Monday, March 24, 2014

Reverse Mortgages, Revisited

Are reverse mortgages a good idea?   In general, probably not.  Why?  Well, "do the math!"

I have written about reverse mortgages before, as they are an interesting beast, and popular in some retirement communities.  One problem with them, is that they can limit your options in retirement, and squander the nest egg that is your principle residence.

A recent article on NBC news, which has re-designed its website to look like Windows 8 (no, that's not a compliment) analyzes the reverse mortgage concept.

"However, Mason explained, these loans come with a lot of fees.
The maximum origination fee allowed for a federally insured reverse mortgage, formerly called a Home Equity Conversion Mortgage, or HECM, is 2 percent of the initial $200,000 of the home's value and 1 percent of the remaining value, with a cap of $6,000, according to the National Reverse Mortgage Lenders Association.
You will also owe a mortgage insurance premium fee based on the amount of funds withdrawn during the initial year. That fee is 0.50 percent of the appraised value of the home if you take no more than 60 percent of the amount available in the first year, and 2.5 percent if you take more than 60 percent of the available amount. On a $200,000 home, 2.5 percent amounts to $5,000, and 0.50 percent is $1,000.
You will also owe a mortgage insurance premium annually, which accrues over time when the balance comes due. The annual premium is equal to 1.25 percent of the outstanding loan balance.
There are also appraisal fees, which vary by region but average around $450. If the appraiser determines that your house requires repairs, you will be required to complete the repairs as a condition of approval.
Finally, there are closing costs, which are comparable to those of any mortgage loan and often amount to about $1,000. Some lenders will also charge a $35 monthly service fee for the life of the loan, but most have dropped that fee, according to Trawinski.
"These loans can be expensive," she said, noting it all depends upon how much you borrow initially. "If you take out a lot of money upfront and exit the home in a very short period of time, it can be a very expensive way to borrow money."

These fees may seem "reasonable" when compared to the value of the home, and for a senior struggling to get by on a day-to-day basis, they may be willing to sign anything, just to get an additional stream of income.  As such, they might not think about how much they are squandering in fees.

In a way, it is like the re-fi orgy of the 1990's and 2000's, where many people (yes, myself included) refinanced their homes - sometimes several times - to pay off debts, take out cash, and just generally live the good life.  

For example, in my case, we bought our home for $185,000 in 1989.   By 2005, it was mortgaged for over $300,000.   Fortunately, we sold it for $680,000.   Neverthless, that represents a lot of borrowed money.   And the closing costs and fees from refinancing were easily $5000 or more, each time we did it.

The thinking was, at the time, that the "overall monthly payment" would be lower, thanks to lower interest rates (which on our original mortgage, was 11.675%!) and thus we could borrow more and pay less.

But as I have noted time and time again, this "monthly payment mentality" often ends up costing the consumer more in the long run, as they squander money on fees, interest, and the like - and also end up spending more money since it appears the incremental amount of monthly payment is insignificant.  So people buy more car, or pay more in loan fees, not realizing they are losing $5000 a pop - only looking at it as $25 a month.

Note that the article above states that there are regulations in place as to how much in fees that a reverse-mortgage holder can charge.  Right off the bat that tells you the sad story of this business - how in the past, unscrupulous lenders charged enormous fees to originate these loans.   Now, granted, many Banks charge "points" as loan origination fees, and many mortgage brokers add on so-called "garbage fees" as well (document prep, courier fees, etc.).  But again, this is why refinancing, over and over again, can be such a toxic thing.  A "serial refinancer" can add tens of thousands of dollars to their loan balance, just in bank fees - all in the name of "lowering monthly payment).

As I have noted in earlier posts - and as nearly every Real Estate "Expert" advises - in a "normal" Real Estate market, it takes five years or more for appreciation to wipe out the transaction costs of buying and selling a home.   If you move every five years, and buy a home every time, you are not coming out ahead, but instead, making a lot of bank managers and Real Estate agents very happy.

And that is the problem with the reverse mortgage.  While you may think that the loan will "last you the rest of your life", in reality it may only last a few years.   Oh, and by the way, it is a loan - one with an increasing balance and increasing interest, over time.

