If you’re a senior weighing the pros and cons of a reverse mortgage, you’re not alone. This product is heavily advertised on television as a way to help you stay in your home in retirement by putting your equity to good use. There are benefits, but there are also risks.
What is a reverse mortgage?
A reverse mortgage allows property owners 62 and older to convert real estate equity into spendable cash.
The vast majority of reverse mortgages are insured through the Federal Housing Administration, (FHA), which means if the debt is not repaid by the borrower, it will be repaid with FHA reserves.
The government calls reverse mortgages “HECMs,” which stands for Home Equity Conversion Mortgages, and borrowers must pay insurance premiums to participate. These premiums are used to fund the FHA’s reserves.
In addition to FHA-insured reverse mortgages, there are two other types:
- Proprietary reverse mortgages: These are available through private lenders, and they are not subject to FHA loan limits.
- Single-purpose reverse mortgage: These are not as common, and the money you obtain from one of these can only be used for one specific need, such as renovating part of your home or paying your property taxes. You can find these options via some state and local governments and non-profit organizations.
How do reverse mortgages work?
Is a reverse mortgage a good idea? To answer that question, you’ll first need to get a grasp on how the loan works and what you’ll pay for it.
A reverse mortgage gives you access to funds without sending you an immediate bill. Consider this math: With a traditional mortgage, if you borrow $100,000 at 3.4 percent fixed-rate interest for 30 years, you’ll have a $443.48 monthly payment (principal and interest). If you borrow $100,000 with a reverse mortgage, your required monthly payments for principal and interest are zero.
Too good to be true? Well, yes. You will still owe money.
With our example $100,000 mortgage, the borrower pays about $443 each month. Of this amount, around $160 is paid toward principal in the first month to reduce the loan balance. The rest of the payment — approximately $283 — is interest, or what the lender charges you for loaning you money. The payment plan continues like this every month, with more of the payment going to the principal and less to interest over time, until the loan term is up.
With a reverse mortgage, the process is flipped. Instead of making a $443 payment each month, the borrower pays nothing. This doesn’t mean the loan is free, however. The interest cost is added to the mortgage balance, so in the second month, the balance grows. Since the loan balance is now a little bigger, the interest cost is a touch higher, and this process continues until the time comes for the loan to be repaid. That repayment usually happens when you move out of the property (you have one year to pay it back after that date) or when you die.
Reverse mortgage pros
You can better manage expenses in retirement
Many seniors experience a significant income reduction when they retire, and monthly mortgage payments can be their biggest expense. With a reverse mortgage, you can supplement a diminished income and continue to pay your bills.
You don’t have to move
Instead of finding a new, more affordable home, a reverse mortgage allows you to age in place (and stay near friends and family, if applicable). Additionally, while there’s a cost to a reverse mortgage, it might be cheaper to get a reverse mortgage than to move house and either buy another home or rent in a new location.
You don’t have to pay taxes on the income
The income you get from a reverse mortgage isn’t taxable because the IRS considers the money “loan proceeds.” At the same time, reverse mortgage interest isn’t deductible until you actually pay it (usually when you pay off the loan in full). Tax rules can be complicated, however, so be sure to see a tax professional for advice before committing to a reverse mortgage.
You’re protected if the balance exceeds your home’s value
Because a reverse mortgage balance grows in size, it’s possible that it can exceed the fair market value of the property over time. However, the amount of debt that must be repaid can never exceed the property’s value, because a reverse mortgage is an example of “non-recourse” financing. The result is that a mortgage lender can have no claims against your other assets, or heirs, in this scenario.
Your heirs have options
Reverse mortgages can be paid off by borrowers sooner, but typically end when the borrower moves, sell the home or passes away. In an estate situation, heirs have several choices: They can sell the property to repay the debt and keep any equity above the loan balance; they can keep the home and refinance the reverse mortgage balance if the property’s value is sufficient; or, if the debt exceeds the value of the property, heirs can settle the loan by giving the title back to the lender. The lender can then file a claim for any unpaid balance with the insurer (almost always the FHA).
Reverse mortgage cons
You have to pay for it
Reverse mortgages have costs that include lender fees, FHA insurance charges and closing costs. These costs can be added to the loan balance; however, that means the borrower would have more debt and less equity.
