It's no secret that Americans are largely unprepared for retirement. But according to some financial advisors, they could be improving their financial standing significantly by factoring in home equity into a comprehensive retirement income plan.
Reverse mortgages give seniors who are at least 62 years old a way to convert their home equity into cash. Given that for the average American, 75 percent of net worth is tied up in their homes, it makes sense to use them as a retirement asset, some in the financial-planning community argue.
"People are coming to retirement, and they don't have much," said Jamie Hopkins, associate professor of taxation at The American College of Financial Services. "They have their home, Social Security and a little bit of savings. Why not use the home equity?"
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Pulling money out helps to diversify the overall risk of retirement assets, Hopkins argued. "People are overweighted in this risky asset," he said. "We can take away that volatility and protect other risky assets for retirement."
Mechanics of reverse mortgages
Most reverse mortgages are home-equity conversion mortgages and are insured by the Federal Housing Administration. To qualify, homeowners must be at least 62 and have substantial equity in their homes. In addition, they must have the means to pay property taxes and insurance.
The amount that borrowers can receive depends on three factors: the age of the youngest borrower (the older you are, the bigger the loan you can receive), interest rates and the home's appraised value. The maximum loan amount varies by county but is capped at $625,000.
Interest accrues during the life of the loan, so the loan amount gets bigger with time. However, "it's a non-recourse loan, so the borrower never has to repay more than the home is worth," said David Johnson, associate professor of finance at The John E. Simon School of Business at Maryville University.
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Three funding options
Borrowers have three ways to access their equity. The first is a lump-sum payment. "I would encourage borrowers not to take a big lump sum of money and blow it right away," said Johnson.
Recent changes to the HECM program prohibit borrowers from taking out more than 60 percent of their home's value in the first year of the loan.
But a lump sum may make sense for some, said certified financial planner Marguerita Cheng, CEO of Blue Ocean Global Wealth.
One of Cheng's clients, an 82-year-old widow, recently got a reverse mortgage for $58,000, the same amount she owed on her original mortgage. "She wanted to do some home improvements so she could age in place," said Cheng. "She could pay her bills, but she wanted some flexibility."
Another option is an annuity to be paid monthly as long as the homeowner stays in the home.
The third way — and the one that gets financial-planning academics most excited — is the line of credit. Taking a line of credit lets the money grow at roughly 4 percent a year, said Hopkins, and it can be tapped at any point. Advisors suggest retirees take out a line of credit early on and let the amount grow.
"You can use it as added portfolio insurance," said John Salter, associate professor of financial planning at Texas Tech University and a principal of the wealth management firm Evensky & Katz.
Salter, along with co-authors Shaun Pfeiffer and Harold Evensky, proposed in the Journal of Financial Planning that a line of credit could be used to protect against portfolio declines. If a nest egg suffers deep losses, as many did in 2008 and 2009, retirees can tap their line of credit for living expenses.
"The biggest risk to a retiree's income plans is sequence-of-returns risk," explained Hopkins of The American College of Financial Services. "The reason why the line of credit works so well is because it's a non-market correlated asset."
After the recession, our clients called, telling us that their banks had canceled their lines of credit, even for people who had good credit. That's the time when you need it most.
John Salter
principal at Evensky & Katz
Some advisors still unconvinced
Although reverse mortgages have gained more acceptance, advisors point out that they've got their shortcomings, too.
First, some advisors take issue with the associated closing costs, which can run several thousand dollars higher than traditional mortgages, due to higher origination fees and FHA mortgage insurance. In addition, borrowers must attend — and pay for — a counseling session.
Then, some advisors, such as Kevin McKinley, a CFP and founder of McKinley Money, believe there are better ways to tap home equity. "I'd prefer [clients] use a home equity line of credit," he said. Though he likes the line-of-credit approach, he has not recommended a reverse mortgage to any of his clients yet.
Reverse mortgage advocates, however, say the product is more flexible than HELOCs or the other options for tapping equity — downsizing. To qualify for a HELOC, borrowers must often demonstrate a steady income stream, something that most retirees don't have. And a HELOC can be canceled at a moment's notice.
"After the recession, our clients called, telling us that their banks had canceled their lines of credit, even for people who had good credit," Salter said. "That's the time when you need it most."
A reverse mortgage line of credit cannot be canceled.
Finally, downsizing into smaller digs as a way to tap home equity, while making good financial sense, may not be what retirees want. More and more retirees want to "age in place," according to AARP.
"I'm the perfect example of this," said Shelley Giordano, chair of the Funding Longevity Taskforce. "My husband is retired, and what did we do? We put on a massive addition to our house so we could have all the kids and grandkids."
— By Ilana Polyak, special to CNBC.com
