Reverse mortgages used to be considered a cash-flow option of last resort. That perception is changing, due to new regulations that have made them safer, as well as new cash-flow strategies that appeal to younger retirees. Still, a reverse mortgage remains an expensive option that requires careful consideration. This excerpt from Jane Bryant Quinn’s excellent How To Make Your Money Last retirement guide provides an introduction to the topic.

I’ve changed my mind about reverse mortgages. I used to see more risk than reward for most borrowers. But the risk has diminished. New federal regulations make reverse mortgages safer for people in their late 70s and 80s who need extra money to help them stay in their homes. New cash-flow strategies make them interesting for people in their early 60s and 70s who want to improve their monthly retirement income.

Reverse mortgages defined

A reverse mortgage is a loan against the equity you hold in your home. You don’t have to repay it as long as you’re living in the house. Instead the lender makes payments to you, entirely tax free. Your only obligation is to cover the cost of homeowner’s insurance, property taxes, and general upkeep.

Eventually, the house will be sold—because you move, enter a nursing home permanently, or die. The proceeds of the sale will be used to repay the loan plus all the accumulated interest and fees. If the house sells for more than what’s owed, the remaining money goes to you or your heirs. If it sells for less, you or your heirs walk away—you get nothing but you’re also not responsible for any additional money owed.

You can get a reverse mortgage, individually, as early as age 62. If you borrow jointly with a spouse, only one of you has to be 62. The younger your partner, however, the less money you will get. If your spouse isn’t on the loan, he or she risks eviction if you die.

Almost all reverse mortgages come in the form of a Home-Equity Conversion Mortgage (HECM). It’s issued by private lenders and insured by the Federal Housing Administration (FHA). You can borrow against a single-family house, a two-to four-unit home provided that you live in one of the units, an FHA-approved condominium, and most manufactured homes that sit on property you own. Mobile homes are out. So are vacation homes. Reverse mortgages can be used only for your principal residence. These loans work best when your home is completely (or substantially) mortgage free. But you can use them to help pay off an existing mortgage, too.

Reverse mortgages are expensive compared with traditional loans. You pay more in up-front and annual FHA fees and the total amount you owe goes up every month because the cost of the interest and fees compounds within the loan. Paying these fees makes sense only if the loan is part of a carefully thought-out plan.

How reverse mortgages work, step by step

  1. A lender agrees to make the loan. How much you can borrow depends on the appraised value of your home, current interest rates, the age of the youngest borrower, and how much (if anything) you still owe on the home (If you have little or no equity in your house, you won't qualify). The older you are and the less you still owe, the more money you can get. Appraised values are capped at $625,500, which limits the amount of money you can borrow on more expensive homes.
     
  2. As part of the deal, you have to pay off any remaining mortgages on the house, including home-equity loans. If you don’t have the cash, you can use the proceeds of the reverse mortgage to help make the payoff. Any liens or court judgments secured by the house have to be repaid, as well. The loan is off the table, however, if you’re delinquent on any federal debt, including student loans that you might have cosigned.
     
  3. Before you can close the loan, you have to reveal the size of your income and savings. The lender must be satisfied that you can pay the ongoing costs of homeownership (insurance, property taxes, condominium fees, upkeep) and still have enough left to live on.
     
  4. You’re required to go through reverse mortgage counseling, by phone or face-to-face. The lender will give you some names. (You can also search for counselors online or call the counseling line of the U.S. Department of Housing and Urban Development at 800-569-4287.) Be warned that the counselors won’t help you choose the best option for your circumstances. Their job is merely to ensure that you understand the terms of the loan and what it means, to you and your heirs, when you spend down your home equity. They’re also required to tell you about alternatives to the reverse mortgage, such as local programs that help low-income homeowners. Customized cost estimates of specific loans may be had from some reverse mortgage counselors working with specialized software. To make the best use of the software, you should talk with the counselor face-to-face, not just over the phone. A HECM counselor’s advice is free or low cost (typically, $125).
     
