If you’re aged 62 or older and own your home outright, or owe very little on it, you can tap some of that equity with a reverse mortgage.
It’s similar to getting an advance on a paycheck, but in this case you are trading in equity in your home for a cash payment, typically tax free. A reverse mortgage will eliminate your monthly mortgage payments. You can use the cash (taken as a lump sum, regular monthly payments, or a line of credit) however you like — to pay off credit card bills, handle medical expenses, or supplement retirement.
You still own your home and get to live in it (the lender simply has a lien on the property that is used to secure the mortgage.). There’s no repayment until your home is no longer your primary residence. But when you move out or pass away, the loan must be repaid. For many, that means selling the home.
You are still responsible for property taxes and insurance. And you will owe more over time, since interest on the cash payments to you will be added to the loan balance.
Reverse mortgages have become attractive to many retirees. Indeed, there are periodic advertising campaigns touting their benefits. However, they may not be ideal for everyone.
“A reverse mortgage can be complicated, and isn’t something to rush into,” the Federal Trade Commission warned in paper on reverse mortgages.1
Reverse Mortgage Types
Reverse mortgages come in three forms with varying levels of cost:
- Single purpose reverse mortgages – offered by some state and local government agencies, as well as nonprofit operations. These are generally the least expensive option.
- Proprietary reverse mortgages – private loans with rates and terms often tied to the value of the property itself.
- Federally-insured reverse mortgages, also known as Home Equity Conversion Mortgages – loans backed by the Department of Housing and Urban Development (HUD). Homeowners are generally required to receive counseling to take advantage of these loans.
Reverse mortgages were originally designed decades ago to help seniors supplement their income and meet unexpected expenses. But they developed a reputation for being the “loan of last resort.”
It was known as a product of desperation for house rich/cash poor seniors who didn’t prepare financially for retirement and were otherwise fiscally irresponsible. (Related: Plan for Retirement)
“Distressed borrowers took 100 percent of their equity out of their homes, blew the money, and didn’t pay their bills,” such as their property taxes and homeowner’s insurance, said Keith Gumbinger, vice president, HSH.com, a mortgage information website. Many seniors ended up in default; some lost their homes.
New financial safeguards for reverse mortgages
Fast forward to today and while the intent of the reverse mortgage program is still the same, the perception is changing, said Stephanie Moulton, an associate professor at Ohio State University and co-author of a 2015 paper on reverse mortgages published in the Journal of Urban Economics. “HUD recognized that in order to achieve the goal of enabling financial stability and independence through the product, some additional safeguards needed to be in place,” she said.
Homeowners can no longer take all their home equity at once — 40 percent of the total amount that can be borrowed is unavailable until a year after the initial loan. Borrowers must also demonstrate they are able and willing to pay their property taxes and home insurance. And there are new protections for the non-borrowing spouse, too, that allow him/her stay in the home as long as it is his or her primary residence — no matter what has happened to their partner.
“These safeguards mean less risk of default, less risk of foreclosure, less risk of loss of residence,” said Gumbinger. “As a result, the product is gaining some new respect.”
Financial planners have taken notice. And they’re targeting — and attracting — not only seniors with limited incomes who are able to use the reverse mortgage to remain in their homes and are able to cover expenses of remaining in their homes, but a new type of borrower as well, said Moulton.
“The profile of an ideal candidate is a more sophisticated borrower looking to use the reverse mortgage any number of ways: as a tool to help smooth retirement income; as part of a longer term financial planning strategy; to pay off their forward mortgage and thus free up monthly cash flow,” he said.
The bottom line: “Baby Boomers either have a greater need to leverage equity during retirement, or are simply more willing to leverage that equity than prior generations,” said Moulton. (Calculator:How much to save for retirement?)
Timing and interest rates
With today's low rates and relatively high home values, "you can get a lot of money out on a reverse mortgage," said Steven Sass, economist at the Center for Retirement Research at Boston College. But those amounts could shrink significantly if home prices fall and interest rates rise.
Consider this example from the Center for Retirement Research: At an interest rate of 5 percent, a 65-year-old homeowner could take out a reverse mortgage of up to $270,500 on a $500,000 house. At a rate of 7 percent, the maximum would be just $182,000.
Bottom line, given the current low interest rate environment? “If you're interested in doing a reverse mortgage, it’s an advantageous time to do it now,” said Sass.
Thoughtful discussions with a financial professional
Regardless, deciding whether to tap your biggest asset – home equity is typically the lion’s share of someone’s net worth – is a decision that should not be made on your own, said Sass.
Beyond having a thoughtful discussion with your financial advisor about things such as how best to employ these funds, whether the release of funds changes your mix of investment holdings, whether or not there are tax implications as a result of your choice, said Sass, you should also have a discussion with family members. After all, spending the equity of your home diminishes the value of your estate, leaving you less to pass along to your heirs down the road.
Additionally, ask whether or not tapping equity through a reverse mortgage would affect your eligibility for Medicaid and Social Security benefits, because it could.
Fees and upfront costs
Another important consideration: the cost. These reverse mortgage loans, with their hefty upfront fees, are more expensive than conventional loans. That’s because a reverse mortgage isn’t decided on your income or credit score.
“There’s no way the lender knows whether it will ever recover the money and the way to offset that risk and cover the costs is to charge higher fees at the outset,” said Gumbinger.
Granted, these fees are not paid out of pocket (they are rolled into the loan), but because they could be 6 percent-7 percent of the loan amount, “it’s one of the main drawbacks to a reverse mortgage, particularly if you don’t have a deep equity position,” Gumbinger added.
1 Federal Trade Commission, “Consumer Information: Reverse Mortgages,” June 2015.