If you watch television, you have probably seen the frequent ads featuring famous actors promoting something called a “reverse mortgage.”
The purveyors of these products claim that by letting homeowners access the equity in their homes, reverse mortgages can provide immediate and lasting financial security for older Americans.
Reverse mortgages are legitimate financial products designed for people above age 62. But are they the magical cure-all that they’re claimed to be? The answer is somewhat complex. Let’s examine how reverse mortgages work, while also looking at the advantages and disadvantages.
Reverse Mortgage Basics
In simple terms, a reverse mortgage is a mechanism for you to access the equity in your home. But unlike a home equity loan or line of credit, you don’t have to pay the money back while you are still living in your home.
If you have a substantial amount of equity in your home, you can get a reverse mortgage loan and receive the loan amount in a lump sum or in monthly payments. This can provide a helpful sum of cash if you need income to live on.
To qualify for a reverse mortgage, you must be at least 62 years old and own the home outright, or have it paid down considerably.
Reverse mortgages have been offered by private companies since the 1960s, but since the 1980s have been administered by the U.S. Department of Housing and Urban Development. (HUD refers to reverse mortgages as “home equity conversion loans,” or HECLs)
Reverse mortgages administered by HUD are insured by the Federal Housing Administration. It’s generally advised that you avoid any reverse mortgage that does not come from an FHA-approved lender.
A reverse mortgage can be a useful tool for some retirees, especially those who do not have substantial retirement savings or income. But there are a variety of reasons why it may not be the ideal vehicle for many people.
Advantages of a Reverse Mortgage
It’s always a good idea to weigh the pros and cons of any financial tool. Let’s start with the advantages of a reverse mortgage.
It’s a Source of Income
Every retiree needs to find money somewhere, as Social Security payments alone likely aren’t enough to cover more than basic living expenses. Ideally, when you retire you will have some sort of income from a pension, a retirement plan, or other investments. But if you have little or no savings and no easy means to acquire it, tapping the equity in your home can be an option.
Financial advisors generally recommend first using other assets such as your 401k or IRA accounts to pay for day-to-day expenses in retirement. But in the absence of these, a reverse mortgage can work.
“I would recommend it if there is no other way to address your retirement income needs,” says Michael Foguth, president of Foguth Financial Group in Brighton, Michigan. “You’d first want to use any other assets you have anywhere else.”
It Allows You to Remain in Your Home
One of the biggest fears that retirees have is that they will be unable to afford to stay in their homes. Without savings or income, they may not be able to afford the property taxes, insurance, upkeep or community fees, if applicable.
A reverse mortgage will usually offer enough money to cover these costs for many years, and in most cases you can’t be forced to move out. The title of your home does not change hands.
The Loan Does Not Need to Be Paid Back Until the Home is Sold
With a traditional mortgage, a homeowner usually makes a monthly payment to repay the loan and interest. With a reverse mortgage, however, there are no payments due while you are living in the home.
So, if a reverse mortgage nets you a $200,000 payment, that cash is yours for as long as it lasts. The loan gets paid back when the house is sold after you move out or pass away
You Can Get a Lump Sum or Regular Payments
Most reverse mortgage companies are flexible about how you receive your money. You can get cash in a lump sum or set up monthly payments. A lump sum can help you if you have some immediate expenses to deal with, and may provide you with greater overall flexibility.
But many retirees prefer the stability and comfort that consistent monthly payments can provide. This payment method can also help ensure you don’t blow through your loan amount too quickly.
If you take the reverse mortgage as a lump sum, you’ll pay a fixed interest rate. An adjustable rate will be applied if you accept monthly payments.
There are five different ways that you can get a reverse mortgage paid out in installments.
- Tenure — Equal monthly payments as long as you live in the house.
- Term — Fixed monthly payments for a specified length of time.
- Line of credit — No regular monthly payments, but you can access a line of credit at any time until the funds are exhausted.
- Modified tenure — A combination of monthly payments and a line of credit for as long as you live in your home.
- Modified term — A combination of monthly payments and a line of credit for a pre-specified period.
Money Comes to You Tax-Free
Any money you receive from a reverse mortgage is not considered “income” for tax purposes. Instead, it’s technically considered a loan advance. This money will not be taxed by the government, and should not impact your Social Security income, either. (It may, however, impact your ability to collect from certain means-tested programs.)
It is worth noting, though, that any interest you pay on the reverse mortgage is not tax-deductible until you pay it. Thus, there’s a good chance you won’t get a tax break during your lifetime.
You Can Use the Money However You See Fit
The money from a reverse mortgage has no restrictions on how you use it. Most people use the cash for day-to-day expenses, but there’s nothing preventing you from using it to fly to France, start a vintage baseball card collection, or buy a personal watercraft. Of course, the faster you spend the money, the sooner you’ll run out of it.