  5. You pay little or no cash up front. All closing and FHA insurance costs can be included in the loan.
     
  6. You can receive the money from your reverse mortgage in one of several ways:
    • A credit line that you can borrow against at any time. This is normally the best choice because it’s not an ordinary credit line. The amount you can borrow rises every year at the same rate as the interest rate you’re paying on the loan. If you use very little of the money during the first few years, you’ll be able to access much more cash when you are older. That makes your HECM credit line an excellent hedge against future inflation or increased medical costs. If you borrow too much too fast, however, you might be entitled only to smaller amounts in your later years.
    • A check a month, for a fixed amount, paid as long as you’re in the house. The lender will calculate the size of the check based on the total sum you’re allowed to borrow. The checks will keep coming even if they exceed your original borrowing limit.
    • A fixed number of checks. Once you’ve received them all, the game ends. No more money will be paid. These checks can be for larger amounts than the check-a-month deal because the lender knows—in advance—when its obligation will end. You can’t exceed your borrowing limit.
    • A lump sum. This is the most tempting choice because it’s nice to have so much cash in hand. But it also makes it more likely that you’ll run through the money and still won’t be able to keep your house. Lump-sum borrowers also have to pay higher fees.
    • A combination of the above. For example, you might take $25,000 up front, $800 a month for as long as you live in the house, and a $60,000 credit line.
  7. Each reverse-mortgage check looks and feels like income. But it isn’t income, it’s a loan. You owe no taxes on the money. Also, you don’t have to count it when figuring whether your Social Security is taxable or whether you owe a higher Medicare premium. It might affect your eligibility for Medicaid, however (Medicaid pays for nursing home care if you run out of money).
     
  8. You don’t have to repay a penny as long as you stay in the house. The loan normally comes due only if you sell the house and move somewhere else, enter a nursing home for a long stay (usually 12 months or more), or die. If you own the house with a spouse and you’re both on the HECM, these terms apply to you both. If one of you enters a nursing home, the other one can stay in the house and keep using the HECM credit line or receiving scheduled monthly payments.
     
  9. You can be forced out of the house if you fail to pay real-estate taxes or homeowners’ insurance, or if you let the house run down. People run this risk when their income is too low to cover their projected living expenses. They take a HECM in a lump sum, spend all the money, then go broke. They default on their insurance and taxes and lose the home.

    A new regulation, first effective in 2015, is greatly reducing this default risk. If your income is marginal, the lender is no longer allowed to give you the whole loan amount. Part of it will be set aside in a special fund that’s expected to cover your housing expenses (insurance, taxes, upkeep) over your lifetime. Sometimes these set-asides leave you with hardly any additional spendable income. In that case, skip the HECM. The lender is effectively telling you that you can’t afford your home. Best to sell right away and downsize.
     
  10. When the house is sold, the HECM is repaid out of the proceeds. If there’s money left over, it goes to you or your heirs. If the proceeds of the sale aren’t large enough to cover the loan, you or your heirs owe nothing but also get nothing. You’ll have spent the entire value of your home.

What does a Home-Equity Conversion Mortgage cost?

HECMs come with fixed interest rates or variable rates. You don’t pay the interest monthly, as you do with regular mortgages. Instead, it’s added to the amount of your loan. Both principal and interest fall due when the house is finally sold.

From a current-income point of view, it makes no difference how much interest accumulates. You always get the amount of borrowing power that you signed up for—the lump sum, the monthly checks, or the credit line. The cost shows up in the amount of money you (or your heirs) realize from the proceeds of the eventual sale. The more interest you owe and the less your house appreciated in value, the less money will be left over for the family.

A fixed-rate HECM is of interest only to people for whom the fixed rate matters more than the cost or the amount of money they receive. The lender normally lets you borrow no more than 60% of the total allowable amount in the first year. That’s all. You can’t come back for the remaining 40% in the second year. You have to take the money in a lump sum; you can’t get monthly payments or a credit line. The interest rate might be nearly double that of a new variable-rate HECM. At this writing, many lenders aren’t even writing fixed-rate HECMs.

A variable-rate HECM also sets a normal borrowing limit of 60% of the allowable loan amount in the first year. But thanks to the lower interest rate, that might add up to more dollars than you’d get from a fixed-rate loan. Twelve months later, you can come back for the remaining 40%.

That is, assuming that you want to take as much as possible up front. You can also take the loan in the form of monthly payments or a credit line. The rate changes every week and can’t increase by more than 10 percentage points above the starting rate. Some loans have lower caps. Remember that rising rates do not affect the income you receive from your loan. Instead, they reduce the amount of equity left in the house when it’s finally sold.

You can pay the fees on HECMs out of pocket but usually they’re added to the cost of the loan and accumulate over time. Here’s a list of your costs:

  • An up-front loan insurance fee, charged by the Federal Housing Administration. You pay 0.5% of the appraised value of your house, provided that you borrow no more than 60% of the allowable amount in the first year. For example, on a $300,000 house you’d pay $1,500. The value is capped at $625,500, so the most you’d pay is $3,125.

