Financial Pain Across America
Inflation is squeezing family budgets. Retirement accounts are down 10-30% and everyone knows stocks sold at low prices can never recover. All seniors say their 2023 Social Security 8.7% cost-of-living adjustment this year is not going to cover higher prices for food, healthcare, and energy.
When a significant percentage of people have a problem, it is not their problem, it is the problem. In America, and around the world, 'the problem' is underfunded retirement plans and pensions.
What is a person to do?
Part of the solution may be found in the brick and mortar of people’s homes. Last summer, The Wall Street Journal reported total U.S. home equity reached $27.8 trillion. Seniors, age 62 and above, hold $11.5 trillion.
Most homeowners will not be able to retire safely without repositioning the ‘location’ of some of their wealth so they can enjoy a life they feel is worth living. This article is about an adage that is relevant today...
The time to get a loan is when you can get a loan.
We will explain this in three sections:
I. Why so many are in this situation
II. The reverse mortgage solution
III. Case study and action steps
Why We're in This Situation - Wealth, Income, Liquidity
There is a difference between wealth and income. We all have a specific amount of wealth, money accumulated from savings, investment profits, and perhaps an inheritance. And we have a certain monthly income from some combination of wages, self-employment, Social Security, distributions from IRAs, and maybe annuities or a pension.
Liquidity is the bridge between wealth and income. It describes how easily wealth can be turned into cash. Most financial calamities are a function of insufficient liquidity, i.e., not having enough cash or cash flow.
If your outgo exceeds your income, your upkeep becomes your downfall.
Most of us struggle with money for two reasons: 1) Lack of financial literacy (they do not teach it in school and many parents never talked about money in the home). 2) People do not know where they stand, i.e., where their money goes, whether they have saved enough, or how much risk are they taking.
Sadly, people who lack financial literacy often struggle more than those who do not. It is a big topic that includes income, savings, investments, debt, credit, housing, retirement, insurance, wills, trusts, and estate planning. Google any of those terms and you will be overwhelmed with information. But where do you start? And how do you navigate?
As a faculty advisor with the National Institute of Financial Education®, I have a gift for you (at the end of this article) that will help you get a better grip on all things financial, and it will give you increased confidence and peace of mind.
Only Two Options
There are only two options when cash is tight:
1. Reposition wealth (optimize assets to better support lifestyle goals)
2. Downsize (learn to be happy with less)
Downsizing examples:
- Drive a car that use regular gas instead of premium
- Move to a less expensive city or state
- Sell and buy a less expensive house
Repositioning wealth means moving it from one ‘location’ to another, whether that is from checking to savings, from savings to an IRA, from a house back to checking, etc.
Optimizing assets means putting them in a ‘location’ that best supports financial and lifestyle goals.
Examples of repositioning wealth or optimizing assets:
- Using 401-k proceeds when leaving a job to buy a lifetime income annuity
- Trading down to a less expensive house and freeing up cash to live on
- Using cash to buy a house instead of taking out a 6% mortgage
- Use savings to buy life insurance or long-term care insurance
- Getting a reverse mortgage to access home equity
The Reverse Mortgage Solution
Nothing compares to a reverse mortgage for repositioning, or safely accessing wealth (for those who are eligible). The alternative is selling the house, paying a typical 5-6% commission, getting a moving van, and all the miscellaneous expenses involved in turning a house or apartment into a home.
Reverse mortgages have unique features that bank HELOCs cannot match; something I wrote about in Danger of a HELOC in Retirement.
If inflation continues for a protracted period, owning appreciating assets will be key. Rent or Own in Retirement explores the danger of not owning an appreciating asset. I have observed that seniors who struggle the most are those who have been long-time renters. Selling and renting is a mistake best avoided… if possible. And, sadly, I realize it is not always possible.
Unbeknownst to most people, including many financial advisors and real estate agents, you can buy a house with a reverse mortgage. The Reverse Mortgage Purchase Strategy is an example of a downsize that leads to a more secure retirement by repositioning (unlocking) wealth to pay for lifestyle and unexpected expenses.
When someone is exploring a reverse mortgage, their three big questions are always
- How much can I get?
- How much will be left in say 15 years?
- Why can’t I get more?
The short answers are:
- When house values or borrowers’ ages go up, they can get more
- When interest rates go up, borrowers get less
- Lenders do not want borrowers to owe more than the house value at the end
Question 1 - How Much Can I Get?
“How much can I get?” is the number one question people ask. The maximum loan amount for a reverse mortgage is driven by three factors:
- Allowed home value
- Interest rate
- Age
Allowed home value is one of the most confusing aspects of FHA-insured reverse mortgages. Every year the government sets conforming loan limits, which are the maximum loan size that Fannie Mae and Freddie Mac will purchase. These limits are based on median home prices in specific metropolitan areas.
Reverse mortgages use the high-balance conforming loan limit - but not in the way you think. This year, the amount is $1,089,300. Here is where it gets confusing. On a conventional mortgage, the conforming limit is the maximum loan amount.
