was phased out. Moreover, there is less flexibility to take upfront draws (because of the higher 2.5 percent MIP on larger draws). And, limits on the sizes of larger HECMs have been reduced by about 15 percent, which makes them less relevant for affluent households, since home equity is smaller relative to total net worth, Kitces argues.
“The truth is, HECMs became more restrictive and expensive—they are worse overall, period. The new rules reduce access for people with limited means, but it’s also not a great-looking deal for the affluent,” he says.
Kitces thinks standard home equity loans are a more attractive option in many cases. And his preferred approach to tapping home equity is to simply downsize.
“We see clients doing it because the house feels large and empty, but it produces a lot of savings,” he says.