Reverse mortgage pros and cons
A reverse mortgage can be a great tool for retirees – they can also cause a number of issues. There are a number of pros and cons with reverse mortgages, also called home equity conversion mortgages (HECM loans), all of which you should consider before applying for the loan. It’s important to know exactly what you are signing up for – educating yourself now can help you avoid the pitfalls of a reverse mortgage.
This is part of our series on reverse mortgages. If you are interested in learning more, we’ve written a few great articles that can help
- Our primer that answers “what is a reverse mortgage?” makes a great place to start.
- An in-depth explanation of how reverse mortgages work, including an example scenario.
- Some important facts about reverse mortgages.
Reverse mortgages pros
Reverse mortgages are becoming safer options for seniors
There were a few heartbreaking issues that were unexpected consequences when congress created the reverse mortgage. Recently, HUD & FHA took steps to address these issues. You can see a list of the changes made to the program since its creation, but I want to highlight a few recent change in particular.
New rules take care of surviving spouses
Prior to a recent change, if a spouse wasn’t included on the loan, they could lose the home when the primary borrower passed away. This is a heartbreaking thought, and a recent change has been implemented to prevent this from happening. In mid-2014, FHA took steps to ensure surviving spouses have the ability to stay in their home, even if they weren’t included as a borrower on the loan.
Financial assessments reduce the risk
When you take out a reverse mortgage, you are still required to pay for other housing related expenses, including property tax, homeowners insurance, HOA dues, and maintenance expenses. Starting in April of 2015, reverse mortgage lenders are now required to perform a financial assessment of the borrower before giving them a loan. On top of that, if there is a chance that the borrower may not be able to meet these other obligations, the lender is required to set aside funds to make sure these payments are made. This set-aside ensures protects the borrower from foreclosure, making reverse mortgages much safer.
Counseling requirement helps educate seniors
Many consider this a “con” but I think it is a great thing. To make these loans safer, borrowers should be educated about what they’re agreeing to prior to closing the loan. Now HUD and the FHA make counseling a requirement to get a home equity conversion mortgage. You can visit the HUD website to find your nearest counselor and get more information about reverse mortgage loans.
Secures housing at low or no cost
According to the 2014 CE Survey, housing expenses for those over 65 years old account for more than 1/3 of total monthly income. For seniors with limited income, reducing housing expenses can provide extraordinary relief. A reverse mortgage can reduce these expenses, doing so in a way that ensures the borrower has a secure living situation.
Refinancing an existing mortgage can lower living expenses
Carrying mortgage debt into retirement is becoming increasingly common. According to Bloomberg, the median loan amount for retirees with mortgage debt is nearly $80,000. This means hundreds of dollars a month in principal and interest payments. With a reverse mortgage, retirees can refinance their mortgage debt & eliminate that monthly payment – significantly increasing their monthly income.
Increase monthly income
Retirees are facing a “cash crunch”. According to the Wall Street Journal, Baby Boomers expect to make $45k per year in retirement, but only have enough savings to generate about $10k per year. They’ve underestimated how much money they will need. A reverse mortgage allows these seniors to access their home equity, and the monthly distributions can increase their income.
Loan proceeds aren’t taxable income
You should definitely consult a professional on this topic. But according to the IRS, money from a reverse mortgage is not taxable income. That means if you choose a monthly distribution, or take a lump sum payment to cover expenses, that money is tax exempt.
Continue to benefit from increases in home value
Seniors maintain ownership of their home with a home equity conversion mortgage. When they decide to sell the home, or payoff or refinance the reverse mortgage, they must only repay the principal debt and any interest. If the value of the home appreciates, the homeowner will benefit from that appreciation.
No pre-payment penalties
The borrower has the option to get rid of their reverse mortgage at any time and has a few different options to do so. There is no pre-payment penalty associated with a HECM loan and they can be paid off at any time.
Multiple ways to tap home equity
When closing the loan, borrowers can choose a number of different payment types. If the cash is required to cover large expenses, like medical costs, borrowers can take a lump sum payment.
If the loan is being used to supplement income borrowers can receive monthly payments from the lender. Seniors can also choose to establish a line of credit, which allows them to draw money as needed from their home equity.
Pay off your debts without a new monthly payment
Seniors are facing a massive increase in health care costs. Based on a report by the Health Cost Institute, A couple that retires at 55 and lives to 85 years old can expect to spend over $700,000 on health care. Retirees who need cash to cover their health care expenses have the option to tap their home equity using a reverse mortgage. Doing so will not create a monthly debt payments or otherwise affect their income stream.
Fees & mortgage insurance can be financed
The costs associated with the loan can be financed, allowing seniors to preserve cash. These include the lender’s origination fee, mortgage insurance, and other loan costs like the appraisal. You can check out our in-depth article on mortgage closing costs to better understand some of the fees that might be included in the loan.
Social Security or Medicare benefits are not affected
Again, you should always consult a professional to determine the potential implications. But generally getting a reverse mortgage will not affect your social security or Medicare benefits. However, it may impact some needs-based benefits such as medicaid, so we encourage you to speak with a benefits specialist prior to taking a reverse mortgage if you are on any needs-based social programs.