    You can take more than 60% of the loan in the first year if you need the money to pay off existing mortgages, tax liens, or other debt secured by your home. But in that case, your up-front FHA fee will jump to 2.5% of the value of the house. On a more expensive house, you’d pay up to $15,625. A HECM that expensive might not be worth its price.
     
  • The annual FHA mortgage-insurance premium. You pay 1.25% a year on the outstanding balance of the loan.
     
  • The loan-origination fee. Some lenders charge this up front; others charge zero up front but raise your interest rate. Fees are capped at 2% of the first $200,000 of your home’s appraised value and 1% of the remaining amount, up to a maximum fee of $6,000. On a $300,000 home, that’s $5,000.
     
  • Repair costs. Before you can borrow, an appraiser has to certify that the house is sound. If the cost of repairs will amount to no more than 15% of the value of the house, you can take the reverse mortgage and use some of the proceeds to make the necessary fixes. If the cost will be higher, you have to make the repairs yourself before closing the loan.
     
  • Closing costs. You pay many of the normal closing costs that you would for any other mortgage, such as document fees, courier fees, title insurance, credit report fees, etc.
     
  • Annual service fees. These are usually included in the interest rate but some lenders charge them separately.
     
  • Compounding costs. You pay interest on all the fees added to the loan. These costs build up fast, making it less likely that you’ll have any equity left when the house is sold.

Using a Home-Equity Conversion Mortgage strategically

A reverse mortgage puts extra money in your pocket right away. But always consider the endgame before signing up. What if you’re unable to stay in your home for life? When you sell, you might get little or nothing after repaying the loan. That would be harmful if you needed cash to buy/rent an apartment or enter an assisted-living home. Ideally, you should manage the loan so that you’ll always have home equity left or, alternatively, always have a pot of savings on the side. Here’s how to think about the most common reasons for taking a HECM:

  • Borrowing as part of a 20 or 30-year spending plan.
    This savvy use of a HECM is catching on with financial planners. It’s what changed my mind about the potential value of HECMs for people in their early 60s and 70s.

    Say that you’re planning for a 30-year retirement. You should generally spend no more than 4-5% of your savings in the first year you retire, plus annual inflation adjustments, if you need the money to last for at least 30 years. For a 20-year retirement, you might take 5-6%. But what if that rate of withdrawal doesn’t deliver the standard of living you want? A HECM can help you increase your annual income by combining your savings and home equity into a single spending pot.

    To do that, take a reverse mortgage as early as age 62. Set it up as a standby line of credit and—at first—don’t borrow against it. Instead, pay your bills by drawing, say, 6% out of your savings in the first year (for a 30-year retirement) and raising that dollar amount by the inflation rate in each following year. When your savings run low, switch to taking the money you need from your reverse-mortgage credit line. By now, the credit line will be much larger than it was when you started.

    There are other ways of setting up your HECM-linked spending plan. You might pay bills from your savings in a year that your investments rise in value and pay them from the HECM credit line in a year the market falls. That saves you from having to sell stocks at a lower price. Or you might pay your bills entirely from the credit line for several years, leaving your investments alone to grow.

    A well-planned rate of withdrawal from both pots of money raises your current income and can lengthen the number of years your money will last. The combo might even raise the amount of money you leave to heirs.

    The longer you wait to take the reverse mortgage, the less efficient it will be. You need 15 to 20 years to spread out the effects of the high up-front cost. Adopt this strategy only if you’ve determined that you’re going to stay in your home and will need a higher income to keep you there.
     
  • Borrowing to pay the bulk of your living expenses.
    This is the classic—and riskiest—use of a reverse mortgage. You live on your retirement savings for as long as you can. As a last resort, you take a reverse mortgage so that you can pay the bills and stay in your house. If you borrow in the form of a lump sum and run through the money, you’re stuck. You might not be able to afford the taxes and insurance anymore. At that point, the HECM lender can call in the loan and force you to sell your house. The sale price might not be high enough to cover the loan repayment. You’d be on the street without enough cash to buy something else.
     
  • Borrowing to eliminate your traditional mortgage.
    Depending on how large your mortgage is, you might be able to use the proceeds of a reverse mortgage to wipe out everything you still owe. That ends the monthly payment and raises your spendable income. This use of a HECM, however, can also be risky business. Presumably, you’re taking the loan because you’re having trouble meeting the mortgage payments and other bills. The new loan will help you stay in your home only if you have enough cash flow to pay your expenses from now until the horizon, inflation included. If this is another form of last-resort borrowing, you should think about selling right away and finding less costly housing somewhere else.
     