But for FHA reverse mortgages, the conforming limit is the maximum home value used in the loan amount calculation. It is not the maximum reverse loan amount. It is the highest value they will use to multiply the percent you can borrow. I know, it is confusing.
As an example, with an FHA reverse mortgage, a homeowner with house worth $1,089,300 can borrow the same amount as someone with a house worth $2 million. On an FHA reverse, any value over the 'maximum allowed value' is ignored. It is as if the house was not worth more.
What if someone’s house is worth more than a million dollars? Then they would look at a proprietary or jumbo reverse mortgage. However, the percentage they can borrow on a jumbo are less than the FHA version because jumbos do not have government insurance. Therefore, the lender must take more risk and since they are not willing to, they reduce the maximum loan percentage. The jumbo percentage has been reduced multiple times in the last twelve months.
Equity
Reverse mortgages allow people to access a percentage of their home equity. What is home equity? It is wealth trapped in a house. The calculate home equity: sale price (value) – selling costs (real estate agent) - outstanding loans.
Example of calculating home equity
(a – b – c = d)
a) House worth $800,000
b) Sales commission (6%) $48,000
c) Loan balance: $280,000
d) Equity = $472,000
One common area of confusion are taxes due from the sale of a home. Home equity and capital gains are not the same. Capital gains are your profit from owning the home. It is what the IRS will use (less exemptions) to calculate the tax on your profit.
To calculate capital gains: sales price – selling costs – purchase price – improvements = gain
A person can have no equity, but still owe capital gains. How? Previous cash out refinances or negative amortization. Click here for a good capital gains calculator.
Interest Rates and Age
The older a borrower is, the more they can get from a reverse mortgage. Each year older gets about 1% more of the value. However, higher interest rates dramatically reduce the maximum loan amount and eat up the gains from being older. Below we will look at the interplay between age and rates.
Look what happened to interest rates over the last 13 months. This is a chart of the 10-yr Treasury. This index is what is used to determine maximum reverse mortgage loan amounts.
In December 2021, the 10-yr Treasury rate was 1.44%. By January 2023, the rate had risen to 3.87%. That is more than double and one of the fastest percent increases in rates ever.
Next, we will show the impact rising rates have had in terms of the percent of value someone can borrow – rising rates have dramatically reduced reverse mortgage loan amounts.
The green line (below) was thirteen months ago, i.e., December 2021. The red line is today, January 2023. That big drop between the green line and the red line is how much less (% of home value) today's homeowners can access.
It used to be if you were in your sixties, and your house was half paid off, you were in decent shape to get a reverse. Now, someone in their sixties needs the house to be almost two-thirds paid off.
Here is the same information in chart form.
Notice how in December 2021, at age 62, an eligible homeowner could borrow 48% of the value of the house. Now, January 2023, a borrower would have to wait until age 80 to get that same 48%. When rates are rising, waiting until you are older to get more does not work out well.
Question 2 - How Much Will Be Left?
The second most important question we get is, “How much will be left in the future if I get a reverse?” That question is usually tied to concerns about kids’ inheritances or having enough money to pay for an assisted living facility when living in the house is no longer an option.
How much will be left depends on three things:
1) How much you took out. The less you take out up-front, and over the years, the more equity left at the end. That is because reverse mortgages negatively amortize, i.e., the interest you do not pay is added to loan balance. So, the balance grows by both future withdrawals and the interest that was not paid each month.
Example:
- 200,000 borrowed
- Unpaid interest at end of first year is 14,000 (200,000 x 7%)
- Balance at end of first year is 214,000
- Balance due at end of year two is 228,980
However, house appreciation can offset the rising loan balance:
- If house value was 500,000
- At start of loan, equity is 300,000 (500,000 - 200,000)
- Appreciation of 4%
- Value at end of first year is 520,000
- Equity at end of first year is 306,000 (520,000 - 214,000)
- At end of year two, equity is 317,820 (540,800 - 228,980)
Notice how there may be more equity in two years than today, even with a reverse, depending on future rates and house appreciation rates.
2) Future home value. House values (house price index), over medium to long time frames, usually go up.
Notice in the chart above: house prices dropped in only one of the last six recessions. The long-term U.S average house price increase was 5.3% (in nominal terms, i.e., not adjusted for inflation). Most reverse lenders use a 4% average annual appreciation for their disclosures.
If you look at the chart above and recognize that most reverse mortgages are held for 7-10 years, (depending on the borrowers’ ages when the loan started and/or if there is one borrower or two), 4% seems reasonable over a 7–10-year time frame. With or without a reverse, if house prices drop, equity goes down.
Below is a graph showing house values, equity, and loan balances over 15 years on a $900,000 house, paying off $280,000 existing mortgage. Disclaimer: interest rates throughout the 15 years will vary, so actual results will differ from the graphs below.
