Faced with rising medical expenses and longer life expectancies, many seniors are turning to their single largest asset as a source of supplemental income: their home.
Indeed, reverse mortgages enable seniors who are 62 and older to convert a portion of the equity in their home into cash without having to sell.
As the name implies, such loans are structured as the mirror image of a regular mortgage. The lender makes payments to you in either a lump-sum amount or in monthly installments based on a percentage of your home’s appraised value. Eligible homeowners can also set up a reverse mortgage as a line of credit, providing access to emergency funds on an as-needed basis.
The money received can be used to pay off your existing mortgage loan and halt your monthly payment, supplement your retirement income, finance a home-improvement project or pay for health-care costs.
And the balance, including interest and financed closing costs, need not be repaid until you sell your home, no longer use it as your primary residence or pass away. Another perk? Proceeds are generally tax-free.
Yet such loans, while potentially solving a host of problems for retirees who are house-rich but cash-poor, also come with some pretty significant risks.
“Reverse mortgages are a useful tool for some people,” said Lori Trawinski, senior strategic policy advisor with the AARP Public Policy Institute. “They can enable retirees to age in place, but we always emphasize that these are loans, and as such, borrowers have obligations.”
Among those obligations, borrowers must stay current on their property taxes, homeowners insurance and any homeowner’s association dues and assessments. They must also keep their home well maintained. Failure to comply can send the loan into default and result in a foreclosure, according to Trawinski.
The amount you owe on a reverse mortgage also grows over time.
Interest is charged on the outstanding balance and added to the amount owed every month. Thus, your total debt increases as the loan funds are advanced to you and interest on the loan accrues.
That means fewer assets left in your estate to pass along to your heirs, which may not matter if you don’t intend to preserve your assets for future generations, said Marla Mason, a certified financial planner and vice president of Presidential Brokerage.
“If you plan to live out your life in your house and you don’t care about leaving a legacy behind, the reverse mortgage is a very valid option,” she said.
However, Mason explained, these loans come with a lot of fees.
The maximum origination fee allowed for a federally insured reverse mortgage, formerly called a Home Equity Conversion Mortgage, or HECM, is 2 percent of the initial $200,000 of the home’s value and 1 percent of the remaining value, with a cap of $6,000, according to the National Reverse Mortgage Lenders Association.
You will also owe a mortgage insurance premium fee based on the amount of funds withdrawn during the initial year. That fee is 0.50 percent of the appraised value of the home if you take no more than 60 percent of the amount available in the first year, and 2.5 percent if you take more than 60 percent of the available amount. On a $200,000 home, 2.5 percent amounts to $5,000, and 0.50 percent is $1,000.
You will also owe a mortgage insurance premium annually, which accrues over time when the balance comes due. The annual premium is equal to 1.25 percent of the outstanding loan balance.
There are also appraisal fees, which vary by region but average around $450. If the appraiser determines that your house requires repairs, you will be required to complete the repairs as a condition of approval, as well.
Finally, there are closing costs, which are comparable to those of any mortgage loan and often amount to about $1,000. Some lenders will also charge a $35 monthly service fee for the life of the loan, but most have dropped that fee, according to Trawinski.
“These loans can be expensive,” she said, noting it all depends upon how much you borrow initially. “If you take out a lot of money upfront and exit the home in a very short period of time, it can be a very expensive way to borrow money.
“But if you borrow less and stay longer, the costs amortize over time, so it’s comparatively less costly,” she added.
Reverse mortgage loans come in three flavors: single-purpose reverse mortgages, which are offered by some states, local government agencies and nonprofit organizations; federally-insured reverse mortgages (HECMs); and proprietary reverse mortgages, which are private loans backed by the companies that develop them.
According to the Federal Trade Commission, single-purpose reverse mortgages are the least expensive option, but they’re not available everywhere and can be used for only one purpose, which is specified by the lender. The lender might indicate, for example, that the money can only be used to pay for home repairs, improvements or property taxes.
HECMs and proprietary reverse mortgages can be more expensive than traditional home loans, and the upfront costs can be high.
The amount of equity you can borrow in a reverse mortgage depends on your age; the type of reverse mortgage you select, such as lump sum, monthly payments or line of credit; and current interest rates. In general, the older you are, the more equity you have in your home and the less you owe on it, the more money you can take out, according to the FTC.
Other sources of cash Before taking out a reverse mortgage, homeowners should consider alternatives, said Sean Keating, a certified financial planner and principal and founder at Patriot Financial Advisors. (All borrowers, in fact, must complete government-approved counseling before they can qualify for a HECM loan.)
For those with the means to pay off a home-improvement project or pricey dream vacation over the course of a few years, it’s generally less expensive to take out a home-equity loan, which involves only an appraisal fee and closing costs and does not deplete the value of your estate. The interest you pay is also generally tax deductible.
Seniors who assume a regular home-equity loan, however, must be prepared to make monthly payments until the loan is repaid.They should also be aware that failure to meet their home-equity loan obligations could result in the loss of their home.
Cash-strapped homeowners who are using a reverse mortgage as a last-ditch effort to hang on to their home should also think twice, Keating said.
“When an older couple cannot afford to live in the home anymore, getting a reverse mortgage will only delay the loss of the house and will leave them with no assets,” he said.
Better to sell the house and downsize, move in with a family member, take on a roommate or explore whether one of your adult children might be willing to purchase the family house through an installment sale, Keating added.
“The kids may not have a lump-sum payment to buy the house outright, but by making monthly installment payments, their parents get to stay in the home, collect a monthly income and the kids eventually own the house so it preserves that asset for the next generation,” he said.
Well-heeled homeowners with a highly appreciated home may benefit the most from a reverse mortgage, according to Keating.
Rather than using bond ladders to create consistent income-a strategy in which bonds’ maturity dates are evenly spaced to enhance liquidity-they can instead keep more of their money in higher-growth equities and use a reverse mortgage line of credit for living expenses during the months or years when the market is down. A more aggressive equity allocation also protects against longevity risk or the chance of outliving your savings.
“That way, you’re not pressured to sell in a down market,” said Keating, noting such strategy only works for homeowners with enough equity to cover one or two years’ worth of living expenses if necessary. “When the market rebounds, you can take out the amount of money you were expected to withdraw from your stock portfolio and pay back the reverse mortgage loan.”
Many state and local governments also offer low-interest and low-cost deferred-payment loans for improving or repairing your home that function like a reverse mortgage.
When mining your home for money, be aware of the fees you’ll pay, the impact on your estate and any alternatives that might be a better bet. At the end of the day, the math must make sense.
“For people who have a need for cash, reverse mortgages can be a useful way to access funds without having to sell their home,” Trawinski said. “But you are also spending down your equity, and the balance of your loan continues to grow, so it’s a good idea to think about alternative programs and sources of cash.”
-Shelly K. Schwartz, Special to CNBC.com