For seniors struggling with expenses, a reverse mortgage may appear to be a practical option. Though such a lifeline seems appealing, a closer look may say otherwise. The industry is rife with scams; fees are high and often hidden. In addition, reverse mortgages may have variable interest rates, so you may wind up owing more over time.
Taking out a reverse mortgage is a significant financial decision, and understanding the pros and cons is essential.
What Is a Reverse Mortgage?
A reverse mortgage is a lending option that allows homeowners to tap into home equity to free up cash for living expenses, medical expenses, or other needs.
Three types of reverse mortgage are available: single-purpose, federally insured, and proprietary. The most common is the federally insured home equity conversion mortgage. The term “reverse mortgage” is commonly used to refer to this type of mortgage, and that is what this article will discuss.
For homeowners over the age of 62, who have paid off all or most of their home (typically at least 50 percent), a reverse mortgage can free up cash for expenses. Typically, a reverse mortgage will not come due until the homeowner moves out, passes away, or chooses to pay off the loan in full. This loan option is only available for primary residences.
When a Reverse Mortgage Might Make Sense
A limited number of homeowners meet the criteria for a reverse mortgage. For those who do, it can be an attractive option, for a few reasons:
Staying Home: It may prevent them from having to downsize. A lump sum reverse mortgage payment can be used to pay off an existing mortgage, which can potentially free up money for cash-strapped homeowners. Monthly payments can help pay for living expenses.
Payout Options: The flexibility of how a homeowner can choose to receive funds from a reverse mortgage may be appealing. Funds can be disbursed in a lump sum payment, a line of credit, fixed monthly payments, or a combination of these options.
Unlike distributions from a retirement account such as a 401(k), the IRS does not treat reverse mortgage funds as income; thus they are not taxable.
No Credit/Shaky Credit: Many reverse mortgages do not require credit checks as part of the application process. For homeowners with shaky credit, this can make reverse mortgages a feasible alternative to other loan options.
Fluctuating Home Prices: If the value of the home falls below the balance of the reverse mortgage, the heirs of the borrower cannot owe more than the home’s value.
On the other hand, if the home appreciates in value, there may be proceeds left from the sale of the home after the mortgage and associated costs are paid. In this case, the homeowner or homeowner’s heirs will come out ahead.
Why it Almost Always Doesn’t Make Sense
While there are some positive attributes to reverse mortgages, the bad tends to outweigh the good for most people.
The interest from a reverse mortgage accrues monthly and is added to the balance. In other words, each month the homeowner is charged interest and fees—on the interest and fees that were added to the previous month’s loan balance.
Lenders may hold borrowers to strict home maintenance standards to protect the resale value of the home. Failing to adhere to loan terms, such as not adequately maintaining the home, or neglecting property taxes, may force the borrower to pay off the mortgage early.
Reverse mortgages include other strict guidelines for homeowners and their heirs. If a borrower moves out of the residence or stops living in the home for longer than a year, before the loan is repaid in full, the loan will need to be repaid.
If the homeowner passes away, heirs must pay back the loan in its entirety, although this amount may not exceed the value of the house. Exceptions may apply if the homeowner is married, or if there are non-spouse co-borrowers on the loan.
Marriage complicates reverse mortgages. If your spouse has a reverse mortgage, and dies or moves out of the home, what happens next depends on whether you are a co-borrower on the loan, or an eligible or ineligible, non-borrowing spouse.
If both spouses were at least 62 and co-borrowers, the spouse who remains in the home will continue receiving funds from the reverse mortgage, if applicable.
If the remaining spouse is not a co-borrower, but is an eligible spouse (married to the borrower at the time the borrower applied for and closes the loan) the reverse mortgage will be put into deferral. This means the eligible spouse can continue living in the home, and will be responsible for the conditions of the reverse mortgage. However, the eligible spouse will not receive reverse mortgage funds.
Leaving a surviving spouse without a major source of income is not ideal. Because of this, unless you and your spouse are 62, and are co-borrowers on the reverse mortgage, this may not be a great option for you.
The reverse mortgage industry is rife with fraud. In fact, reverse mortgage scams are one of the top scams the AARP warns its members about. Predatory lenders prey on cash-strapped seniors.
Costly Fees and Mortgage Insurance
Reverse mortgages are often littered with costly fees. Origination fees, service fees, and mortgage insurance premiums can snowball into exorbitant costs.
Mortgage insurance pays the difference if a home’s equity falls below the amount of the reverse mortgage amount. The upfront mortgage insurance premium is paid at closing and is typically 2 percent of the home’s appraised value. Ongoing mortgage insurance premiums are levied annually and are typically 0.5 percent of the outstanding loan balance.
Costly Interest Payments
The majority of reverse mortgages have a variable interest rate. This means that the interest rate can increase over time, which exacerbates the cost of the loan.
Another stark difference between reverse mortgages and regular mortgages is that interest payments on reverse mortgages are not tax-deductible until you repay the loan in full.
While a reverse mortgage borrows against a home’s equity, it can also reduce it. If you are counting on your home to be a large factor in your family’s inheritance, you may want to think twice.
Avoid the Dilemma Altogether
A problem can be solved with a solution. However, a dilemma is a difficult choice between two or more alternatives. Taking out a reverse mortgage should not be seen as a solution but as a dilemma.
The best course is to make changes before the situation becomes desperate. Alternatives include home equity loans, refinancing, downsizing, or seeking out assistance with monthly costs such as utilities.
A better answer is to prepare for retirement by outlining contingencies, working with an advisor, and coming up with a realistic budget. The earlier this is done, the more time there will be to address concerns that could give you a headache in the future.
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