Notice the difference in equity (black line) between a 4% appreciation (above) and 0% or flat house prices (below). If house prices never go up, the growing reverse mortgage balance will eventually eat up all the equity.
There has never been a 15-year period where house prices stayed flat, i.e., 0% appreciation. That does not mean it cannot happen, it just never has. The third component on how much will be left is about rates.
3) Interest rates since loan started. Most reverse mortgages have variable rates and lifetime caps. Lower rates over time mean a lower loan balance at the end - less interest accrues. Notice (below) the differences in home equity based on interest rates at the beginning of the loan and over time.
The following examples, like the one above, are based on a $900,000 value, paying off a $280,000 existing loan, and rates staying constant based on the 1-yr Treasury rate at time of origination.
If rates started and stayed where they were on 12/17/21, you would have the following:
Versus if rates started and stayed where they were on 1/3/23:
Notice above how much less you can borrow now versus a year ago and how much higher the eventual loan balance is. That does not mean a reverse mortgage is not the best solution for someone today.
There are plenty of stocks you wish you sold a year ago rather than last month. The point is things have shifted but most of us are having trouble keeping up with just how much things have changed. In general, house prices went up, stocks went up, and rates trended down for a decade. It is hard to shift one's thinking.
The table below illustrates the rate impact and shows the difference in initial line of credit available as well as the difference in wealth (equity) 15 years from now.
HPI stands for house price index and is a measure of the house appreciation rate.
Conclusion
Rates significantly impact the initial amount available and how much home equity will be left at the end.
Homeowners who wait are taking a risk that they may be eligible for even less in the future. While no one knows what rates or house values will be tomorrow, the following is certain.
- If rates go up further, borrowers will get less
- If house prices drop, borrowers will get less
If you are currently eligible for a reverse mortgage, and if one will solve one or more problems you are facing, acting now is a smart move. Consider the alternative.
Case Study
Vance, age 62, lives in Orange County, CA with a house worth $900,000 and an existing mortgage of $379,000.
Toward the end of 2021, Vance called to learn about reverse mortgages and how one might help him. He was concerned about his job stability and was planning to retire in 2022.
He called again in March of 2022. At that time, he was eligible for a reverse mortgage that would have paid off his existing mortgage, but he still was not sure. He was hoping to get a reverse to both pay off his existing mortgage and give him a line of credit to use for health insurance until he turned 65.
At the end of May 2022, Vance was laid off from his job because of a significant slowdown in his industry. He called again to explore his reverse mortgage options. Sadly, because of rising rates, the maximum reverse mortgage loan amount was less than in March. Vance would now have to bring $32,000 to closing because the lower available reverse mortgage amount would not cover his existing mortgage.
Vance decided not to proceed, instead hoping rates would go down in the Fall and he could get a larger loan. Sadly, rates kept going up, and by winter 2022 the maximum reverse loan amount dropped to the point where Vance would have to bring $92,000 to closing.
He did not have that much liquid cash and taking it from his IRA would have entailed some significant tax implications – he would have to withdraw more than $92k to end up with $92k. His IRA withdrawal would have been treated as ordinary income.
We recently learned that Vance sold his house and plans to rent a small place. He told us rents were much higher than he imagined. The worst part is Vance no longer owns an appreciating asset. Someday Vance may relocate to a less expensive area and be able to use the Reverse Purchase Strategy to buy another house and again own an appreciating asset.
Key Takeaways & Action Steps
For 10 years, house prices went up, rates stayed low, and reverse mortgages were easy to get. Now the concern is a future improvement in rates may be offset by sagging house prices.
Bottom Line
If you are eligible for a reverse, consider proceeding while you can. You do not want to be like Vance and have the opportunity disappear before you are ready to act.
Something else most people do not realize you can refinance a reverse mortgage in the future (at a discount) if doing so improves your situation – i.e., lowers your interest rate or increases how much you can get. So, the risk of acting now is lower than it seems.
At the beginning I promised a tool to help your financial literacy and clarity. As a faculty advisor with the National Institute of Financial Education®, I am pleased to offer you a free subscription to an application that will help you get smarter about money and gain a sense about how you are doing in terms of preparing for or navigating retirement. If you would like to learn more, click here: www.financialclaritysolution.com. Click Get Started in the upper-right-hand corner. There is no cost to you, and you will not have to provide your last name, address, birthdate, social security number, etc.
And if you’d like to see how a reverse mortgage might be useful to your future financial plans, click here: www.reverseloanamount.com.
About the Author
Kent Kopen has been a reverse mortgage specialist since 2007. Mr. Kopen earned the CRMP (Certified Reverse Mortgage Professional) designation in 2017 from the National Reverse Mortgage Lenders Association in Washington D.C. Kent is licensed to practice in CA, CO, TX, AZ, and FL. Mr. Kopen teaches educational courses focused on retirement strategies to real estate brokers and professionals who offer financial, tax, and legal advice to seniors.
