The Reverse Mortgage as a Retirement Income Product
Retirement Income Journal, April 7, 2010, FINAL
By: Joseph A. Tomlinson, FSA, CFP
Home equity is destined to become an important source of funds for retirement, and the
reverse mortgage is a product designed for this purpose. In this article, I’ll evaluate the
reverse mortgage as a product for generating lifetime income, either directly or in
combination with an immediate annuity.
The Need to Use Home Equity
For many older Americans, the equity in their home is their largest asset. Data from the
Federal Reserve's Survey of Consumer Finances shows that for individuals over the age
of 65, home equity averages about 2 ½ times the amount of financial assets.
The Center for Retirement Research at Boston College has estimated that without
tapping home equity, 61% of Americans are at risk of not being able to maintain their
standard of living in retirement, and the trend is worsening. In a recent study they
conclude:
"Not tapping home equity may be a luxury that future retirees can ill afford as
Social Security replaces a smaller share of pre-retirement incomes and people
rely increasingly on meager 401(k) balances rather than on traditional
pensions."
Retirees can generate funds from home equity by downsizing, or by borrowing against
their home's equity value. The reverse mortgage is a product specifically designed for
retirees who wish to stay in their home and have access to its equity.
So far, reserve mortgages have been used by only about 2% of eligible homeowners.
They have generated quite a bit of press coverage—some positive because the product
meets a growing need, and some negative because of the high fees.
Product Design
Reverse mortgage lenders offer a number of different ways to utilize home equity.
Homeowners may take the loan in any of the following forms: as a lump sum advance,
as a credit line account, or as a regular monthly payment that lasts as long as the owners
remain in the home.
As a rule, the borrower is not required to make any repayments until he or she vacates
the home. Proceeds from the sale of the home may used to pay off the loan balance. Any
excess of realized sale value over the value of the loan goes to the homeowners or their
heirs. Because the loan is non-recourse, the borrower's obligation cannot exceed the
home value, regardless of how long the homeowners continue to occupy their home.
Here is a sample quote (3/20/10) from Wells Fargo, currently the largest reverse
mortgage lender in the United States:
Home Value
Age of Youngest Owner
Advance or Credit Line
Available
Monthly Funds Available
Variable Loan Interest Rate
$300,000
75
$162,915
$1,120
2.73% + .5% mortgage insurance fee
= 3.23%
The "Advance or Credit Line Available" is significantly less than the home value because
the loan balance grows over time with interest. Amounts available will vary inversely
with current interest rates, and directly with the age of the owner.
The "Monthly Funds Available" is the annuity-like payment that owners can choose to
receive as long as they remain in their home. The "Variable Loan Interest Rate" in this
quote is based on a spread over Libor.
(Note: in examples that follow, I've used a projected 6.00% borrowing rate instead of
3.23%. Current rates are at historic lows, so I've based the examples on a rate more in
line with past averages.)
Fees
Now for the scary news. Here are typical fees based on the above example:
Origination Fee—paid to
lender
Closing Costs—paid for
legal, appraisal , and other
services
Mortgage Insurance
Premium-Paid to
FHA/HUD for guarantees
Servicing Fee-paid to
lender for monthly
servicing
Total Up Front Fees
2% of first $200,000 of
home value, 1% above
$200,000
Similar to a conventional
mortgage
$5,000
2% of home value + .5% of
loan balance
$6,000 + .5% of loan
balance (included in the
6.00% projected borrowing
rate)
$35 per month
$2,500
$13,500
The total fees are much higher than for conventional mortgages. Fortunately for
borrowers, most of these fees can be financed and do not require up-front cash. One way
to understand the impact of the fees is to look at the effective loan interest rate as a
function of how long the homeowner stays in their home and keeps the reverse
mortgage. This calculation is based on the cash the borrower receives and the loan
amount paid back at maturity.
Duration of Reverse
Mortgage
5 years
10 Years
15 years
20 years
20 years (example when
home value limits loan
amount)
Effective Interest Rate—
Monthly Pay Mortgage
14.85%
8.76%
7.44%
6.93%
5.61%
Effective Interest Rate—
Lump Sum Mortgage
7.81%
6.98%
6.69%
6.54%
5.56%
The effective interest rates show the impact of the up-front costs. For example, a
homeowner taking out a monthly pay reverse mortgage and keeping the mortgage for
five years, would be effectively borrowing at a rate close to 15%.
However, for borrowers who stay in their homes for longer durations, the rates look
much more attractive. The rates shown in the last line of the chart are based on an
example where home prices increase 2 ½% each year and loan balances eventually
bump up against home values, effectively lowering the borrowing cost.
