Anyone in or near retirement who has plenty of home equity but not enough income has likely heard the reverse mortgage (RM) sales pitch: "Unlock" some of that equity, taking it tax-free with no obligation to pay it back until you sell your house or when your heirs sell it after your death. Perhaps best of all, the repayment amount can never exceed the value of the home. While it may sound compelling, reverse mortgages come at a cost.
What is a reverse mortgage?
When you take out a reverse mortgage, you continue to hold the title to the house. However, instead of you making payments to a lender, as with a "forward" (traditional) mortgage, a lender pays you. The payments you receive are a loan against a portion of your home equity.
Reverse mortgages are available to homeowners age 62 or older who own their homes outright or have substantial equity in their homes. If a husband and wife are both on the title, the younger spouse must be at least 62. If there is still a traditional mortgage on the house, it must be paid off at the time of closing on the reverse mortgage, either with money from the RM or other funds.
Reverse mortgages can be taken as a lump sum, a line of credit, or a series of equal monthly payments for a set period of time (or until the younger owner dies or decides to sell the house). The money is not taxable, nor does it impact Social Security or Medicare benefits.
RM borrowers have to keep paying property taxes and homeowner's insurance, as well as keep up with maintenance and repairs. Failure to do so can lead to default.
The loan amount — plus interest, mortgage insurance premiums, and other fees — must be paid back, either by the owner or the owner's heirs when the house is sold. Most RMs are "non-recourse" loans, which means if the loan amount owed is greater than the value of the house when it is sold, the U.S. government covers the loss. (Actually, such losses are covered by the hefty mortgage insurance premiums paid by RM borrowers!) If, on the other hand, there is equity remaining after the sale, the owner (or the owner's heirs) gets to keep it.
Types of reverse mortgages
The percentage of home equity that can be borrowed depends on the age of the younger owner (the amount goes up with age), the value of the home, the interest rate, the initial mortgage-insurance premium, and the type of RM utilized.
The most popular type of RM is the federally-insured Home Equity Conversion Mortgage (HECM), which accounts for 99% of today's reverse mortgages. There are two types of HECMs: the "Standard" and the "Saver." With the Standard, you can borrow about 10-18% more than with the Saver and at a lower interest rate, but the Standard's fees are much higher.
Until just recently, HECM Standard loans taken as a lump sum were available at a fixed interest rate. However, as of April 1, 2013, all HECM Standard loans — no matter how they are taken — are available only with a variable rate. That rate is based on the LIBOR (London InterBank Offered Rate) plus a margin, with a lifetime cap. HECM Saver lump-sum loans are still available at a fixed rate.
As shown on the nearby chart, a 65-year-old with a paid-off home worth $300,000 could use an HECM Standard to borrow about 60% ($180,131) after factoring in closing costs of almost $11,000. That would translate into $996 per month for as long as he or she occupies the home. A 75-year-old could borrow nearly 66% ($196,931), resulting in monthly income of $1,237. These estimates were generated on 3/14/13 using the calculator found at ReverseMortgage.org.
The price of a reverse mortgage
One of the most significant downsides of a reverse mortgage is the high cost. The main expenses include:
- Origination fee
As compensation for processing the loan, a lender can charge an HECM origination fee of up to $2,500 for a home valued at less than $125,000. For homes worth more, lenders can charge a maximum of 2% of the first $200,000 plus 1% of the amount over $200,000, up to a cap of $6,000.
- Mortgage insurance premium (MIP)
The HECM Standard requires an up-front mortgage-insurance premium of 2% of the home's value; the HECM Saver costs far less — only .01%. With either type of loan, there is also an annual MIP of 1.25% of the mortgage balance, making your real interest rate 1.25 percentage points above the quoted rate.
- Closing costs
These costs include the appraisal, title search and insurance, surveys, inspections, recording fees, credit checks, and more.
- Servicing fee
This monthly fee (typically $30-$35) covers the cost of sending you account statements, disbursing loan proceeds, and making sure you adhere to the terms of your agreement.
Most of these costs are usually financed as part of the loan. This can make the otherwise daunting level of fees seem more palatable in that they do not have to be paid out of pocket. However, they will immediately decrease the equity in the home, which will decrease the amount available to borrow against, and leave less equity after the loan is repaid.
Proceed with caution
If you're considering a reverse mortgage, here are some recommendations:
- Think it through.
Ask yourself whether you really want to start tapping the equity you've built up over the years. Would you be comfortable living with the knowledge that what may be your last financial safety net (and perhaps a prime source of inheritance or charitable contribution funds) is dwindling with each reverse mortgage check you receive?
- Consider alternatives.
One option may be to downsize, using the proceeds from the sale of your current house to buy a less expensive home with cash, or to pay for a rental. You would free up some funds that could supplement your retirement savings, and you would likely lower your monthly expenses.
- Get quotes from several lenders.
While some costs of an RM are fixed, others are negotiable. Get written estimates for all costs (including, in the case of a variable rate, the margin being charged on top of the LIBOR) so you can make accurate comparisons.
- Get input from those who know.
Anyone wanting to obtain a government-backed RM must meet with an FHA-approved counselor to make sure they understand all of the costs and implications. However, the counseling sessions have received some criticism for not being very thorough. So, find people who have an RM and ask how it has worked out for them. What do they regret? What advice would they offer?
- Be careful about who is on the title.
As mentioned earlier, to qualify for an RM, the younger person on the title must be at least 62 years old. This may tempt a couple to take a spouse who is younger than 62 off the title. However, once the older spouse dies, the loan will become due. A younger spouse who is no longer on the title will forfeit the right to live in the home unless the loan is paid back in its entirety.
- Think twice about taking an RM as a lump sum.
Lump sum reverse mortgages have the highest default rates. People tend to run through the money faster when they receive it all at once. Far better to treat an RM as supplemental income, taking it on a monthly basis or only as needed via a line of credit.
For older homeowners needing income, a reverse mortgage can look tempting. But gather all the facts, and be aware of the costs — both financial and emotional — before signing on the dotted line.