Evaluating Reverse Mortgages As InvestmentsAdvisor Perspectives
Reverse mortgages have been receiving considerable attention in recent years as a retirement planning tool, with particular focus on the line of credit (LOC) feature. Retirees may be able to use a LOC to provide additional funds for retirement or in more specialized ways such as supplementing retirement savings portfolios during stock market downturns. Much of the research on such uses, including my own, has involved building full financial planning models that incorporate LOCs.
However, it is useful to narrow the focus to the performance of LOCs, as one would for any financial investment. That is the approach I will take in this article to provide an additional perspective for analyzing reverse mortgages.
This article is based on an example of a 65-year-old individual owning a $350,000 home and utilizing a LOC, and the loan parameters are generated using the calculator provided by the National Reverse Mortgage Lenders Association (NRMLA). Under HUD rules, this individual can obtain a reverse mortgage LOC with a gross amount of $183,050. The up-front costs for setting up the LOC – loan origination, mortgage insurance, closing costs – are estimated to be $15,326 and, assuming those are borrowed as part of the reverse mortgage, the net amount available as a LOC is $167,724. This borrowing source will be accessible as-needed, and repayment will not be required until the borrower permanently leaves his or her home. Also, the loan is nonrecourse, and the borrower’s repayment obligation is capped at 95% of the appraised value of the home – no worries about deficiency payments as with a conventional mortgage.
The interest rate for the LOC loan is a variable rate based on 1-month LIBOR plus add-ons for loan origination and mortgage insurance. The initial loan rate is 4.64% based on the NRMLA calculator, although lenders do have some flexibility in setting loan rates and front-end charges. A unique reverse mortgage feature is that the LOC does not remain fixed at the initial amount, but, instead, any unused LOC grows at the variable loan rate.
My analysis is pre-tax, and LOC borrowings are, indeed, tax free. There may be some deductibility of loan interest at the time of repayment, but the tax rules on this are not completely settled.
Measuring LOC performance
We now turn to the task of determining how best to assess the performance of the LOC as a financial instrument. The basic structure involves periodically borrowing funds as withdrawals from the LOC and then repaying the loan when the reverse mortgage is closed out. In the most straightforward cases, the repayment is simply the loan balance, i.e. the accumulation of the withdrawals at the variable interest rate charged for the reverse mortgage loan. But there are a couple of additional considerations that may also affect the performance measurement:
- If the up-front costs of setting up the reverse mortgage are borrowed as part of the reverse mortgage, they will also accumulate interest charges and be included in the total loan balance.
- If, at the time of loan repayment, the reverse mortgage loan balance exceeds 95% (i.e., if the value of the home declines over the loan period, or if the mortgage balance grows above this threshold) of the appraised home value, the nonrecourse character of the reverse mortgage limits the required repayment to this 95% value.
More generally the “repayment” can be thought of as the difference between: (1) the home value that would have been realized without a reverse mortgage and (2) the actual home value (if any) realized after reverse mortgage loan payoff.
Read the full article here by Joe Tomlinson, Advisor Perspectives