Reverse Mortgages: The Good and the Bad
According to Consumer Reports some 70% of retirees’ net wealth is locked up in their homes. Given that, you’d think that reverse mortgages would be a very popular solution for tapping into all that wealth. Yet prior to 2012, the cost, complexity, and even stigma of utilizing a reverse mortgage have made it the choice of last resort for elderly retirees needing cash. Things changed starting in 2012 when the Federal Housing Administration (FHA), which insures most reverse mortgages through its Home Equity Conversion Mortgage (HECM) program, created the HECM Saver which lowered costs and added flexibility. Reverse mortgages are now being used not just as a last resort but as one component of a comprehensive retirement plan.
The key benefit of a reverse mortgage, available to homeowners ages 62 and older, is your ability to tap into a portion of your home’s equity value without having to sell your home. You can withdraw a lump sum of money or you can create a line of credit similar to a home equity line of credit (HELOC), from which you can draw cash when needed. The amount you can borrow depends on your age (the older you are, the greater the amount), current interest rates, and the value of your home. Nothing needs to be paid back to the lender as long as you or your spouse is alive and living in the home. After you pass away, your estate pays back the principal plus accrued interest to the lender, typically by selling the property. Any remaining equity goes to your heirs. The best part: if there’s not enough equity in the property to cover the loan, the FHA pays the difference to the lender, preserving the remaining assets in the estate for your heirs.
The line of credit option has become the most popular choice since it offers the most flexibility and incurs the lowest costs. As with a HELOC, if you don’t borrow the money, you don’t pay any interest. Unlike a HELOC, a HECM line of credit cannot be reduced or frozen, and the loan does not become due until your death. The HECM line of credit even grows as you become older regardless of your home’s value.
Reverse mortgages, however, don’t come for free. There are closing costs and loan origination and servicing fees similar to what you’d incur with a traditional mortgage, not to mention FHA insurance premiums to cover any lender losses from equity declines. And of course there is the interest that you have to pay on the loan, which in the case of a line of credit is variable based on prevailing rates. All these factors make reverse mortgages more expensive than traditional mortgages. Of course, none of these costs have to be paid out-of-pocket. Nonetheless they do limit the amount you can borrow and also affect the amount of equity your heirs have to give up when your house is eventually sold.
Some additional benefits of a HECM reverse mortgage:
- It’s much easier to qualify for as compared to a traditional mortgage.
- Mandatory independent counseling by a government-trained non-profit agency before you can apply provides a measure of consumer education and protection.
- Your executor/trustee has up to one year to pay off the loan after repayment becomes due.
There are additional downsides as well:
- The loan can be called early due to non-payment of property taxes, homeowners insurance, or failure to adequately maintain the property, potentially forcing you to sell the house prematurely.
- Having extra money available (especially when taken as a lump sum) puts you at risk of spending it down too quickly or becoming a target for financial abuse by family or financial advisors. That’s why a reverse mortgage should never be utilized except as part of a well-thought through retirement plan.
There are other alternatives to a reverse mortgage if you want to access some of the equity built up in your home. The simplest is to downsize by selling your current home and either buying or renting a less expensive, smaller house. Alternatively, if your adult children have the financial wherewithal you can create a sale-leaseback arrangement in which you sell the house to one (or more) of your children and then rent it back using the cash you get from the sale. Your children benefit by getting rental income and tax write-offs (as long as you structure the transaction properly according to the IRS), and you get the cash. However, once the lease expires, your children have the right to kick you out. You may not be comfortable giving up that degree of control over your home.
A private reverse mortgage is another option. You’ll benefit because your children will charge you less than commercial lenders, your up-front costs will be lower, and there won’t be ongoing mortgage-insurance expenses. Plus the interest rate – which the IRS sets each month – will be lower than what commercial lenders charge. But again it’s important to structure the deal so that it passes muster with the IRS.
Reverse mortgages have emerged as a viable retirement planning tool as long as they are used carefully and thoughtfully. And the more tools we have, the better the likelihood that we can afford to do all the things in our later years that we’d always hoped to be able to do.