You see, most seniors taking out such loans are usually only a few years away from the retirement home or some medical crises.   And I say this, as I live on retirement island, and I see, firsthand, how long seniors last, before they move off the island - feet first, or to an "assisted living center".   And I'd say the average is about 10 years or so, maybe less.   Often, when one spouse gets sick, the other has to move as well.   And then there are those who just decide that island living is not for them, and move back to be "closer to the grands".   And yea, there are even those who buy a house here, stay a few years, and then decide they want a different house here on the island, and sell that.

So, using a $400,000 average value for a home here, taking out $200,000 in a reverse mortgage, let's do the Math, based on living here ten years.   The closing costs would be as follows:

Origination FEE:  $4000.00
One-Time Mortgage insurance: $1000.00
Annual Mortgage Insurance (1.25%):  $2500 x 10 = $25,000
Interest: 4% x 10 years = $80,000

Total Fees and Interest:  $110,000

This is assuming that you take out a lump sum, and thus pay the highest interest.   You could also structure the loan as a line-of-credit, so you only pay interest on the money that you borrow.  But let's assume you take out this $200,000 reverse mortgage, and you withdraw $20,000 a year for ten years.

Now the interest part is hard for me to calculate, mostly because finding interest rates online for reverse mortgages is damn near next-to-impossible.   This article from U.S. News and World Report (home of the dumb college rankings) notes that interest rates for reverse mortgages are "higher than home equity loans" which means my 4% rate is a bit conservative, if anything.

This calculator from Reversemortgage.org is helpful, and sort of validates my rough estimates:




Enter a Desired Line-of-Credit        

You Could Get
Interest adjusts >

Interest rate index
  Plus lender's margin
Initial loan interest rate
  Plus mortgage insurance
Initial total loan rate
Initial creditline growth rate
Lifetime cap on loan rate
HECM Expected Rate
Monthly Service Fee
Value of the home
Home value limit
   Lesser of limit or home value
Loan principal limit
   Less Service fee set-aside
Available principal limit
   Less Financed Items
      Loan origination fee
      Mortgage insurance
      Other closing costs
Net Principal Limit
   Less Lump-Sum Cash 
     Fixed-Rate Unusable Funds
   Less Selected Creditline
     Available In First Year
     Available After First Year
Left for monthly advance
   Monthly Advance
     No more lien payments
   Increase in monthly cash
Monthly Term
Total Fees & Costs

HECM LIBOR
1-month LIBOR
Monthly

0.156%
2.500%
2.656%
1.25%
3.906%
3.977%
12.656%
5.330%
$0.00
$400,000
$625,500
$400,000
$191,600
$0
$191,600

$6,000
$2,000
$2,631
$180,969
$0
--
$180,969
$104,329
$76,640
$0
$0
+0.00
$0.00
Tenure
$10,631


HECM Fixed
Fixed Rate
--

--
--
5.060%
1.25%
6.310%
--
5.060%
5.06%
$0.00
$400,000
$625,500
$400,000
$210,400
$0
$210,400

$6,000
$2,000
$2,631
$199,769
$115,609
$84,160
$0
$0
$0
$0
$0
+0.00
$0.00
Tenure
$10,631


As you can see, there are a lot of variables in the equation here, including whether you get a fixed (over 5%!!!) interest rate, or a variable (which can cap at over 12%!!).  And this scenario is for a Line of Credit which allows you to take out as much (or as little) as you want.

If we take out money in $20,000 increments over ten years, the interest would be a lot less.  How much less?  Well according to the moneychimp compound interest calculator, at 4%, we are looking at $49,727.03 in interest, which would be about $30,000 less than the amount I calculated above.

So after a decade, you now owe $280,000 on your home, after being paid $200,000 in $20,000 increments.  If housing in your area increases at about 2% per year (which is about normal) then the house is now worth $487,597.77, which means you still have another $207,597.77 in equity in the house.

Of course, at this point, you'd have to take out another reverse mortgage if you wanted to keep living the house, and with fees and all (which are much higher when you go over 60% of the equity value, presuming someone would even touch such a loan) it would be even a worse deal.

Or, you could take out less each year and stay in the home longer - that is assuming you still can stay in the home, and are not so befuddled and incapacitated that you can't keep the place up.   Oh, and by the way, maintenance on the home is not optional.   You let the place fall down around you and the reverse mortgage lender can foreclose on you to protect their investment, and you are out on the street, broke!

