A reverse mortgage can be useful in some cases.
When it comes to reverse mortgages, the first note should always be one of caution. These are extremely popular vehicles for scams and fraud, both because they involve the elderly (a popular demographic for fraud) and because they involve permanent real estate transfers. So be extremely careful. Only discuss a reverse mortgage with trusted, known institutions and, as a general rule, do not respond to people who reach out to you on the subject.
That said, reverse mortgages can be a valuable source of income for some retirees. Specifically, this is a financial product designed to solve the Catch-22 at the heart of home equity. Most Americans hold the majority of their wealth in their home. But to access that wealth you need to sell your house, so you’ll likely have to spend much (if not most) of that money on a new place to live.
A reverse mortgage can give you some of the value of your home without you having to sell the property. There are, of course, downsides. Most notably, a reverse mortgage gives your lender a claim on your home and some authority over your day-to-day lifestyle.
Under the right circumstances this is a potentially valuable option, but make sure to review this loan carefully. Here’s what you need to know, but you should also consider consulting a financial advisor to explore all of your options.
What Is a Reverse Mortgage?
A reverse mortgage is a loan that you take out against the value of your home. In most cases you do not have to repay this loan while you are alive and living in the house, allowing you to access the home’s equity without having to sell or move out.
Most reverse mortgages are heavily regulated by the Federal Housing Administration (FHA). They are restricted to individuals age 62 and older, and are intended to help Americans supplement their retirement savings.
When you take out a reverse mortgage you receive a loan based on the equity you hold in your home. This is defined as the property’s market value, less any debts tied to the property itself (for example any liens, HELOCs or mortgages). You can generally receive the loan in one of three ways: a lump sum, a stream of income, or a line of credit. Of these, most reverse mortgages offer either a lump sum or a stream of income. A line of credit, which is in many ways a standard home equity loan, is less common.
The amount of a reverse mortgage is capped by the FHA, which sets the maximum federally insured reverse mortgage at 60% of the borrower’s home equity. For example, say that you own a $500,000 home outright. A lender could lend you up to $300,000 in principal, before applying interest. Most lenders will not extend a loan that high, however, and will typically extend loans worth between 40% and 50% of the home’s underlying equity. For example, with a $500,000 home you might be more likely to receive a reverse mortgage worth $221,950.
All reverse mortgages charge interest, typically around the same rate as a traditional 30-year mortgage. So, for example, currently many lenders were offering reverse mortgages at interest rates between 6% and 7% per year. This is what gives a reverse mortgage its name. Where a traditional mortgage decreases year-over-year as you pay it off, a reverse mortgage increases over time. Your principal can increase if you take the mortgage as income or a line of credit, and each period your lender will compound interest to your total balance.
You can only take out a reverse mortgage on your primary residence and you must own the property. Most lenders also require a minimum equity in the house, and may require little or no remaining debt on the property.
A reverse mortgage generally comes due for payment under three conditions:
- If you move out of or sell the house.
- If you allow the home to fall into significant disrepair or tax arrears.
- Your estate will repay the loan after your death. Posthumous repayment means that your estate or your heirs can repay the cash value of the loan, or your lender can sell the house and take the value of the loan from that sale.
A standard reverse mortgage cannot go underwater. If the value of this debt exceeds the value of your house, your lender can keep all the proceeds of selling the property but they cannot seek additional repayment from either you or your heirs.
Reverse mortgages aren’t right for every situation. Consider consulting a financial advisor to talk through your strategy.
The Pros and Cons of a Reverse Mortgage
The advantage to a reverse mortgage is retirement income.
Most households hold most of their wealth in their home. This is particularly true for households in lower income quintiles, where often someone’s home can be worth significantly more than their retirement portfolios. A reverse mortgage allows these retirees to access that stored value without having to move out of their home.
The secured nature of a reverse mortgage also helps make it much safer for retirees. With one very big exception (see below) they don’t have to worry about repaying this debt. The lender will simply collect the value of their home from their estate. Since this is a secured loan, it’s also tends to have a lower interest rate than many other types of personal lending. Finally, since this is a loan, the money is tax-free. You can keep and spend the full value of the reverse mortgage.
