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The Best Reverse Mortgage Payment Plan
from: Tim PaulReverse mortgages are products available only to senior citizen homeowners (over age 62) that allows them to take cash equity from their homes to use for living expenses. Under a reverse mortgage, the lender makes loan payments to the borrower and the loan is repaid when the house is sold or the homeowner dies. The HUD/FHA Home Equity Conversion Mortgage (HECM) is by far the most popular type of reverse mortgage.
The HECM program offers borrowers a variety of options by which they can elect to be paid the borrowed funds:
line of credit - by far the most popular option which allows homeowners to draw funds as needed;
> lump sum - similar to a regular home equity loan with funds paid at closing;
term - fixed payment for specified number of years (e.g. 10 years);
tenure - equal monthly payments for as long as the borrower remains in the home
combinations of the above
Nearly four out of five HECM borrowers (78%) opt for the line of credit payment option. There are two big reasons why people feel this is the best choice:
First, funds are drawn only when needed and interest accrues only on funds actually drawn-down. This maximizes flexibility and minimizes interest costs. Second, the untapped balance of the line of credit actually grows at a healthy rate until the funds are drawn. This means the size of the loan available to the homeowner can grow.
With features like this it's not hard to see why the line of credit option is so popular. But is this really the best deal for seniors?
Increasingly, research suggests that the lowly tenure payment option - selected by only five percent of borrowers - may be the best financial choice. The tenure option provides guaranteed equal monthly payments for as long as the borrower lives in the home.
For example, studies, such as done by Met Life and the Society of Actuaries, consistently find that a large majority of both retirees and pre-retirees underestimate life expectancies. According to Met Life, not only do people underestimate longevity, they do not view it as a financial risk. Just 2 of 10 (23%) people understand that longevity is the greatest financial risk facing retirees. Inflation is a very significant financial risk, selected by 41% of respondents, but it is important to note that longevity risk is exacerbated by inflation risk.
Like an annuity, the tenure payment option provides a regular monthly income stream that can help protect borrowers from outliving their resources.
Another study from the Center for Retirement Research at Boston College concludes that the HECM lifetime income plan (tenure option) is the best financial choice for seniors under almost all scenarios:
"We find that over a wide variety of assumptions about asset returns, the optimal strategy for all but the most risk tolerant households is to take a reverse mortgage in the form of a lifetime income. We are informed by the National Reverse Mortgage Lenders Association that only a small minority of borrowers choose this option, as most choose a line of credit. Our findings appear to be yet another manifestation of the widely documented reluctance of households to annuitize their wealth in retirement. There are substantial differences in reverse mortgage equivalent wealth among strategies, and in our base case a household with average housing and financial wealth...would be 33 percent better off taking a lifetime income at age 65 relative to taking a line of credit when financial wealth is exhausted." (From "Optimal Retirement Asset Decumulation Strategies: The Impact of Housing Wealth, Wei Sun, Robert K. Triest, and Anthony Webb - November 2006 -
To be sure, there are good arguments against choosing fixed payments. For one, over time inflation will erode the purchasing power of fixed monthly payments. Also, if the homeowner is forced to sell because of declining health or other factor, the loan must be repaid and the monthly income stream stops.
Still, as the reverse mortgage marketplace continues to grow, it is important that potential borrowers consider all payment options. The overwhelming popularity of the HECM line of credit payment option may be more a sign of a "follow the crowd" mentality, not sound financial decision-making.
About the Author
Tim Paul is a financial management executive with more than 25 years experience. His websites focus on personal finance issues including HELOC Loans and providing unbiased reverse mortgage information to senior homeowners.
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