How Retirees Can Use Their Home's Wealth as an Emergency Fund

With more baby boomers moving into retirement every day, the wealth locked up in their homes seems ripe for the picking. And a relatively new way to put that wealth to work—the standby reverse mortgage strategy—is garnering increasing attention. Some researchers say the strategy can increase the longevity of a retiree’s portfolio by opening the door to an income source to tap in an emergency.

The standby strategy puts to use some of the reverse mortgage’s quirky features to provide a flexible pot of money to help manage cash flow. First, the retiree takes a reverse mortgage as a line of credit. Any unused balance grows at the same rate being charged on the line of credit.

If a borrower receives a $100,000 line of credit at a 5% interest rate but doesn’t tap the funds, that line of credit would grow to $105,000 after a year and then about $110,000 the next year, and so on. “The idea is to set up the line of credit early and let it start to grow,” says Wade Pfau, a professor of retirement income at the American College of Financial Services and author of Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (Retirement Researcher Media, $20).

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This effectively allows you to create a ready source of cash if you need it. The money isn’t taxable, so you can cover a major expense with no ill effect on your tax bill. That might protect some of your Social Security benefits from being taxed or prevent you from going over the income threshold that triggers Medicare premium surcharges. If you tap the line in an emergency, you can pay the loan back without penalty when you are able to restore your borrowing power.

The reverse mortgage can play a role in the bucket approach to retirement portfolios, the strategy that calls for keeping a couple of years’ worth of income needs in cash, with two or more buckets holding more volatile investments. The idea is that you routinely sell assets from the other buckets when it’s time to replenish the cash.

But what if the market has taken a beating just when you need to sell? Tapping your reverse mortgage to refill the cash bucket could give your stocks time to recover. When stocks are back up, you could pay the line of credit off, to use for another rainy day.

Perhaps counterintuitively, impending rate hikes actually boost the attractiveness of the standby reverse mortgage strategy because lines of credit carry variable interest rates that will climb as interest rates rise. And, the higher rate will apply to your unused balance to boost your borrowing power. The ability for the credit line to grow is a key advantage of the strategy. Interest rates for a reverse mortgage recently ranged from 3.38% to 3.53%.

The costs of taking a reverse mortgage have come down in recent years, which helped the standby strategy gain traction with retirement experts.

When shopping, ask about the origination fee, which the government limits to a maximum of $6,000. You may find loans with zero to little origination fees, but the interest rate will be higher in that case. That’s a trade-off: You’ll get less proceeds up-front with a higher interest rate, but the unused line of credit will grow at a faster rate. Other typical loan closing costs generally run about $2,000 to $3,000.

You will owe the annual insurance premium of 1.25%, as well as an up-front premium of 0.5%. (If you have to access more than 60% of your proceeds to pay off an existing mortgage, that up-front premium jumps to 2.5%.) But the annual premium is based on how much you actually borrow from the credit line, not the full line of credit.

Of course, any loan means you’re putting your collateral at risk. You must maintain the home and keep up with property insurance and property taxes. Fail on those fronts, and you risk a loan default, which could lead to foreclosure. If you use up all the proceeds from the reverse mortgage, you won’t be able to tap the home for cash again unless you’re able to pay off the line of credit. This strategy “needs to be part of an overall responsible plan,” Pfau says. “If the person will spend anything they have, it could be a problem.”