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Ecology of Money

Should You Consider a Reverse Mortgage?

Reverse mortgages can be useful tools for some retirees, but mind the complexity and costs, says contributor John Wasik.

As financial devices, reverse mortgages (RMs) are like 3-D printers. They can do some interesting and useful things, but they are complex and can be expensive.

Reverse mortgages were originally designed for those who came up a little short when they reached retirement age. Today, however, they are being used for purposes other than just retirement income.

Should you consider a reverse mortgage? Read on to learn about what they are, how you can use them, what they cost, and their drawbacks.

What They Are
Unlike traditional mortgages, which require a monthly payment to pay off principal and interest, RMs tap the equity in your primary residence to provide you a monthly payment or lump sum. You can take out an RM on a home you've been living in for a long while, or one you're buying. It's a loan that uses your home as collateral. You defer paying off the loan until you move out, sell, or die.

As products that didn't exist before 1990, RMs are relative newcomers to the home-finance world. Their volume has grown from less than 200 loans some 25 years ago to more than 51,000 last year. The biggest year was 2009, when more than 114,000 RMs were originated, according to the U.S. Department of Housing and Urban Development (HUD), which insures the loans through its Federal Housing Administration. Although the current market for RMs is relatively small--only about 3% of those who qualify have them--they are expected to grow in popularity as baby boomers age.

The first RMs, also known as Home Equity Conversion Mortgages, were variable-rate products that adjusted monthly. HUD capped their volume until 1998, when the government allowed 150,000 RMs to be issued annually. Their popularity boomed immediately before and after the housing boom (2006-11), as more homeowners tapped their equity for a variety of purposes.

The housing bust, which resulted from the popping of a credit bubble in 2007, forced some RM holders into difficult financial situations, which were compounded by job losses and a recession. Some 10% of reverse-mortgage holders faced defaults when they were unable to pay property tax or insurance bills.

How They Are Used
Conceived as ways to help "cash poor" retirees, RMs have increasingly taken on new roles in financial planning. According to Tom Davison, a certified financial planner recently retired from Summit Financial Strategies in Columbus, Ohio, how RMs are used typically depends upon the age and financial situation of the retiree.

For early retirees--those between ages 62 to 70--Davison says RMs can serve as a planning tool, even for those who have well-funded retirements. What if you or your spouse live another 30 years or so past retirement age? Then, an RM line of credit could serve as a backup source of cash that could function as a form of longevity insurance so that you don't outlive your money. The loans can also help fund expensive long-term or in-home care. "One of the biggest risks in retirement is paying for expensive in-home care," says Davison. "An RM line of credit is a good standby if you have big health-related expenses."

For others, an RM could address more immediate short-term needs, such as cash for needed home repairs or to pay off large, nondeductible debts going into retirement. "From a practical sense, RMs can help alleviate debt and improve quality of life," says Scot Stark, a certified financial planner with Stark Strategic Capital Management in Freeland, Maryland.

How Much Do the Loans Cost?
An RM's cost depends on a few factors. After an appraisal of your home and subtraction of what you owe and how much equity you hold in your home, the lender will determine a "maximum payout" or "principal limit." No lender will loan you the full amount against what you own. The older you are, the higher loan amount you will qualify for. The loan is based on a percentage of your home's market value and what you own minus the mortgage balance, with 75% as the maximum value. So, if your home equity is worth $100,000, for example, you'd only be able to get a maximum loan or line of credit for $75,000.

How much you pay for the loan depends upon when you pay the mortgage insurance premium and whether you want an adjustable-rate or fixed-rate loan. Mortgage insurance will cover the lender in the event of a default on the loan. You could pay either 0.5% or 2.5% of the mortgage insurance premium upfront. The more insurance you pay upfront, the larger the amount of cash you can pull out at closing.

Davison notes that the cost involved also depends upon the interest rate you choose, how much cash you need in the loan's first year, and if this is a refinance of your current residence or purchase of a new primary residence. The loans can provide a lump sum upfront, monthly payments, or a line of credit. "When choosing to use a line of credit, the unused line of credit will automatically increase every month and can't be reduced, frozen, or canceled by the lender--no matter what happens to the home's value," Davison notes.