But let's say you take out $10,000 a year, for 20 years.  You are now looking at $109,692.02 in interest accruing over that time period plus another $25,000 in annual mortgage insurance.  You've spent $164,692.02 just to borrow $200,000 over 20 years.   Compound interest is a bitch - when you are borrowing.  It is your friend, when you are holding.

Now granted, your home may be worth $594,378.96 by that point, so you still have about $200,000 in equity left in the home.  At least that's something.   But we are talking about relatively small amounts of money in extra income every month - $1667 a month over 10 years, maybe $880 over 20.

We could also get a Tenure Contract (this gets complicated, doesn't it?)  What have I always said about complicated deals?  They generally don't work to the consumer's advantage.  The more complicated you can make any financial transaction, the easier it is to conceal the real cost from the consumer.   A tenure contract is like an annuity, except instead of paying you for life, it pays you so long as you live in the house:
 
You Could Get
Interest adjusts >

Interest rate index
  Plus lender's margin
Initial loan interest rate
  Plus mortgage insurance
Initial total loan rate
Initial creditline growth rate
Lifetime cap on loan rate
HECM Expected Rate
Monthly Service Fee
Value of the home
Home value limit
   Lesser of limit or home value
Loan principal limit
   Less Service fee set-aside
Available principal limit
   Less Financed Items
      Loan origination fee
      Mortgage insurance
      Other closing costs
Net Principal Limit
   Less Upfront Cash 
     Fixed-Rate Unusable Funds
   Less Selected Creditline
     Available In First Year
     Available After First Year
Left for monthly advance
   Monthly Advance
     No more lien payments
   Increase in monthly cash
Monthly Term
Total Fees & Costs


HECM LIBOR
1-month LIBOR
Monthly

0.156%
2.500%
2.656%
1.25%
3.906%
3.977%
12.656%
5.330%
$0.00
$400,000
$625,500
$400,000
$191,600
$0
$191,600

$6,000
$2,000
$3,837
$179,763
$0
--
$0
$0
$0
$179,763
$1,069
+0.00
$1,068.61
Tenure
$11,837


HECM Fixed
Fixed Rate
--

--
--
5.060%
1.25%
6.310%
--
5.060%
5.06%
$0.00
$400,000
$625,500
$400,000
$210,400
$0
$210,400

$6,000
$2,000
$3,837
$198,563
$114,403
$84,160
$0
$0
$0
$0
$0
+0.00
$0.00
Tenure
$11,837


 


Now this scenario was based on my being age 62, the earliest age you can take out such a loan.   After ten years, you have taken out $128,280 in cash.  Over 20 years, $256,560.   In other words, this is about an average between my 10- and 20-years scenarios, and if you stay in the house 10 or 20 years, the numbers will crunch out about the same.

By the way, $200,000 invested at 4% interest will buy you a 25 year annuity paying that same $1069 a month, according to bankrate.com.   If you are really interested in a life annuity or a fixed-term annuity, it might be a better deal to buy one of those directly.  They can last as long as you live (or for a fixed-term) regardless of whether you "stay in the house" or not.
 
Note that you can see how their actuaries are thinking here - that I might live another 15 years or so, or more precisely, I might keep the loan another 15 years or so.  The amount of money available for monthly payment is neatly in-between my 10- and 20-year scenarios.  The dirty little secret of reverse mortgages is that people don't leave the home feet-first but rather end up selling the home and paying off the reverse mortgage before they die.

If you can "stay in the home" and live a really long time, you might clean up on the reverse mortgage - to the point where the mortgage company loses money on the deal.   Note however that the loan balance does have to be paid when you die, so if you have other assets (IRA, 401(k)) in your estate, they will go to the reverse mortgage company.   If you have no heirs or don't particularly like your children (a common theme here on retirement island) this is not an issue.

This AARP article has more information on these loans.   This must of been written back when AARP was actually an organization that helped retired people, instead of exploiting them.  But unless you can "beat the reaper" the reverse mortgage people will come out ahead, every time.   At worst, they might not make as much money as they hoped (with fees, interest and all).  It is highly unlikely they will end up losing money, in many cases.

Now,  let's consider another alternative.  Supposed you sold the home at market value for $400,000 and downsized to a $200,000 home that was smaller, cheaper to heat and cool, has lower property taxes, and is easier to take care of - for an older person.

