This is not yet something that is likely to affect most of my readers, as few of you are in your sixties or seventies (I think). But a friend's parents are considering a reverse mortgage and I thought it would be an interesting disucssion. Most of us have parents who are around the age targeted by reverse mortgage companies. So, if not yet for ourselves, we should be educated for our parents, other relatives or friends' parents.
Homeowners in many parts of the country have seen the value of their home double or more over the last five years or so, creating an instant retirement plan for those who did not previously have one. A blessing, if you are in that position. Money sent from the heavens. But the most important question for those who are planning not only to live in their house, but to live off of it is, what is the best way to access my equity?
The simple answer would be to simply take out a home equity line of credit or loan and use those funds as a sort of retirement account. Withdraw money as needed, manage your cash flow so that you don't run out. Of course there are drawbacks. The money that you take out must begin repayments immediately. So you would be using the money borrowed to make your payments. It also does not absolve any existing debt that you may have, namely your existing mortgage.
So, for many older Americans in this position, the reverse mortgage has become a popular solution to all of these questions. But what is a reverse mortgage, how does it work, and is it really a good idea?
What is a Reverse Mortgage?
According to reversemortgage.org, a reverse mortgage is, "a special type of loan used by older Americans to
convert the equity in their homes into cash. The money from a reverse
mortgage can provide seniors with the financial security they need to
fully enjoy their retirement years."
Just like a traditional mortgage it is a loan against your house, but unlike a traditional mortgage, it is not used to purchase the property, but to extract the equity in either the form of a line of credit or a monthly payout.
How does a Reverse Mortgage Work?
The concept of a reverse mortgage is surprisingly simple. It is the opposite of a traditional mortgage (forward mortgage). In a traditional mortgage a loan is issued to the homeowner, generally for the purchase of property, and payments begin immediately, allowing the homeowner to pay the principal down over a period of time. Assuming we are talking about fully amortizing loans, the homeowner will be able to pay the mortgage off in full at some point in the future, commonly 30 years.
A reverse mortgage also issues a loan to the homeowner, however the homeowner does not make payments on this loan. Ever. Instead a first position lien is placed on the property, and the homeowner may receive either a line of credit for some portion of the equity or annuity like payments that will be guaranteed for life. Interest accrues on the loan and is never paid off. Rather the balance continues to grow every month. Upon the death of the homeowner, the mortgage company takes possession of the house unless the heirs make arrangements for repayment of the debt.
What are the benefits to a Reverse Mortgage?
There are two major benefits to using a reverse mortgage:
- If the homeowner is at or near retirement age and continues to struggle to make end meet due to the burden of a mortgage payment, this will relieve them of the monthly payment. This is a big relief to many retirement age homeowners wanting to retire, but worried about their mortgage payment.
- This allows the homeowner to use the equity in their house as a retirement fund without having to sell and move. Many older homeowners have spent the greater part of their lives in their final house. Many have seen their children grow up there, and have deep roots in the neighborhood. Selling the house would be a painful option.
What are the drawbacks to a Reverse Mortgage?
- The interest rate is typically 1.5-2% higher than traditional mortgage rates. Anyone thinking about using a reverse mortgage should consider comparing the cost and benefits of using a cash out refinance traditional mortgage.
- The other costs are fairly high. There is an origination fee which will be the greater of $2000 or 2% of the maximum qualifying amount. There is typically a mortgage insurance premium equal to 2% of the lesser of the value of the house or the maximum qualifying amount in the first year and 0.5% of the loan balance annual after that. There are also appraisal fees and a litany of closing costs.
- The likelihood of keeping the house in the family after the death of the homeowners is unlikely. However, for anyone considering a reverse mortgage, the likelihood is low under any other option as well.
Is a Reverse Mortgage a good solution?
There are many Americans for whom it would be their best option. The basic profile would likely be someone who owns their home, needs either higher monthly income or mortgage debt relief, is at or near retirement, does not have significant other assets, and highly values living in their current house.
Bottom Line and Disclosure:
There is quite a bit more about reverse mortgages that I did not cover. I am not an expert on reverse mortgages, real estate, real estate laws, any other type of lending or borrowing. This is general and incomplete advice. You should consult with your own financial advisor before making any major financial decisions, including investments or changes to your portfolio or balance sheet. You, alone, are responsible for any losses or damages that may and will likely result from your financial decisions.