That said, there are some significant disadvantages to a reverse mortgage.
Although this money is tax-free, your lender will charge compound interest. Over the course of your retirement that can add up significantly, potentially competing with the cost of taxes on regular income. You will also have to pay up-front origination and lending fees, which can easily cost tens of thousands of dollars.
You will also share a property interest in your home. You will need to maintain the property based on terms set by your lender. If you aren’t careful, this can create an intrusive presence in your day-to-day life, since a third party will now have a legal interest in the state of your housekeeping, and it can sometimes involve expensive repairs or upkeep that you might have otherwise passed on. If you need or choose to move out of your home, you will have to pay off the loan or sell your house. And a reverse mortgage will significantly complicate any estate planning, since your heirs will need to repay the loan if they want to keep the property.
Finally, while a reverse mortgage can supplement your retirement, it usually won’t generate a significant income on its own. For example, say that you are 62 years old and take a reverse mortgage at 6% interest. Even an extra $1,000 per month ($12,000 per year) would add up to more than $460,000 in debt by age 82. This can make a real difference to the right household, but make sure that you don’t give away your home in exchange for a minor retirement boost. A financial advisor can help you project specific numbers for your situation.
When Should You Take a Reverse Mortgage?
A reverse mortgage can make sense in the right situations, including:
You plan to remain in your home throughout retirement
While obviously you cannot anticipate all future needs, and particularly any long-term or residential care issues that might emerge, a reverse mortgage often makes the most sense if you have no plans on leaving your home. This will eliminate the potential issues that can arise when you trigger repayment by moving or selling the house.
You don’t anticipate any inheritance issues
A reverse mortgage can significantly complicate your estate planning. If neither your estate nor your heirs repay the loan with cash, your lender will sell your home for repayment.
For some people, this isn’t a problem. Perhaps your heirs don’t particularly need or want your home. Perhaps, if they do, they will have no problem repaying the loan. Or, perhaps you simply do not have any significant heirs or estate plans in general. However you get there, estate planning is one of the biggest issues with a reverse mortgage. This becomes much easier if you have no particular estate planning needs to begin with.
You have unexpected expenses
While a reverse mortgage can modestly supplement your month-to-month income, it can provide a very significant one-time loan. That can make this a great source of funds if you have unexpected costs. For example, say that you suddenly need long-term care or have a medical event. A reverse mortgage can provide an infusion of cash to help you cover those needs.
You outlive your savings
Longevity risk is a very real concern when it comes to retirement planning. Most households don’t have enough money to fund an indefinite retirement. Instead, they need to plan for spending down their money gradually, hoping to make those savings last.
A reverse mortgage can be an excellent backup plan. If you end up outliving your retirement savings, you can tap your home equity to supplement your income during the later years of your retirement. Consider speaking with a financial advisor before you commit to a plan to make sure you are allocating your resources effectively.
You want defer withdrawals and/or Social Security
This option has more potential downside.
A reverse mortgage can be a good source of early-retirement income. One approach is to take the majority of your early retirement income from a reverse mortgage, deferring Social Security until age 70 and leaving your portfolios in place. This will maximize the value of your retirement income, increasing your benefits and letting your assets grow for several more years.
However, that additional income will come at the cost of maximizing your mortgage debt. Unless you plan on paying off this loan in retirement, your mortgage will have decades of compound growth before your estate pays it off. This might not concern you, particularly if you have few inheritance plans, but it’s important to consider.
The Bottom Line
A reverse mortgage is a retirement planning tool that lets retirees access some of the value of their home equity without having to sell their house. It’s important to be extremely careful with reverse mortgages, since they are more risky than typically advertised, but they can still be very useful.
Tips On Estate Planning
- Always, always, always plan for taxes in retirement. This might be the easiest mistake to make as you prepare your savings and income strategies, and we’re here to help you avoid it. For example, let’s discuss some of the potential tax implications of taking out a reverse mortgage.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now. You can also check out SmartAsset reviews.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
Photo credit: ©iStock.com/Wasan Tita