Q: "Can seniors insure themselves against running out of money?"
A: If they have significant equity in a home they occupy as their principal residence, the answer is "yes," the HECM reverse mortgage administered by FHA can be used for this purpose. (HECM stands for home equity conversion mortgage.)
The problem: Millions of seniors retire with a modest nest egg that they intend to use up during their retirement years, but face the risk that their funds will be fully depleted while they are still alive. They may follow the advice of a financial planner who tells them how much of their fund they can draw each year consistent with a low probability of running out of money. However, a low probability of going broke can be a source of continued anxiety.
A standard remedy for anxiety associated with low-probability hazards to life, limb or pocketbook is insurance. In this case, the insurance is provided by the federal government with the HECM reverse mortgage program. But the senior must use the program properly.
Using a HECM as an insurance policy: A HECM can be used to insure against running out of money by electing a credit line for the maximum amount available, which will depend on the senior’s age and the value of her home. The actual amount borrowed at the outset is just large enough to cover the upfront charges. Her credit line grows at a rate equal to the interest rate on her HECM, which changes every month, plus the 1.25 percent insurance premium.
Consider a senior with a house worth $400,000 who retires now at 62 and plans to draw down his nest egg over 20 years. If he takes a standard adjustable-rate HECM at the rate on Nov. 14, 2012, of 2.459 percent, he receives an initial credit line of $230,359, which untouched grows to $483,000 over 20 years if the interest rate stays the same. But at an interest rate of 8 percent, his credit line at age 82 would be $1.5 million, and at the maximum rate of 12.459 percent (10 percentage points above the start rate), it would be $3.6 million.
While many borrowers fear adjustable-rate mortgages because rising rates increase the mortgage payment, that is true only on standard mortgages. On a HECM there is no required payment, and rising rates increase the growth of an unused credit line. Seniors using the HECM to insure against the possibility that their financial assets will run out benefit from rising interest rates.
Cost of the insurance: The cost of this policy to the senior is the upfront fees, which are financed, and which also grow over time. The fees in the example amount to about $17,000 in 2012, growing to about $36,000 in 20 years at the current interest rate.
There has never been a better time to take a HECM: Given the borrower’s age and property value, the amount that can be drawn on a HECM depends on the interest rate and the property appreciation rate: the lower the interest rate and the higher the appreciation rate, the larger the draw. HUD assumes a property appreciation rate of 4 percent, which has been the average over many decades, and does not adjust for changes in the economy. The interest rate used, however, termed the "effective rate," is a market rate that adjusts every week and is now below the floor of 5 percent set by HUD. It can go no lower, but it can go higher, and it will in time.
The bottom line is that initial credit line draws are now at their peak, and the rate of increase in credit lines will accelerate when interest rates start to rise. The time to take a HECM is now.
Intrafamily tension over loss of equity: Reverse mortgages result in loss of equity in the home, which can be a source of tension between the seniors involved and their heirs, who are usually their children. Using the HECM as an insurance policy, however, uses only a small part of the equity unless the worst happens — the seniors run out of money and must draw on their credit line. Explaining to the kids that they will use the line only if they have to should go a long way toward melting their resistance.