Let's say your home is worth $300,000 and you have $90,000 remaining on the loan. You also live in Chicago, and were born in 1945. Here are three possible RM options, using the Mortgage Professor RM Loan Calculator.

  • Cash upfront at closing after paying 0.5% insurance premium on an adjustable-rate loan: $2,562. After one year: $65,880. With 2.5% insurance premium: $16,470. Interest rate: 2.06% annually.
  • Cash upfront at closing for a fixed-rate loan: $3,062 with 0.5% premium; $16,470 with 2.5% premium. Interest rate: 3.9% annually.
  • Monthly income: $377 for life for 0.5% insurance; $335 for fixed-rate loan.

These examples illustrate the myriad variations that RMs offer. In exchange for taking more risk on adjustable loans--the risk is that rates go up--you can get more money upfront. And the more insurance you take out on the front end--which reduces the lender's risk--the more money you can tap.

Your final fees depend upon what option you choose. Those fees include upfront origination fees and other settlement costs. In these examples, the total settlement costs (if you roll them into the loan) amount to $5,758 for the fixed-rate loan with a 0.5% insurance fee (included) and $12,258 for an adjustable loan with a 2.5% insurance premium.

As with any loan, if you roll closing costs into the loan balance, you are decreasing the total amount of cash you get back. While that's convenient if you don't have the upfront cash, it means you will owe more over time.

Since there are so many variations to these loans, try a calculator first to see what you can qualify for, then see if the total costs make sense. You can always save money if you do some comparison shopping or work with a mortgage broker.

Drawbacks
Despite their ability to provide much-needed cash or a regular income stream to retirees, RMs have their drawbacks. For starters, it is more complicated to pass your home along to your heirs with a RM. Fortunately, the heirs will never owe more than the house is worth, notes Davison. "The heirs can pay the loan off from other resources or a new mortgage if they want to keep the house," he adds. If the home is worth more than what's owed, heirs can sell it and keep the equity. If it is worth less than what's owed, they can transfer the home to the lender and fully satisfy the "nonrecourse" loan.

Then, there are the costs of the loan. Is a loan worth it after you consider all of the expenses? Is there a cheaper way to access the money you need without doing a reverse mortgage? For example, you will be able to reap a higher Social Security benefit by retiring later than your "normal" retirement age, which for most people is 66. At 70, you'll reap the highest-possible monthly payment. Other options besides working longer and deferring Social Security may include tapping into equity in whole-life insurance policies--you can obtain an interest-free loan, or simply cash it out. Also consider conventional home-equity loans or home-equity lines of credit. While they may be more difficult to qualify for, they may be lower cost.

Finally, an RM makes little sense if you plan to downsize or move out. You will have to pay upfront costs to obtain the loan--plus insurance--so a short stay in your home means you may not be able to recoup those expenses.

Planning for a Reverse Mortgage and Avoiding Fraud
Because reverse mortgages are complex products that will trigger financial consequences down the road, you need to talk with a loan counselor, certified public accountant, or other qualified financial professional before you forge ahead.

In recent years, unfortunately, reverse mortgages have also been used to scam older homeowners. Swindlers have deceived homeowners into taking out the loan and then stolen the proceeds. The Financial Industry Regulatory Authority has put together a nice document about what RMs are and how to avoid scams; access that report here.

The best way to avoid RM fraud is to ignore unsolicited offers and seek the advice of a certified mortgage counselor. You can talk with HUD-approved housing counselors, although they will charge you a flat fee ($125 or less) for their time. It's well worth it to understand the inner workings of these loans. Visit HUD's counselor search page or call their referral line, 800-569-4287.

John F. Wasik is a freelance columnist for Morningstar.com and author of 14 books, including Keynes's Way to Wealth: Timeless Investment Lessons from the Great Economist. The views expressed in this article do not necessarily reflect the views of Morningstar.com.