  • Borrowing for fun and grandchildren.
    I’ve seen celebrity TV ads aimed at the early 60s crowd, urging you to borrow a lump sum against your home and spend it while you’re still young. Take a cruise! Buy an RV! Send your grandchildren to college! All worthy goals, but will you be blowing your home equity too fast? Can you pay your bills for the rest of your life when that form of savings is gone? Taking a reverse mortgage is an expensive way of paying for a vacation. Instead of the lump sum, consider taking a credit line and using modest amounts each year to give yourself a more comfortable life. (Note that lenders love for you to take lump sums because they collect high interest on all the money from the first day. That’s why they pay all those aging celebrities to shill.)

When you sell the house, what then?

Don’t leave yourself stranded with no cash on hand. If you decide to leave your house (or have to leave for reasons of health), you’ll want enough savings or home equity on hand to set up new digs. If you’ll need assisted living, you’ll find better choices when you can pay the bill yourself for at least the first few months before going on Medicaid.

So don’t borrow every possible dime against your home. Take the reverse mortgage in the form of a credit line and monitor how much savings and equity you have on hand each year. Maybe your house will rise in value, adding a bit to your equity, but don’t rely on that. If your total pot of savings looks threatened, downsize while you still can extract some cash from the sale.

Spouse Warning: Don’t let yourself get kicked out!

This warning applies to spouses who are not on the deed to the house or on the HECM loan.

On loans made prior to August 4, 2014, you’re at great risk. If the borrowing spouse dies, the loan becomes “due and payable.” To stay in your home, you’ll have to repay the outstanding loan balance or 95% of the home’s current market value, whichever is less.

If you can’t raise the funds by refinancing the HECM or getting a traditional mortgage, you might have to move out. The loan also becomes due if the borrowing spouse enters a nursing home and stays for more than 12 months. (At this writing, litigation brought by AARP has led to a delay in evicting nonborrowing spouses. Whether they'll be allowed to stay in the home permanently has not yet been decided.)

The rules change for HECMs made on August 4, 2014, or later. The nonborrowing spouse will be able to stay in the home provided that he or she keeps up with the taxes, insurance, any condominium fees, and repairs. The reverse mortgage will not fall due. The age of the nonborrowing spouse will affect the amount of money the borrower can receive. If your spouse is younger, you’ll get less.

  • Big warning
    Payouts from the reverse mortgage end if the borrowing spouse dies or leaves the home permanently. The remaining spouse will not receive more monthly payments or be allowed to tap the credit line. He or she will have to pay all the household bills from whatever money is already on hand. Even that right will apply only to a nonborrowing spouse who was in place when the HECM was made. A spouse who entered the picture later will have to pay off the loan or move out.
     
  • Best advice for spouse protection
    He or she should be on the deed to the house and the HECM should be signed jointly. If your estate plan requires some other arrangement, be sure that the spouse can afford the house if left alone.
     
  • Alert to parents who have an adult child at home, perhaps a child who’s impaired
    The child can’t be made part of the reverse mortgage contract. If you die or move to a nursing home permanently, the child will have to buy the house or move out. If the child inherits the house there might be no home equity left to assist with his or her support. For you, a HECM might not be the right way to go.

Where to find tons of information on reverse mortgages

  • Go to the website mtgprofessor.com. Jack Guttentag, real-estate expert and professor of finance emeritus at the Wharton School of the University of Pennsylvania, has put together the best package of information and guidance I have found anywhere. You get a sophisticated calculator showing what you can borrow at different ages and with different options. At this writing, you can even get personal advice from Jack or one of his surrogates.

    You’ll also find offers from loan advisers who agree to follow best practices when arranging a reverse mortgage. They’ll suggest a package of up-front cash, fixed payments, and a credit line intended to meet your needs and hold down your costs over the period you’ll keep the loan.
     
  • Go to AARP.org/revmort. AARP provides questions to ask yourself before taking a reverse mortgage, a guide to these loans, and warnings about what can happen if you borrow to cover your basic expenses and then run out of money.
     
  • Go to ReverseMortgage.org, the website of the National Reverse Mortgage Lenders Association. You’ll find more info on reverse mortgages and a glossary of terms. NRMLA also posts estimates of current reverse-mortgage prices. But they’re consistently higher—sometimes much higher—than the prices offered by lenders on mtgprofessor.com.