You can’t get as much with the fixed-rate option
HECMs are structured so that both adjustable-rate and fixed-rate financing options are available. If you want fixed-rate financing, though, the amount of equity you can access is smaller than what you could tap with an adjustable-rate reverse mortgage.
You could inadvertently violate other program requirements
Simply put, a reverse mortgage could cause you to violate asset restrictions for the Medicaid and Supplemental Security Income (SSI) programs. This is complicated stuff, so be sure to speak with an attorney who specializes in elder law or a legal clinic before searching for a reverse mortgage program.
Your home can be foreclosed
Since reverse mortgages don’t have required monthly payments for principal and interest, it might seem as though foreclosure is impossible. Not so. Seniors can have their homes foreclosed if they do not pay property taxes or maintain homeowners insurance or fail to pay HOA dues.
You could have a hard time navigating changes to your status
Reverse mortgages can be complicated, and if something changes with your status, your reverse mortgage options can change, too. If you go to a long-term care facility, for example, would you still be considered a resident in your home? If you marry after obtaining a reverse mortgage, must your spouse move out of the property if you die? For details regarding these and other questions, it’s best to speak with a lender or an attorney who specializes in elder law, or contact a pro-bono legal clinic.
Is a reverse mortgage a good idea?
You’ll have to weigh all the pros and cons of a reverse mortgage to figure out if it’s right for you, and more importantly, you’ll need to think about how those positives and negatives fit into your personal situation.
Here are two signals that it might make sense to compare reverse mortgage options:
- You’re planning to stay in your home for a long time. Remember all the closing costs of your original mortgage? You’ll have a similar set of upfront costs with a reverse mortgage that you can either pay for in cash or roll into the loan, so you’ll want to make sure that you’re going to be there long enough to justify that extra money.
- You can cover all the other costs of your home. With a reverse mortgage, you still need to pay for homeowners insurance and property taxes and maintain your home. Be sure to calculate all your monthly expenses to determine if you will be able to pay for these costs and your other essential bills.
It’s important to note that HUD HECM standards have changed in recent years to help mitigate risks, and also in part due to program losses. As a result of these changes, the number of reverse mortgages insured by the FHA fell to just over 41,800 in 2020.
Here’s a look at the changes that have taken shape to reduce the risks of reverse mortgages:
- To cut losses in 2013, HUD limited the amount HECM borrowers can obtain from a property, and also the amount of cash borrowers can withdraw from a HECM during the first year.
- In 2014, HUD established a “residual income” requirement that stipulates that after basic expenses, reverse mortgage borrowers must have enough cash left over to pay monthly living costs, including property taxes and insurance.
- In 2017, HUD reduced the amount reverse borrowers can finance and changed premium costs.
- In 2018, HUD created a new rule that allows it to require two appraisals for properties it regards as too risky. The reverse mortgage is then based on the lower of the two appraisals.
- In 2019, HUD tightened standards to require lenders to review tax returns, bank accounts and similar information to ensure that borrowers can pay ongoing housing costs. If the assessment is insufficient, the lender must then set aside HECM money to ensure that tax and insurance bills are paid.
Reverse mortgages have gained a less-than-perfect reputation amid headlines of foreclosures, and that news should serve as a reminder of the need to be wary of any option that puts your home at risk.
However, here are two key reasons that seniors might consider examining their reverse mortgage options today:
- Elevated equity: Over the past decade, home equity has grown as home values have risen. The average American homeowner gained around $17,000 in equity between the third quarter of 2019 and the third quarter of 2020, according to CoreLogic. Seniors benefited in the last year, too, gaining a record $7.7 trillion in home equity collectively, the National Reverse Mortgage Lenders Association reported.
- Record-low interest rates: It’s a cheap time to borrow money, as interest rates on 30-year loans have held near 3 percent.
Ultimately, comparing the pros and cons of a reverse mortgage shouldn’t be a solo activity. This is a financial decision that requires careful consideration of implications for your most valuable asset: your home.
To help you assess whether a reverse mortgage is a good idea, start by talking to a HUD-approved housing counselor.