Why Reverse Mortgages May Make Sense as Retirement Funding Tools

Few, if any, retirees like the idea of going into debt to fund retirement. Yet with more and more households coming up short on cash savings, millions of retirees have turned to reverse mortgages as a source of retirement income.

Although hardly ideal for financing retirement, reverse mortgages may help close an estimated $4 trillion retirement funding shortfall, according to an estimate by the Employee Benefit Retirement Institute.

Reverse mortgages (also known as home equity conversion mortgages) are loans that tap into your home equity to provide a monthly income stream.

Available to those age 62 and older and guaranteed by the federal government, these loans allow you to borrow up to as much as $679,650. Exactly how much you can borrow is based on your home equity and age. Generally, the older you are, the more you can borrow.

These vehicles can also offer a way to diversify your retirement income if you own your home outright or have built up substantial home equity. Despite the 2007-2009 housing recession, home equity is still a source of wealth for many Americans. Home prices have been steadily rising in most areas during the past decade.

"For most Americans, home equity is one of their largest assets," says Jamie Hopkins, a professor of retirement planning at the American College in Bryn Mawr, Pennsylvania. "The average 65-year-old couple has about two-thirds of their wealth in home equity."

Although reverse mortgages were the subject of myriad lender abuses a decade ago, the Department of Housing and Urban Development has tightened up consumer protections in recent years, Hopkins says. That means homeowners who shouldn't be borrowing are less likely to be given loans.

Moreover, reverse mortgages can provide some diversification to your retirement income, since housing prices tend to not move in lockstep with the stock and bond markets.

Here are some things to consider when exploring whether a reverse mortgage is right for you.

Take a Tally of Your Retirement Income Sources The best way to start this process is to look at your various retirement income sources. How much do you or will you receive from Social Security? Do you have a guaranteed pension? What about savings in IRAs and 401(k)s? Based on your current or projected living expenses, will your retirement income from those sources be enough to support your lifestyle?

Or what if we hit a bumpy market and you'd rather not touch your investments when they are down? A reverse mortgage might enable you to create an income stream while leaving your retirement kitty alone for the time being.

"A great time to tap into a reverse mortgage is during a period of bad stock market returns," notes Hopkins. "when stocks are down, it's the worst possible time to sell stocks. Instead, use your home equity as part of a holistic plan. Not many homeowners use this strategy, though, although research supporting it has been around for six or seven years."

To bolster your retirement income, you can either set up the reverse mortgage as a line of credit or take out a lump sum. In either case, you still own the title to your home, although how much you owe, rather than own, rises over time. If you want to leave your home to heirs, they will need to pay off the borrowed amount if they want to own the property. Most heirs sell the property to pay off the loan.

How Much Will It Cost? Reverse mortgages are more costly than conventional mortgages or home-equity loans. And you're creating a new debt when you probably least want it: in retirement. Don't even consider one if you're struggling with paying insurance, taxes, and maintenance expenses on a regular basis. Having a low percentage of home equity would likely disqualify you from a loan, as well.

The closing costs of reverse mortgages are rarely bargains, ranging up to a $6,000 maximum or up to 2% of the loan amount. Embedded in the cost of the loan is also a federal insurance premium, which is an up-front flat 2% of the maximum claim amount (typically the value of the home) and an ongoing MIP of 0.5% on the outstanding loan amount.

The high expenses of a reverse mortgage make it unsuitable for those who don't plan to stay in their homes. If you plan to move within a few years, the upfront expenses can be onerous. There are also third-party, origination, and servicing fees. Since the market has become competitive in recent years, however, Hopkins says these fees are negotiable.

Some Drawbacks Reverse mortgages are complicated because they have multiple sets of rules attached to them. A lender can find that your home may need repairs, for example, which will require you to spend money to fix the issues.

You also have to own and occupy the property you're borrowing against and be able to make all tax payments and do ongoing maintenance. And you can't be subject to other federal debts, such as being in arrears to the IRS.

The complexity of reverse mortgages and past reputation are two barriers for most retirees, though. Only about 50,000 reverse mortgages are initiated each year. That's down from a peak of about 155,000 in 2009.

Then there's the matter of how much is owed and when the debt is paid. According to ReverseFunding.com, the loan must be repaid when the last surviving borrower dies or the home is no longer the borrower's primary residence. The loan also becomes due if the homeowner fails to pay property taxes or homeowners insurance or fails to keep up the property.

Also keep in mind how a reverse mortgage works: Your equity goes down every month you use one of these loans, while the amount you owe goes up. Interest and fees are also added to the loan balance.

"Many people interested in a reverse mortgage still owe money on their home," notes the Consumer Financial Protection Bureau. "If this is your situation, you will be trading one loan for another, usually a larger one. If you owe a lot on your current mortgage, you may not have much money from the reverse mortgage left over to spend on other things."

Education is essential: You'll need to understand how these loans are financed and how much you are paying to access your equity. The government requires counseling before you borrow, but it wouldn't hurt to consult your accountant or a fee-only financial planner before you see a lender. Also consult the CFPB's "Reverse Mortgages: A Discussion Guide," which is a useful, plain-English primer on the subject.

Getting a reverse mortgage also may not work with your estate plan, since the value of your property will be diminished by the debt you incur from the loan. If you're considering a reverse mortgage, be sure to discuss it with your family. They might have some insights on why the loan may or may not be the best choice for you.

John F. Wasik is a freelance columnist for Morningstar.com and author of 17 books, including Lightning Strikes: Timeless Lessons in Creativity from the Life and Work of Nikola Tesla. The views expressed in this article do not necessarily reflect the views of Morningstar.com.