While there are closing costs associated with selling the home (Realtor's fees being the biggy, at 6% or so) you can easily walk away with $376,000 in cash.  If you buy a smaller home, for $200,000, you may pay a grand or so in closing costs (for a cash sale) and end up with $175,000 to spend. 

Now, if you divide that over 10 or 20 years, you may end up with less money every month, it is true, but if you take into account the lower operating costs of the smaller home, you may end up further ahead.   And after 10 years, that $200,000 home is worth $243,798.88, after 20 years, $297,189.48

Or, that $175,000 could be invested, for example, in stocks or bonds, and thus generate income.  You could buy a 20-year annuity with it, which at 4% would generate $1056.94 a month in income.  4% is a pretty low number.  Chances are, you could do even better than that.

Or, using the 5% rule, you could take out about $730 a month (increasing each year with the rate of inflation) for about 30 years, before that $200,000 ran out.   Your money would last longer and not be tied to living in a particular home.   It does leave you with more options, except of course, the option of keeping your home.

As you can see, with the smaller home, your monthly income is the same or greater, and over time, you end up with more money in terms of equity in the home.  In fact, over 20 years, about a hundred thousand dollars in more equity.

Twenty years is a long time, and statistically speaking, most retirees don't live that long past age 62 (the earliest age you can qualify for a reverse mortgage).  But in this day and age, it is not unheard of to live to be 85, 90, or even 100.   But 20 years is really a "leaving feet first" scenario.   And you might end up in assisted living or some other controlled environment.

It is an interesting thought experiment, and all I can say is crunch the numbers first.   There may be situations where such a mortgage might be appealing.   But I suspect most of these are sold on the idea of the monthly payment mentality, and as a result, many retirees don't "do the math" on all these fees and interest they are being charged.

And speaking of the "monthly payment mentality" - how many seniors do you think are taking out reverse mortgages so they can make a car payment?   I'm willing to bet, more than a few.   Think about it - you are paying interest twice - once for the reverse mortgage, and once again for the car payment.

But that is the temptation and I guess I can't fault folks for that, to some extent.   You want to enjoy life to the fullest, and it seems like an easy solution, to get a reverse mortgage and end up with more income (generally tax-free) and thus be able to live "high on the hog" for a few years.  When it comes time for the rest home, well, you don't want to have money anyway, as Medicaid won't kick in, until you are poor (another example of unintended consequences of government actions).

Think about it.  You are frugal and practical, and you scrimp and save, and you don't squander your money.  You have a stroke or something and have to go into assisted living.   You have to burn through the remainder of your wealth, before medicaid picks up the tab at the nursing home.

Your neighbor, however, gets a reverse mortgage, goes on cruises and buys new cars every three years.  He squanders a ton of dough on Jet Skis and Penis boats and shows off his wealth - burning through it at a tremendous rate.   He has a stroke and ends up in the nursing home.  Since he is "broke", medicaid immediately picks up the tab.

Who was being smart and who was being dumb?   It is an interesting question.  And the more I think about this retirement thing, the harder it is to answer that question.

But, taking aside that extreme scenario (which may not be that extreme), I think in general it is better in life to have money than to have debt, in most situations.  I'd rather be the Senior who downsizes and has $300,000 in equity after 20 years, than the one who "stays in the home" and has $200,000.

This is not to say I would never, ever get a reverse mortgage.   But I think it is highly unlikely I would ever do so.  Even at age 54, the hassle of home maintenance (cleaning gutters, pressure-washing the siding, mowing the lawn, fixing plumbing, etc.) seems like a boring pain-in-the-ass.  Yea, it was fun when I was 30, doing "chores" on the weekend.   But today, I'd rather be doing something else.  In ten years, I can guarantee I would rather not be cleaning gutters.

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2 comments:

  1. Sorry for the formatting errors that made this hard to read, initially. When I imported the tables, they created a lot of spurious HTML

    ReplyDelete
  2. The bottom line is, if you look at the two scenarios (staying in the $400,000 house and getting a reverse mortgage versus downsizing to a $200,000 house and spending the difference) you come out about $100,000 ahead in the latter scenario.

    However, you don't get to stay in the $400,000 house. If that is worth $100,000 to you, than I suppose it is a bargain with the devil.

    On the other hand, it illustrates how having "more house" costs "more money".

    If you are facing financial difficulty, it would seem that having less house would be a more logical choice.

    ReplyDelete

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