Pros and Cons of Reverse Mortgages: Are They a Valuable Retirement Tool?
There’s a lot of conflicting chatter on the Internet and by rumor about how reverse mortgages work. In addition, financial businesses in just about every city are pitching products for reverse mortgages with radio spots, or telling people they may miss out on a closing opportunity due to pending federal law changes. This is the universe of marketing, and it oftentimes creates confusing perspectives about reverse mortgages.
Pros of Reverse Mortgages
Fundamentally, a reverse mortgage is a way of pulling equity out of an owned home to increase one’s cash flow. The program is specifically aimed at retirees over the age of 62 to increase their monthly net income for bills, living expenses, and even modification costs to make a home more livable for senior citizen. In the meantime, the borrower still technically owns the home and can continue to live in it until a “maturity event” occurs (the borrower dies, moves out or the loan is repaid).
No Monthly Payments
A key factor that works to the cash flow benefit of borrowers is that reverse mortgages do not have monthly payback requirements like traditional loans. Instead, the money owed is paid back at the end of the loan period when the maturity event occurs. This means the borrower can live in a home for years without payment in the meantime. The actual repayment occurs when the borrower is no longer alive or present to own the home. If there is a co-borrower on the loan they can continue to live in the home under the same guidelines. The co-borrower has the same benefits as primary borrower. The loan does not become due and the terms of the loan remain the same until the last borrower on the loan permanently leaves the residence.
No Income or Asset Requirements
A home reverse mortgage can be an effective way for a borrower to release equity funds from an owned home and improve personal cash flow. For those on a fixed income, their home is their largest financial asset and can represent the means by which they can maintain their desired cost of living for years to come without issue. How well a reverse mortgage works depends on key factors including the borrower’s age, the property value, and the time period involved.
No Minimum Credit Score
Because the reverse mortgage is practically guaranteed by the value of the home it is attached to, it is considered a guaranteed loan. This means the home is the collateral for the full value of the loan. That being the case, there’s no need to look for a borrower credit score because there are no lifetime payments being made. The lender just collects the home and liquidates it at the maturity event or gets paid in cash for the loan at the end by a family member.
No Restrictions on use of Proceeds
There are generally no restrictions on how the funds of a reverse mortgage are used if provided with a federally-insured mortgage. Where a single-purpose reverse mortgage is applied for, however, restrictions can be in place because these are treated instead as private agreements between private parties.
Because the value provided in a reverse mortgage comes from property a person already owns and has paid taxes on, either as the property itself or with post-payroll tax income, there are no further taxes to be applied to the loan proceeds. Loans are generally not considered taxable income until they are forgiven. Then tax agencies like the IRS come knocking because they treat forgiveness as a financial boon and define it as income by law.
Loan is Non-Recourse
A key factor about the reverse mortgage is that the amount is set, based on the appraisal of the home at the time the loan is originated. That means that the loan doesn’t suddenly balloon to twice its size come the maturity point. However, what can happen is that the home loses equity between when the loan was borrowed and when the home is being transferred. In such cases, the family or next of kin owner could be stuck with a loan bill for the difference where the home liquidation is not enough to pay off the reverse mortgage balance.
No Personal Guaranty
There is no additional collateral or personal guaranty of a reverse mortgage once it is executed and attached to a house. The property provides the basis of the mortgagees lien; nothing else is required from the borrower after the fact.
Trust or Life Estate
A common myth about reverse mortgages is that the house suddenly goes to the bank or lender when the borrower dies or leaves the residence. This is not true but rumor tends to be believed more often than not. What does occur is that the loan creates a legal lien on the home, blocking transfer until the lien is resolved (i.e. paid off). The actual title of the home can be put into estate planning or placed in a trust, it just will have a condition to clear before final disposition occurs. This is the legal effect of a lien. The borrower still keeps title and ownership for the life of the loan while he or she is alive and in the home financed. Where the lien is not satisfied, then the lender has the right to force a sale of the home to get the loan proceeds paid in full. That’s where the rumor of homes being taken comes from.
Interestingly, it was a federal government policy from the U.S. Department of Housing and Urban Development that was being abused, allowing lenders to force a surviving spouse to pay up on a reverse mortgage the full balance when another spouse on the loan died. Lenders were treating the first spouse’s death as a maturity event, regardless of the second spouse being alive and living in the home. That turned into forced liquidations as the lenders sought their funds with forced home sales. The surviving spouses often had to turn to bankruptcy for protection from foreclosure, having no savings to pay off the reverse mortgage involved. The Supreme Court nullified this policy and wiped it out in 2013.
Guaranteed Income for Life
Marketing often uses terms like “guaranteed income for life” being possible with a reverse mortgage, but this is an exaggeration. In reality what the person gets is the full cash value of the home appraisal at the time of the loan origination. That can seem like a lot of money, and could support someone’s living costs for a good number of years if used frugally. But it is by no means sufficient for one’s entire life in many cases. The risk is that with modern medicine and longer mortality on average, a person could run out of money and still be alive.
The federal government, in an effort to control a market predisposed to target and impact senior citizens only, passed laws and rules to standardize how reverse mortgages could be applied. This in turn required the same fees and general loan requirements in all reverse mortgages, regardless of where, whom, and how they were applied for or lent. As a result, there is little customization in a standard federally-insured reverse mortgage, regardless of whether one is in California or New York.