The chart illustrates the point made by many loan counselors: that homeowners should
not consider a reverse mortgage unless they expect to remain in their home for a long
time.
The Lump-Sum/Annuity Alternative
It is almost never a good idea to borrow money to buy a financial product, but it may be
worthwhile to consider taking a lump sum reverse mortgage to purchase an annuity that
produces lifetime income. The type of annuity could be either an immediate annuity or a
variable annuity with a guaranteed lifetime withdrawal benefit.
In the following example, a hypothetical 75-year-old woman owns a house worth
$300,000 (mortgage-free). She would like to generate as much income as possible from
the equity in her home. Based on the Wells Fargo quote (above), she could take out a
reverse mortgage that would pay her $1,120 per month for as long as she stays in her
home. Alternately, she could take the maximum lump sum, $162,915, and buy an
immediate annuity (with no refund at death) that, based on Vanguard/AIG rates, would
pay $1,281 per month, thus increasing her monthly income by $161.
As another option, she could buy a variable annuity with a guaranteed minimum death
benefit. For a 75-year-old, the guaranteed withdrawal percentage would typically be 5%.
Unfortunately, 5% would only generate $679 monthly, assuming she purchased the
annuity and immediately began taking withdrawals.
Impact on Estate Values
Another important consideration is the impact on amounts left to heirs. The following
chart provides a comparison of the three product options in terms of the estate values at
different durations.
The estate value is the difference between the home value (assumed to increase 2 ½%
annually) and the loan value, for both the immediate annuity and the reverse mortgage
strategies. For the variable annuity strategy, the estate value also includes a projection
of the growth of the assets in the VA account. The estate value cannot be less than zero.
Not surprisingly, the strategies that produce high monthly incomes produce the low
estate values.
The difference between the estate values for the reverse mortgage strategy versus the
immediate annuity strategy, reflects the lack of a refund feature in the immediate
annuity--the form of the product chosen to maximize income. By contrast, the monthly
pay reverse mortgage is like an annuity that pays a refund equal to the home's net equity
value.
The variable annuity strategy produces the highest estate values, but that's primarily
because monthly income is drastically reduced.
Present Value Measure
It is not straightforward to judge the tradeoff between monthly income and estate value,
so the next chart uses present values to combine them into a single measure.
I used the 6.00% borrowing rate to calculate the present values. Based on this measure
we can see that attractiveness of the immediate annuity strategy depends on longevity—
early deaths are penalized, and long lives are rewarded. The monthly reverse mortgage
strategy does better than the immediate annuity strategy up to about age 90 in this
example, so it is likely to be the favored strategy if the borrower has legacy interests.
The variable annuity strategy performs the worst under this measure. It is completely
dominated by the reverse mortgage. (For variable annuity product charges, I assumed
a total of 2.25% annually to cover product fees, investment expenses, and GLWB fees.)
For all three strategies there's a change in tilt between years 15 and 20, which reflects
loan values bumping up against projected home values.
These results will vary depending on choice of assumptions, but, nonetheless, I feel this
analysis provides a reasonable comparison of the product alternatives.
Conclusions and Future Analysis
The key conclusions I draw form this analysis are:

Despite their high fees, reverse mortgages can be attractive for individuals who
plan to stay in their home for a long time.




Effective borrowing costs are exorbitant for shorter-term loans.*
The monthly pay reverse mortgage provides 10%-15% less income than using an
immediate annuity, but provides substantially more value in the event of an early
death.
For maximum income if estate value is not a concern, consider taking a lump sum
reverse mortgage and investing the funds in an immediate annuity.
A strategy of purchasing a variable annuity with a guaranteed withdrawal benefit
with a lump sum reverse mortgage does not appear competitive.
This article offers a start at analyzing the reverse mortgage as a retirement income
product, but more research is needed. This analysis was done on a before-tax basis, and
a more refined evaluation needs to consider tax effects.
It would also be useful to look at examples where the client has both housing wealth and
other savings, and therefore more options in creating retirement income. This analysis
can also be improved by developing stochastic forecasts to compare the risks in various
strategies.
Such additional research can lay a foundation for incorporating the reverse mortgage
product into financial planning software.
*Most reverse mortgages offered currently are under the HUD/FHA Home Equity Conversion
Mortgage program, and fees are based on maximum allowances. If the market grows and
become more competitive, products may become available with reduced up-front fees that will
make them more attractive for shorter durations.