You Can Never Owe More Than the Value of Your Home
You’ve probably heard horror stories of people who have found themselves “underwater” on their traditional home loan. This can’t happen with reverse mortgages. Under the terms of most reverse mortgage loans, you can never owe more than your home is worth.
This is possible because you pay mortgage insurance premiums to the FHA. (You can read more on this insurance below.)
Disadvantages of a Reverse Mortgage
As with anything in life, there are a number of downsides to reverse mortgages you should be aware of.
You Are Paying to Access Your Money
Remember that the equity in your home is your money. It stems entirely from money that you earned and paid out over the years. Doesn’t it seem kind of crazy that you need to pay interest and fees to access it?
If you want a cheaper way to get cash when you are older and you’ve still got time before you retire, open a 401k or IRA and invest in a broad set of stocks or mutual funds with low fees and commissions.
It Can Be Expensive
It’s bad enough that you are paying to access your equity. But the story gets even worse when you analyze the overall cost of a reverse mortgage.
While you won’t have to pay back a reverse mortgage loan as long as you are living in the house, there are expenses associated with the loan that you either must pay upfront or that will be rolled into the loan.
This cuts into the amount you ultimately receive. First and foremost, there are interest charges, with rates that are typically higher than traditional mortgages.
Other costs include:
- Loan origination fees — The lender will look to cover its costs by charging you a fee to originate the loan. This can be several thousand dollars.
- Mortgage insurance premium — The terms of most reverse mortgages state that a borrower can never owe more than the value of their home. To ensure this protection, the FHA requires you to pay a mortgage insurance premium upfront as well as on an ongoing basis.
The upfront mortgage insurance premium is 2% of the loan value, and you’ll also be required to pay a premium equal to 0.5% of your loan balance annually. This can add up to thousands of dollars in additional loan costs.
- Closing costs — You may incur numerous charges to close the reverse mortgage loan, including documentation preparation fees, recording fees, and fees to check your credit report. This can add several hundred dollars to the overall cost of the loan.
- Appraisal fees — Before you complete a reverse mortgage, you must have the value of your home appraised. This can cost as much as $450. The appraiser may ask you to make repairs on the home to ensure it meets building codes, potentially adding to your costs.
- Servicing fees — Your lender may charge a monthly fee to disburse the loan proceeds and cover costs like sending you statements. This can be as much as $35 per month.
All of these fees and costs can truly add up. They can make a reverse mortgage far more costly than other mechanisms for retirement income.
You Must Pay Back the Loan When You Leave a Home
Many people get a reverse mortgage because it gives them income that allows them to stay in their home. But, what happens if your health declines and you must be moved to a long-term care facility? What if you need to move for any other reason?
In this case, you will be be required to pay back the reverse mortgage within one year — thus, potentially forcing the sale of your home. If you are the only borrower on the loan, your spouse and other people living in the home may then be forced to move.
Of course, this could be burdensome for you and your relatives, who may have to address your long-term care needs while also dealing with the sale of your home.
Your Heirs Lose a Potential Asset
Often, when a parent passes away, they leave their house to their children. The children can then either choose to live in the home or sell it and pocket the proceeds.
With a reverse mortgage, the equity in the home is depleted. Your next of kin must pay the loan back, and this may force them to sell the home. They will end up with nothing unless they’re able to sell the home for more than what you owe. Your heirs could even end up losing money if the proceeds of the house aren’t enough to cover their own closing costs.
Foguth, however, says leaving money for your heirs shouldn’t be a serious consideration if you don’t have money to survive on. “I tell my clients, ‘you have to take care of yourself first,’” he says.
A reverse mortgage is not a scam. But it’s not the best method of generating income for retirement, either.
In fact, if you plan properly for your retirement, a reverse mortgage shouldn’t even be a consideration for you. It should be considered an option of last resort for people who have no savings or assets to draw from except from the equity in their home.
Foguth says he has recommended the use of a reverse mortgage to a client just once. It was to an older woman whose husband had passed away, leaving her farmhouse as the only asset that might give her money to live on. A reverse mortgage allowed the woman to remain in the home until she died.
The best advice is to avoid the need for a reverse mortgage in the first place. This means starting to think about retirement long before it comes. Investing as much money as you can using tax-advantaged accounts such as a 401k and Roth IRA can help you accumulate enough wealth to ensure you have substantial assets to draw from.
Proper planning can also give you enough funds for long-term care, even after you leave your home. It can even result in leftover money and other assets to leave to loved ones.
Do you know anyone who has used a reverse mortgage to pay for retirement expenses? Would you consider applying for a reverse mortgage? Let us know in the comments section.