Mortgages and Reverse Mortgages (RAMs) after Retirement

"Should People in their sixties take out a mortgage?"

The short answer is "Not if you don't have to." Now if I suddenly vanish, the explanation will be that the loan industry put a contract out on me.

Success in loans, and sales in general, is often attributable to selling people stuff they don't need. If you don't sell something, you don't eat. Getting people to call or stop by the office is expensive. The traditional idea of sales is that you have to make a sale at every opportunity, whether it really makes sense for the client or not.

The various tricks of selling a mortgage to retired folks is a case in point. "It's a cushion," "It's there in case you need it," and all sorts of other stuff to that effect. Combine this with the "If you wait until you need it, you won't qualify!" and most folks who don't know any better will cave in and apply.

This is exacerbated by the fact that most people seem to want to stay in the same home they raised their family in. This is very understandable, emotionally, and often the worst thing you can do financially.

Let's consider the typical three or four bedroom house with a yard, and the retired couple. It becomes more and more difficult, physically, for them to do the required routine cleaning, and even more difficult to do the maintenance and repairs that any home needs from time to time. Sometimes the kids are close enough and willing to help, sometimes they aren't. If their finances are tight in the first place, they get tighter and tighter over time.

Into this environment comes the guy with a Reverse Annuity Mortgage (RAM) to sell. This is a special kind of mortgage, with a special protection for the homeowner (here in California, and in many other states as well) that they cannot foreclose in your lifetime. You cannot be forced out. Well, what if you're sixty-five and live to 100, as a far larger proportion of today's 65 year olds will? That's thirty-five years they are locking this money up for, and there is always the possibility that by the time they consider the cost of selling, etcetera, there will be no equity. The interest rates are significantly higher than a regular "A paper" mortgages, higher than most sub-prime loans, even, and the pay to the loan officers who do them is much higher than a typical loan.

Lending is a risk based business, and that kind of lending carries its own risks. Who pays for the risk to the lender? You do. Especially as opposed to the typical loan where half have refinanced in two years and ninety-five percent in five, this is a long term loan they are being exposed to. Yes, the recipient could get cancer and die in a few years, but they could well survive that. The lender has no way of knowing what the interest rate environment for the money will be in a few years. So either the rate the clients get is variable, or the clients pay a higher rate to have a fixed interest rate.

Once you start taking money out of the RAM, it starts earning interest. Since in the most common forms the homeowners are typically not making payments, it's usually compound interest. If you are making payments, it makes your cash flow even tighter, and you need to take more money. In either case, your balance is increasing, faster and faster with time, until you hit the limit, at which point you can no longer get additional money. This often happens surprisingly quickly, as you have the power of compound interest working against you. This all but guarantees that the family will have to sell the home, often for less than they could have gotten had they the luxury of a longer sale time. Furthermore, if keeping the home in the family is something you would like, a Reverse Annuity Mortgage is almost certain to torpedo the hope.

Contrast this with the swap down option. Suppose instead that adult children buy a small place suited to the parents needs such as a condominium, and the parents live there, while the adult children live in the parents home. This minimizes cleaning, upkeep, and maintenance that the parents need done.

If this won't work, another option is selling the home and buying something smaller. Remember, a RAM will almost certainly cause the family to lose the home anyway. You get more mileage out of cashing in the equity by selling, and investing the equity, than you will from borrowing against the equity. Instead of working against you, compound interest is on your side. Most states have laws preserving property tax basis if that's something that is advantageous.

Let's say that with a $500,000 home, moving down to a $200,000 condo. Net of costs, you net at least $250,000 to invest, and let's say you do so at 7 percent, significantly less than a well invested portfolio. This gets you $17500 per year, or about $1460 per month, indefinitely, and you keep both the condo and the $250,000. Contrast this with taking the $1460 per month out of your equity. Even if you can find a RAM at the same 7 percent, the entire equity is gone out of your home in a little over fifteen years, and that's without including initial loan charges.

Nobody can make you do this, and there are many reasons why you might not want to. But looking at it from a strictly financial viewpoint, it's hard to find the justification for a Reverse Annuity Mortgage. In fact, I have never seen a situation where I would recommend it from a viewpoint of financial prudence. There might be family situations that make it the "least bad" solution, but that doesn't mean it isn't bad.

Caveat Emptor

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