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Ask Dr. Don
Bankrate.com

Reverse mortgages

Dear Dr. Don,
I am 77, recently widowed and own my home free and clear. I have a home equity line of credit for approximately 25 percent of the home's $450,000 market value and have about $5,500 on that line.

I'm considering a reverse mortgage line of credit to take care of required maintenance, repairs and possibly long-term health care. I'm able to obtain one for 50-percent more available cash than the home equity line I have. However, the reverse mortgage would require upfront fees and closing costs of $11,000, which, while they don't have to be paid upfront, immediately place me (psychologically at least) in debt for that amount.

The interest rate on the reverse mortgage would be 1 percent higher than the home equity line. Meanwhile, the issuer of the home equity line has agreed to increase that line by 50 percent to provide the same funds as the reverse mortgage. I understand that the interest on the home equity line of credit is deductible from the federal income tax. But I cannot decide which one to take! Can you help me?
Thank you,
Ira Interest

Dear Ira,
A reverse mortgage is an interest-only loan that capitalizes the interest expense along with the principal. That means that there are no loan payments at all until the note comes due. The loan balance grows with the interest expense added to the cash payments made to the homeowner.

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Events that could cause the lender to call the note, depending on the note's terms include, moving out of the house and selling the home or upon your death. The home doesn't have to be sold when the loan is called -- the lender just needs to be paid. The National Reverse Mortgage Lender's Association describes the process of getting a reverse mortgage in this pamphlet.

Depending on how you structure the loan, you can get a lump-sum at closing, use the reverse mortgage like a line of credit, receive a regular cash distribution, or some combination of these actions. You indicate in your letter that you're interested in a reverse mortgage with a line of credit.

There are three types of reverse mortgages, categorized by the insurance provisions on the loan: FHA insured, lender insured and uninsured. The Federal Trade Commission has an online brochure that describes the differences in the three types of reverse mortgages.

These mortgages are very attractive to retirees because they don't have to find room in their household budget to make loan payments while tapping the equity in their homes. They pay a price for that convenience because of the additional risks to the lender (or insurance company) on this type of loan.

Let's assume that you expect to need an average of $500 a month, or $6,000 a year, from a credit line. The minimum required monthly payment on a home equity line of credit, or HELOC, is typically the interest expense on the balance. Make the assumption that you draw on the line to both meet your needs for income and to pay the monthly interest expense, and you've got a loan balance that grows much like a reverse mortgage. The table below shows a comparison between the two loans assuming a $500 a month draw on the credit line and a 1 percent difference in interest rates on the two loans.

Reverse mortgage, HELOC comparison

Home's market value
$450,000

Current HELOC
$112,500
 
   
Interest rate
Closing costs

Reverse Mortgage

 $168,750

7%

 $11,000

 Expanded HELOC

 $168,750

6%
 n/a
 
Year ($500 a month draw)
 Reverse mortgage ending loan balance

 HELOC ending loan balance

Difference in loan balances

            1

 $17,980

 $6,180

 $11,800

            2

 $25,449

 $12,731

 $12,718

            3

 $33,440

 $19,675

 $13,765

            4

 $41,991

 $27,035

 $14,956

            5

 $51,140

 $34,837

 $16,303

            6

 $60,930

 $43,107

 $17,823

            7

 $71,405

 $51,874

 $19,531

            8

 $82,613

 $61,166

 $21,447

            9

 $94,606

 $71,016

 $23,590

          10

 $107,439

 $81,457

 $25,981

          11

 $121,170

 $92,525

 $28,645

          12

 $135,861

 $104,256

 $31,605

          13

 $151,582

 $116,692

 $34,890

          14

 $168,402

 $129,873

 $38,529

          15

 $186,401

 $143,845

 $42,555

This is just one scenario and your actual needs for money can and will vary substantially from what I've presented here.

The HELOC lender will typically have the periodic right to call your loan, which could force the sale of your home if you can't come up with the funds, while the reverse mortgage lender's right to call in the note will be limited to the named events in the mortgage. I've also presumed that you don't have any closing costs associated with the credit line being raised on your existing home equity line.

Along with the periodic call provisions, a HELOC also typically has a draw period limiting when you can withdraw funds. My example assumes that you can extend the draw period, but it's the lender's option to extend, not yours.

Financing the $11,000 in closing costs explains $30,349 of the differences in loan balances after 15 years, but if you pay the costs out-of-pocket today you'll lose the investment income that the money would have earned.

If you can use the mortgage interest deduction on your taxes, then the HELOC gives you an annual deduction. You'll have to wait until you pay off the note on the reverse mortgage before you can use the mortgage interest deduction. That also skews the results toward using the home equity loan.

The HELOC wins hands down if its closing costs are negligible, if you can use the mortgage interest deduction, and if you can get comfortable with the lender's terms concerning a draw period, minimum payments and the final loan term. You'd also want to make sure that a trusted friend or family member had the ability to act on your behalf if you became unable to do so.

My best advice is that you don't look at this loan in isolation from your household budget, any other investments and your expected financial needs. Get a big picture review of your finances and financial goals by talking to a fee-based financial planner.

Your assumptions about your needs for long-term health care and home maintenance may be shortsighted and a planner could structure your income, investments and loan to better meet your needs. The National Association of Personal Financial Advisors can help you in finding and interviewing a fee-based financial planner.

-- Posted: June 12, 2002

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