FA Playbook

Rethinking reverse mortgages: Bad move or bright idea?

Andrew Osterland, special to CNBC.com

Reverse mortgages are the ugly stepchildren of the home-lending industry, and not just because they get hawked by celebrity spokespeople like Henry "the Fonz" Winkler on late-night infomercials.

Most financial advisors see the products as a last resort for cash-strapped seniors—and a bad one at that. They are expensive, restrictive and usually don't provide enough income to help borrowers meet their financial needs for very long.

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"The concept is sound—people have equity in their homes and can generate income from it, but the products in the marketplace still leave a lot to be desired," said Ric Edelman, CEO of Edelman Financial.

He has never recommended a reverse mortgage to any of his more than 26,000 clients. "Between the expenses and the limitations on them, we don't feel they solve the problem of seniors who are tight on cash," Edelman said.

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A reverse mortgage enables homeowners of at least 62 years of age to get a lump-sum payment, a stream of payments or a line of credit they can tap based on the amount of equity they have in the property.

The amount someone can borrow depends on the value of the home (up to a maximum of $625,500), their age and prevailing interest rates. The higher the property value, the older the borrower and the lower the interest rate, the more people can borrow.

Now is a particularly good time for [reverse mortgages], with interest rates so low. If I were 62 years old, I would be getting one.
John Salter
wealth manager with Evensky & Katz Wealth Management

The Federal Housing Administration, which insures most reverse mortgages, passed rules recently limiting loans to 50 percent of home value in the first year. As long as borrowers continue to pay their taxes and maintain the property, they will never have to leave the house or "pay back" the loan.

Edelman, however, said the income from reverse mortgages is often not enough to get people very far if problems arise—health-care costs being the most common issue. If they do have to sell or leave the house after a few years, anyway, the deal gets very expensive, as most of the high costs of reverse mortgages (origination fees, insurance and closing costs) are booked upfront.

"People are better off selling the house and finding someplace more affordable to live," he said.

Lazetta Braxton, a a certified financial planner serving a large number of middle-income clients, also thinks people need to be very wary of tapping the equity in their homes if they have no other assets. "I see problems for people who don't have other options and don't get educated about [reverse mortgages]," she said.

Braxton, too, has yet to recommend them to clients but has helped people on a pro bono basis who have used them. "If you need the money to live, you're going to tap it, but people have to understand the consequences," she said. "If it's your last asset and you deplete it, you're done. You have to have a Plan B."

Yet not all advisors are down on reverse mortgages. John Salter, a CFP and wealth manager with registered investment advisor Evensky & Katz Wealth Management, thinks that everyone should at least be considering them as part of their retirement planning.

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Salter, who holds a Ph.D. in financial planning, is particularly keen on the Home Equity Conversion Mortgage (HECM) Saver, a line of credit developed and insured by the Federal Housing Administration in 2010. It has more limitations on the amount you can take out in the first year than previously, but the upfront fees are lower, and borrowers can pay off the loan without penalty.

In a paper co-authored with colleague Harold Evensky and Shaun Pfeiffer, an associate professor at Edinboro University in Pennsylvania, Salter argues that this more affordable and flexible line of credit can be used in conjunction with investment portfolio management to help people stretch their savings significantly further. "Now is a particularly good time for [reverse mortgages], with interest rates so low," said Salter. "If I were 62 years old, I would be getting one."

The basic strategy for clients with an investment portfolio is to tap the equity line to cover living expenses during bear markets. "When the portfolio is down, you don't want to sell depreciated assets, so you tap the line of credit," explained Salter. "When the portfolio recovers, you take money out to pay off the loan."

Salter ran the numbers for portfolio withdrawal rates of 4, 5 and 6 percent under various market conditions, assuming a home value of $250,000 and a portfolio value of $500,000. If the portfolio value dropped more than 20 percent over a 12-month period, the line of credit would be used to meet cash needs. Otherwise, the sale of portfolio assets would cover costs.

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Salter concluded that the strategy worked for all three withdrawal scenarios, helping portfolios last longer and improving overall retirement distributions. "This is about risk management," said Salter. "If you're trying to protect yourself for 30 years down the road, you want the letter of credit."

The other arguably worthwhile use of reverse mortgages is to enable people to delay filing for Social Security until 65 or 70 years old, in order to get a bigger benefit.

Edelman, however, is still not sold on the idea. "I've seen [Salter's analysis], and I don't agree with his premise or conclusions," he said. "It comes down to the income you receive, and it's usually not enough. Things happen in life, and the loan has to be repaid. In the real world, it doesn't work."

—By Andrew Osterland, special to CNBC.com

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