Insured by the Government
Markets don’t stay still just because someone takes out a reverse mortgage. Home equity values can change, going up and down, as well as home property values. That said, the laws on reverse mortgages restrict lenders from the ability to force sales when the market value drops and a home falls below the value of the loan taken out on it. Instead, the government insures the loan, so the lender is protected and the consumer or their next of kin is not harassed.
The two big types of reverse mortgages are HECMs and Single-purpose Reverse Mortgages.
The Home Equity Conversion Mortgage, or HECM, is financially underwritten by HUD. As a result, the loan itself has higher costs for the consumer so the federal program covers its costs, but there are no income requirements and no medical precondition restrictions. Further, the funds can be used as the consumer likes.
Alternatively, the Single-purpose Reverse Mortgage is a local loan not offered in every state. Sometimes the lender is a state or local government, and sometimes it is a private lender, usually a non-profit agency. These are designed to benefit those consumers who qualify as lower income. They are almost always specific to a single purpose, usually for a home modification/repair.
Most people apply for and utilize the HECM choice.
In a normal home sale, if there is a loan outstanding, the home is sold and the loan is paid off first. If there is more equity leftover, it goes directly to the seller as cash. The same applies in a reverse mortgage when the home is turned over or sold.
The amount that can be borrowed in a reverse mortgage is capped. It will never be the full value of the home to make sure some amount of equity is retained by the homeowner. Typically, reverse mortgages are allowed to borrow up to 42 to 60 percent of home value, depending on the age of the youngest person involved in the loan.
The borrower continues to retain title to the home involved and the lender only has a lien on the home. No one is automatically forced out when a loan comes due, but the loan does need to be addressed and not ignored as the lien gives the lender the right to seek payment by forcing a sale when not paid back. Once the loan becomes due, the borrowers’ estate, or whomever is handling the borrowers’ affairs upon passing, has up to a year to sell the property. FHA allows 6 months plus two 3 month extensions.
Cons of Reverse Mortgages
There are disadvantages to a reverse mortgage that everyone should understand prior to signing the signature line to approve one by contract. Here are the big ones:
Loan Balance Increase
The rates used in reverse mortgages are adjustable and move with the loan market. That means the overall cost of the loan can fluctuate from year to year, reducing any leftover equity balance assumed by family in the home if sold to pay off the loan at the maturity event.
Another cost note to be aware of: while up front a reverse mortgage cannot be used if a home already has another mortgage in place, the reverse mortgage can go through if it immediately pays off the old mortgage and assumes the debt. It’s basically swapping one loan for another.
Fewer Assets for Heirs
Family members are typically not happy with a reverse mortgage. Fundamentally, it means there will be less for them in an estate plan because it is unlikely the borrower will leave any funds to pay off the reverse mortgage loan due on death or moving out. Then again, most borrowers figure it’s their asset and their life to live, so they don’t feel obligated to save a massive estate to fund a will disposition. It’s often more a matter of emotion than financial need which way a person goes with this issue.
Real Estate Taxes
A reverse mortgage does not absolve a borrower of any property taxes due on a home. These are still required and have to be paid, or a tax lien can be issued by the local government jurisdiction the home sits in, forcing a sale for taxes due.
Typically the fees associated with a reverse mortgage run higher than a traditional mortgage due to FHA mortgage insurance, origination fees, and normal expenses associated with a real estate transaction.
If a borrower moves out or dies, the reverse mortgage comes due. This can be seen as a trap for some, feeling tied to homes they don’t want to live in any longer. Additionally, those who need to move closer to health resources can find the reverse mortgage a big problem, not wanting to sell yet but also not wanting to stay in the home as a primary residence. If the homeowner is out of the home longer than a year (12 months specifically), the maturity event is triggered.
An applicant needs to be at least age 62 or older to be approved for a reverse mortgage. With a married couple, the critical age is the younger of the two people involved, not the older spouse. Further, there also needs to be an actual primary residence home involved.
FHA Now Requires Income Verification
As a new requirement, the federal government also now wants to be sure that reverse mortgage borrowers can cover their property taxes and homeowners’ insurance costs. This is typically verified by either income or asset balances.
When is a Reverse Mortgage a Good Idea?
No one should just jump into a reverse mortgage. Taking some time to do homework and understanding all the ramifications is essential to making a good choice. There are risks with outliving the proceeds of a reverse mortgage, especially with today’s health system and mortality rates. People need to think about how to resolve that problem if it occurs as they will be unlikely to just start a job again in their far later years. There is no question that the tool can be popular and an easy answer to immediate, pressing expenses, but these mortgages also come with big drawbacks. No one should go into one blindly.
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*Reverse mortgages are loans offered to homeowners who are 62 or older who have equity in their homes. The loan programs allow borrowers to defer payment on the loans until they pass away, sell the home, or move out. Homeowners, however, remain responsible for the payment of taxes, insurance, maintenance, and other items. Nonpayment of these items can lead to a default under the loan terms and ultimate loss of the home. FHA insured reverse mortgages have an up front and ongoing cost; ask your loan officer for details. These materials are not from, nor approved by HUD, FHA, or any governing agency.