Reverse mortgages could help in retirement

Seniors who built retirement nest eggs risk running out of money if they live too long. Those who own homes, however, have a valuable option: They can use reverse mortgages to reduce that risk.

The caveat: They must unlearn what they thought they knew about shopping for a mortgage.

Do the arithmetic. John retires at 65 with $2 million of financial assets that, along with Social Security, must support him for the rest of his life. Whether it does depends mainly on the rate of return earned on his assets, the rate at which John withdraws money from those assets, and how long he lives.

If his fund earns a constant 6 percent a year and John withdraws a monthly stipend equal to 4 percent of the $2 million divided by 12, rising by 2 percent each year as an inflation offset, he will succeed. He will draw $6,667 a month to start, and because this is less than the growth rate of his wealth, his wealth will rise, to $4 million by his 108th birthday.

These numbers come from a spreadsheet developed with my colleague Allan Redstone that will be available shortly on my website, www.mtgprofessor.com. The spreadsheet makes it easy to model many different combinations of the factors that affect how long a retiree's wealth will last.

For example, considering how highly priced common stocks are today, and how low interest rates are, a 6 percent rate of return on John's wealth appears unduly optimistic. If we reduce the assumed rate of return to 4.5 percent while retaining the withdrawal rate as it was, John's wealth will gradually decline, hitting zero when John reaches 103. A further reduction in rate of return to 3.5 percent results in John running out of wealth when he hits age 96. For most retirees, that would be unacceptable.

The standard remedy is to reduce the withdrawal rate by an amount that pushes the asset depletion point far enough out that John is comfortable with the risk. If the withdrawal rate is reduced from 4 percent to 3.15 percent, John's wealth will last until he reaches age 107. But this also involves reducing the initial monthly stipend from $6,667 to $5,250, which may mean a big scale-down in lifestyle.

If John is a homeowner, however, there is another option.

Add a reverse mortgage, also known as a home equity conversion mortgage (HECM), and let it sit unused until it's needed. Thus, while John's financial assets are being depleted, his credit line is getting larger. He draws on the line only if he is still alive when his assets are depleted; otherwise, the equity in his house passes to his estate.

If John's house is worth $400,000, he can command a credit line of $210,519, which will grow at a rate equal to the interest rate on the adjustable-rate reverse mortgage he selects. Assuming a rate of 6 percent, the line will reach $1,351,000 when John runs out of money at age 96, extending monthly draws until he reaches 108. If the rate is 3.5 percent, the line grows to $624,000, and it extends the draw period only until John reaches 100.

If John dies before his wealth is fully depleted, the HECM credit line may never be used. The cost in that case is the initial settlement cost of $6,282 if paid in cash at the outset. If John finances the settlement costs, as most seniors do, the cost is the future value when the reverse mortgage is paid off, which will be considerably higher, yet tiny compared with the draw amounts.

Get the right HECM. Retirees who select a credit line to hold unused as their sole reverse-mortgage option should view themselves as investors. When market interest rates rise, investors benefit - borrowers lose.

For example, using the same adjustable-rate HECM, John takes a $100,000 unused credit line. Jane draws $100,000 in cash. In Year 2, both John's line and Jane's debt grow at the prevailing interest rate - a higher rate that makes Jane worse off makes John better off.

This should affect John's shopping strategy in two ways. First, in selecting between alternative combinations of interest rate and origination fee, John should select the highest rate/lowest fee combination. Second, in selecting between ARMs with a 5 percent rate-increase cap and those with a 10 percent cap, he should choose the second.

That seniors with different objectives should select reverse mortgages with different features points to the need for lenders to offer options.