Preserve Credit As An “Insurance” Policy
The final use for a reverse mortgage is to preserve the line of credit as an insurance policy against a variety of retirement risks. Preserving credit as insurance involves setting up a HECM reverse mortgage as early as possible and then leaving it unused until needed. The up-front costs for the reverse mortgage could be treated as an insurance premium that may never need to be used if everything else goes well in retirement. However, a variety of potential pitfalls face retirees, and implementing a reverse mortgage earlier in retirement could support a sizeable pool of contingency assets.
For more information, download our Reverse Mortgage 101 Cheatsheet.
I have already discussed one aspect of this insurance protection in which a line of credit is opened and then used to support retirement spending only in the event of portfolio depletion. In this regard, the insurance provided by the HECM is against market losses that risk the ability to meet retirement-portfolio distribution goals. This was one of six strategies to coordinate portfolio spending with home equity. In this edition of the book, the slower growth of the line of credit reduces the strategy’s competitiveness with other coordinated strategies, but it does remain as a viable option.
Another aspect of the insurance that could be provided by a HECM line of credit is to treat it as a large contingency fund to help meet unplanned expenses. For example, a reverse mortgage could help as part of a divorce settlement. In this scenario, the reverse mortgage could allow one ex-spouse to stay in the home, with the reverse mortgage used to pay a necessary portion of the home’s equity to the other ex-spouse. Alternatively, the home could be sold with the proceeds split, and then each of the ex-spouses could use his or her half of the home equity with a HECM for Purchase to obtain a home of similar value to the original. The line of credit could also be used to support in-home care or other health expenses to avoid or delay institutional living in the face of long-term care needs.
The focus of this article is a final insurance aspect that requires a bit more explanation: using the HECM as a way to protect the value of your home. With the current HECM rules, those living in their homes long enough could reap a windfall when the line of credit exceeds the home’s value. This potential windfall is amplified by today’s low interest rates. Even if the value of the home declines, the line of credit will continue to grow without regard for the home’s subsequent value. Though this strategy remains, I will explain how the updated rules from October 2017 have dramatically reduced the likelihood for this strategy to create benefits for newly issued loans.
Combining the principal limit with the fact that a HECM is a nonrecourse loan means that the HECM provides a valuable hedging property for home prices. What is the specific probability that the value of a standby line of credit will grow to exceed the home value? I have sought to answer this by simulating future home prices and future one-month LIBOR rates that will guide the growth of the line of credit. With each of these values projected over time, we can determine how frequently a line of credit may exceed the value of the home across a large number of simulated futures.
For this example, I assume the borrowers are sixty-two years old, the ten-year LIBOR swap rate is 2.25 percent, the current one-month LIBOR rate is 1.25 percent, the lender’s margin is 2.25 percent, and up-front costs will be financed from the investment portfolio. This combination results in an expected rate of 4.5 percent and a principal limit factor of 43.9 percent.
The initial effective rate is 4 percent (1.25 percent LIBOR, 2.25 percent lender’s margin, and 0.5 percent mortgage-insurance premium). If interest rates never rose, it would take far too long for a 1 percent spread in the growth rate (4 percent less 3 percent for an assumed home-value growth rate) to allow the line of credit, which is initially 43.9 percent of the home value, to grow and surpass the home value. But if we forecast one-month LIBOR rates to gradually increase in the future, the increased variable rates for the HECM line of credit improve the odds for the principal limit to eventually exceed a randomly fluctuating home price.
Exhibit 1.1 shows the probabilities by age ninety-two that the HECM line of credit has grown to exceed the home’s value for a sixty-two-year-old borrower. With these simulations, there is a 50 percent chance of this and the potential to obtain a windfall from the line of credit, since it represents a nonrecourse loan. This serves as protection, especially when the value of the home declines during retirement.
For the applicable rules for loans issued before October 2017, I previously reported that this median break-even age was eighty-one, so the new rules have increased the age by eleven years—reducing the odds that retirees will benefit from the strategy. When considered with the increased up-front costs for reverse mortgages triggered by the new rules, I do not expect many retirees to open reverse mortgages now with a primary intention of treating the HECM as a protection on the value of their home.
Exhibit 1.1: Probability that HECM Principal Limit Exceeds the Home Value for a 62-Year-Old
A few caveats of this strategy to hedge home prices with the HECM are worth discussing. First, these probabilities may actually be underestimated, because any given home may experience more price volatility than the overall Case-Shiller index for home prices. David Blanchett has estimated the volatility of individual homes at double the level of overall home price indices used in these simulations. Individual homes are at more risk of experiencing substantial price declines relative to the index, creating more opportunity for the hedging value to be realized. The line of credit becomes valuable in cases when the home price falls. In financial language, it is essentially a “put option” on the value of the home. The line of credit can provide a positive net payment when the home value declines.
Second, there is an important aspect of timing the decision about when to access the line of credit. The longer you wait, the greater the potential growth for the pot of funds that can be obtained. Generally, the principal limit, loan balance, and line of credit grow at the same rate. But for any loan balance, the growth reflects the growing interest and mortgage premiums due rather than growing access to new funds. Waiting is advantageous, but if you wait too long and suddenly die, it’s too late and the line of credit is no longer available. Estates and nonborrowing spouses cannot take advantage of the windfall after the sudden death of the borrower. It is best not to become too greedy once a windfall has developed from the nonrecourse aspects of the HECM program.
Finally, to be clear, this use of a HECM line of credit as home-value protection can be considered a “loophole” in the current program. Opening a reverse mortgage and then not using it works against the interests of some lenders and the government’s mortgage-insurance fund. The lender is not able to charge interest, which could create real difficulties for lenders that have reduced up-front costs by providing a higher margin and have paid a commission to the loan originator. Also, the mortgage-insurance fund is unable to collect further premiums to support coverage of any shortfall to the lender when the borrower gets more out of the home than it is worth. This surely explains part of the justification for the government to close a large portion of this “loophole” for new loans issued since October 2017.
With this approach, borrowers may also be encouraged in subtle ways to let the value of their home decline so that they can make a smaller repayment. Thus, while this option is available today—and I could say that it is even encouraged with the heightened government efforts to reduce the speed at which borrowers use up their lines of credit—I expect that the government will eventually work to further weaken or eliminate this hedging opportunity.
As new businesses are increasingly able to offer real-time estimates of home value, one possibility for future borrowers is that the borrowing capacity will be capped at the appraised home value. Another possibility is that the government could begin to charge the mortgage-insurance premium on the value of the principal limit rather than on the loan balance. This would vastly increase the cost of the insurance strategy, possibly overturning its value completely. However, for the time being, these insurance opportunities exist within the current HECM program.
This is an excerpt from Wade Pfau’s book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (The Retirement Researcher’s Guide Series), available now on Amazon.