Learn the potential benefits and pitfalls of reverse mortgages, including what to look for and what to avoid.
Judging from recent TV ads, reverse mortgages offer Americans age 62 and up a chance to cash in on years of equity they’ve built up in their homes, allowing them to pay for retirement expenses and avoid moving. However, if you’re eyeing this route, you should consider looking beyond the ads and getting educated about reverse mortgage pros and cons, because these loans (and that’s really what reverse mortgages are) might not be appropriate for everyone.
Essentially, a reverse mortgage allows you to convert a portion of your home equity into cash. Once considered “loans of last resort,” reverse mortgages can potentially be an option for homeowners in certain circumstances, including those living on a fixed income, some third-party advisors say. The number of reverse mortgages has been rising, and U.S. seniors have more than $6 trillion in home equity, according to the National Reverse Mortgage Lenders Association (NRMLA).
On the other hand, reverse mortgages can be difficult to pay off, and could end up forcing some seniors to stay in their homes longer than they might want to. Reverse mortgages come with fees, many of which can be quite high, and there are a number of other risks to consider before deciding whether such a loan is right for you.
A reverse mortgage is a type of home equity loan that doesn’t require monthly mortgage payments. It’s the opposite of a traditional mortgage in many ways: the lender makes a payment or payments to the homeowner, either through a lump sum or regular installments. It’s really an interest-bearing loan secured by the equity in your home. Reverse mortgages can also take the form of a line of credit. The loan doesn’t need to be paid off until the borrower dies, sells the house, or moves, but there are large amounts of fees and compounding interest that must be repaid.
Many reverse mortgages are known as home equity conversion mortgages (HECMs) and are made through the U.S. Department of Housing and Urban Development (HUD) and guaranteed by the Federal Housing Administration (FHA). But it’s important to note that not all reverse mortgages are made and guaranteed by government entities such as HUD or FHA. And like other mortgages, a reverse mortgage can be sold, so you need to stay on top of who owns your loan.
Like many loans—and remember, a reverse mortgage is a loan—reverse mortgages have their pros and cons.
Retirees living on a fixed income could struggle to keep pace with rising property taxes or medical bills. For homeowners who may not have access to a home equity loan or line of credit, a reverse mortgage can be a source of cash, which can help some retirees stay in their homes, rather than be forced to sell their property in order to meet expenses. But again, the fees can be quite high.
The NRMLA recommends that prospective borrowers consider its seven-question “self-evaluation checklist,” including:
On its website, NRMLA recommends borrowers “have a plan to ensure the money supports and sustains them for as long as they want to stay in their home.”
Consider building a future with fixed-income products.
There are many potential drawbacks of reverse mortgages, third-party advisors caution. Because interest accrues over the course of the loan, and many of these loans have large fees and high interest rates, your debt can grow over time, which may make it more difficult to pay off.
Another drawback: Reverse mortgages typically require you to stay in the home for the length of the loan. If you eventually end up moving in with family or to an assisted living facility, the loan becomes due. Unless you have the cash on hand to repay the loan, this will result in the immediate sale of the home, affecting anyone else currently residing there. Yes; even your spouse, potentially, if he or she is not on the loan.
Fees and other upfront costs associated with a reverse mortgage are another potential detriment. If you intend to leave your home within two to three years, a reverse mortgage might be inadvisable, analysts say.
Sandy Jolley, a consultant and consumer advocate who’s been critical of what she views as the “predatory” practices of some reverse mortgage lenders, recommends homeowners consider a five-step “suitability” checklist to determine if a reverse mortgage is ‘right’ and beneficial for your unique circumstances.” The list starts with creating a long-term financial plan that factors in how long you expect to live. As most investors likely know, having your financial plans in place—and updating them regularly—can be a critical step before making any major financial decision.
For example, if your plan is to eventually sell your home in order to pay for long-term care, the amount owed on a reverse mortgage at that point may be so high that you can’t afford to sell your home. You might end up losing your home and all the equity in it. So if you took out a reverse mortgage in order to raise your quality-of-life in your final years, you might end up with the exact opposite.
Also, understand that, despite any assurances to the contrary, it’s possible to lose your home with a reverse mortgage. If you’re unable to meet all of the loan obligations, such as taxes, insurance, maintenance, and other costs, the lender may be able to foreclose on your home, leaving you with no place to live, and no more home equity to draw upon. Or, suppose your spouse or life partner dies, and your name was not on the loan. If the balance on the loan is higher than the equity in the home, you might find yourself with no home and nowhere to go.
And know that when you die, a reverse mortgage may live on for quite some time. If a balance is owed on a property at the time of the owner’s death, the holder of the loan could tie up your estate in court for months or years, as it eats into the value of your estate.
Now that you know some of the pros and cons, here’s how a reverse mortgage works in practice.
To take out a reverse mortgage, you must be 62 years or older; own your home outright or have a considerable amount of equity (often at least 50%); occupy the property as your principal residence; not be delinquent on any federal debt; and have the resources to continue to make timely payment of property taxes, insurance, and any homeowners association fees, according to HUD guidelines.
The loan amount depends on the borrower’s age, interest rates, home value, and other factors. FHA stipulates that principal limits must be the lesser of the home’s appraised value or the agency’s current mortgage limit of $679,650 as of 2018. These variables help determine a “principal limit factor.”
A simplified example: A person with a home valued at $250,000 and a principal limit factor of 0.5 could borrow $125,000 through a reverse mortgage. (Several free reverse mortgage calculators are available through a quick Web search.)
Generally speaking, the older you are and the more valuable your home, the more money you can get.
You may qualify for a reverse mortgage even if you still owe money on an existing mortgage. However, the reverse mortgage must be in a “first lien” position, meaning any existing debt must be paid off, according to the NRMLA.
For example, if you owe $100,000 on an existing mortgage and qualify for a $125,000 reverse mortgage, you’d be able to pay off the entire existing mortgage and still have $25,000 left over to use as you wish.
Now that you’ve seen a few of the reverse mortgage pros and cons, take a look at your circumstances and also consider talking to a financial advisor and tax professional. There may be other ways to secure cash in retirement, including dividend-paying stocks, annuities, and fixed income.
Don’t assume a reverse mortgage is the right choice because the features sound good, Jolley says on her site. “Appealing features are not reasons to get a reverse mortgage. A reverse mortgage is a complex financial product that comes with lifelong consequences. You must make absolutely sure a reverse mortgage is ‘right’ for you.”
For additional information on reverse mortgages, read this investor alert from FINRA: “Reverse Mortgages: Avoiding a Reversal of Fortune."
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