Debt cannot be passed to your heirs
Home equity conversion mortgages are non-recourse loans, which means the borrower or their heirs will never owe more than the value of the home. If the debt becomes greater than the home is worth, the reverse mortgage lender cannot try to collect any remaining balance from the borrower’s estate or from the personal assets of any heirs.
Reverse mortgage cons
Negative amortization loan
A negative amortization loan is a loan where the payments do not cover the interest accrued, so the balance of the debt is increasing. Because reverse mortgages don’t require monthly payments, the total amount of debt increases every month.
You may outlive your equity
Depending on your age when you close your reverse mortgage, there is a chance you outlive your home equity. Depending on the type of loan you choose, you may or may not continue to receive monthly distribution payments. We calculated an example loan where the borrowers lived a ridiculously long time – to 110 years old.
They far outlived their equity, so when they passed away, their heirs did not receive any money from the sale of the home. However, their heirs did not have to inheret any debt associated with their reverse mortgage either.
Adjustable interest rates
Borrowers interested in receiving monthly distribution payments will be required to have an adjustable rate for their loan. This means that over the life of the loan, your interest rate may increase. A rate that starts at 4.25% can increase monthly in a rising interest rate environment. Most loans have a lifetime cap, but it’s high – in our example, the cap was over 12%. If interest rates rise quickly, the accrued interest on the debt can quickly eat up your home equity.
Short term index rates move frequently
Reverse mortgages with adjustable rates are often tied to short term indexes. In our example loan, the rate was based on the 1 month LIBOR index rate. These short term indexes tend to be more volatile than their longer term counterparts. As you can see below, the 1 month LIBOR rate has stayed relatively low in our current rate environment. But historically, it is more susceptible to wild swings when compared with a longer term index, like the 10 year treasury note. A rapid increase in interest rates could translate to less equity when the loan comes to maturity.
Limited access to cash
In an effort to make these loan products safer, the regulators place limits to how much cash you can take out, how quickly you can use it. Generally you can only access 60% of your principal limit within the first year of closing your loan, but there are some exceptions.
Not all housing expenses are eliminated
Reverse mortgages can eliminate any principal and interest payments associated with an existing mortgage. However, the borrower is still responsible for costs like property tax, homeowners insurance, HOA dues, and maintenance expenses.
Reverse mortgage fees
There are a number of fees that come as a result of your new loan. This includes the lender origination fee, closing costs, and mortgage insurance. In our example, these fees were more than $10,000.
Less home equity to leave to your family
I’m listing this here, but this point could be argued. It’s true – a reverse mortgage is going to eat into your home equity, and ultimately there will be less equity to pass on to your heirs.
If a reverse mortgage borrower is using cash from the loan to pay off other debts, this is less of an issue. Especially if the interest rate from the reverse mortgage is lower than the interest rate for the other debts. But at the very least, the borrower will have to pay the fees associated with the loan, which will lessen the amount they will be able to leave their heirs.
It can create hardships when family members have to cover living expenses for their parents or grandparents. It would be great to pass something on to your family but at what cost?
Needs-based programs (like Medicaid) may be affected
All borrowers should discuss these implications with a professional, particularly someone who works with government benefit programs. But your new income from your reverse mortgage could affect qualification for needs based government programs like Medicaid or Supplemental Security Income.
Not all properties qualify
Some properties aren’t eligible for a reverse mortgage. According to HUD HECM loan guidelines, to be eligible for a reverse mortgage the property must be the primary residence of the borrower, no more than four units, and must be one of the following types of properties:
- Single-family homes
- Manufactured homes (built after June 1976)
- Condominiums or townhouses
- Properties in planned unit developments (PUDs)
It’s also worth noting that properties held by a trust are eligible for reverse mortgages, which could have an advantage when considering estate planning. And in the case of purchase a home with a reverse mortgage, the property cannot be “flipped” by an investor.
A lien is added to the home
If the home is paid off, a reverse mortgage puts a lien on the home where there wasn’t one before.
Mortgage interest is not deductible until you pay it
The IRS does not allow reverse mortgage borrowers to write off their mortgage interest each year – instead, they take the deduction when the interest is paid. This may eliminate a deduction for some borrowers, increasing their tax payments.
Not everyone will qualify
Qualifying for a reverse mortgage has become more difficult. I’d argue this is a pro, and not necessarily a con. To qualify for a home equity conversion mortgage, there’s an equity requirement, borrowers must pass the financial assessment, the property must meet certain requirements, and the loan itself may be subject to FHA lending limits.
Advertisements can be misleading
Reverse mortgage lenders have a history of using deceptive advertising. The CFPB and FTC have been cracking down on this recently, but always be sure to do your own research before closing a loan!
Alternatives to Reverse Mortgages
Reverse mortgages aren’t the only option for cash strapped seniors. Retirees that need to cover large expenses can leverage personal loans or other types of debt that will not affect the equity in their home.
For those that want to tap their home equity, but want to limit their risk, they can apply for a cash out refinance loan or a Home Equity Line of Credit – both allow the homeowner to convert part of their home equity to cash.
Other sources for information
As with everything you read on the internet, we encourage you to take our advice with a grain of salt. You should always consult a professional before doing any major financial transaction – the pros and cons described here are for informational purposes only.