Reverse Mortgage Pros and Cons
We’ve all seen the commercials about reverse mortgages but may still be unsure of they’re the right choice. A reverse mortgage is a home loan for qualified borrowers age 62 typically with substantial equity in their home. The money you receive can provide retirement income (and peace of mind) that fixed income securities probably can’t. As more and more banks are embracing reverse mortgages, they are becoming increasingly popular with people in, or approaching retirement. Here are some reverse mortgage pros and cons people may overlook:
Reverse Mortgage Pros and Cons
If you qualify, you can take your money in a lump sum, through monthly payments or with a line of credit (or a combination of these). If you take it as a lump sum, you should be able to lock in a fixed rate, which is a valuable option given how low interest rates are currently (conventional mortgage rates are 3.5% and reverse mortgage fixed rates under 5%). You can also use a reverse mortgage to purchase another home.
The loan proceeds from a reverse mortgage are tax free.
Maybe the best part of the reverse mortgage is you don’t have to make principal and interest payments on the loan. You receive the loan and defer repayment (until the house is sold, the borrower moves or passes away), allowing borrowers to use the funds for medical needs, high-interest debt repayment or to simply enjoy yourself. Most of the closing costs, excluding the initial mortgage insurance, are often rolled into the reverse mortgage.
Pay Off Your Existing Mortgage
You can use the proceeds from the reverse mortgage to pay off the remaining balance of your regular mortgage, if you still have one.
Stay in your House
The borrower gets to stay in their own home (in fact, they are required to remain in the home if it’s their primary residence).
Maximize Social Security Benefits
Utilizing a reverse mortgage near the eligibility date (age 62) may provide you the financial flexibility necessary to delay tapping Social Security benefits until age 70, which will substantially boost your payout.
Hedge Against Deflation
Finally, not only will the money help you with living expenses in retirement, its purchasing power could grow in a deflationary environment. Cash will be king during deflation as credit contraction brings down asset prices to rock bottom levels.
Can’t Get ‘Underwater’
The comforting aspect of a reverse mortgage is that you can’t owe more than the value of your home (assuming it is an FHA HECM) since the loans are non-recourse. If the housing market tanks after you get a reverse mortgage and there is negative equity in the home at the time the loan comes due, the onus is on lender, who is back-stopped by the Federal Housing Association (since reverse mortgages are government insured). The funds they use to ensure this backstop are the borrower’s annual MPI payments. But if there is any leftover or positive or remaining equity in the home after the reverse mortgage has been completely paid off, that amount can go to the heirs. The bank does not own the home.
Protection from Rising Rates
If the loan proceeds are obtained in a lump sum, the interest rate on the loan can be fixed. When we eventually experience a rising interest rate environment, the loan interest will accrue at the low fixed rate you’ve locked in (today, fixed reverse mortgage rates are around 5%). But monthly payouts and line of credit typically have variable interest rates. Something to consider.
Further, if you receive the lump sum and place the funds in safer, short-term instruments such as Treasury-only money market funds or U.S. Treasury Bills, you can benefit as interest rates rise. You’ll be able to continually roll the money over into higher and higher rates because the maturity of your financial instruments are so short.
Unfortunately, most investors have done the opposite, buying the riskiest, longest-term bonds they can find, looking for those higher yields. The durations of bond portfolios (sensitivity to interest rate movements) are at record levels so when interest rates do rise, there could be a clamoring for your conservative investments if the bond bubble bursts.
A Financial Lifeline
The harsh reality is that many people won’t have adequate retirement savings from traditional savings and investments. A 2015 Government Accountability Office showed that 29% of Americans age 55 and older don’t have any retirement savings of their own or defined benefit plan (pension). For those that do, the situation isn’t all that much better. The same GAO study revealed that Americans aged 65 to 74 (i.e. reverse mortgage eligible) have just $148,000 in savings on average.
If you converted that sum into lifetime income (through an annuity equivalent) you’d receive just $649 per month. And remember this study was published on May 12, 2015 just a few days before the all-time high in the S&P 500 Index of 2134.72. Market volatility could erode this number quickly.
If deflation causes the stock market to take another nosedive, as we expect, it could be tough for many retirees to obtain capital. The coming credit contraction could be severe and tighten lending standards across the board. We would certainly prefer to have the loan proceeds up front, sooner than later.
Reverse Mortgage Cons
Getting the loan proceeds up front (over 60% of principal limit) will cost you more in fees at closing, typically about 2.5% of the home’s appraised value (your initial mortgage insurance premium). Even though reverse mortgage fees have come down, the closing costs are still high.
Higher Interest Rates
You’ll probably incur a higher interest rate than a traditional mortgage, especially when adding on the annual 1.25% initial mortgage insurance premium.
You must be 62 years or older to qualify. If you are under this required age, you may consider a cash-out refinance or ‘cash out refi’. This has some similarities to reverse mortgages and gives you access to lump sum cash if you are in a bind.
You also typically required to receive a financial counseling session on the ins and outs of a reverse mortgage before you can access any loan proceeds (assuming its FHA backed). You may have to pay for this as well (typically $175- $200) but it can often be done over the phone.
Variable Interest Rates
We mentioned the variable rates associated with the scheduled payments method, which could balloon if interest rates rise rapidly. This could erode the equity in your home very fast, leaving less for your heirs.
Frozen Line of Credit
Further, if you choose the scheduled, line of credit method there’s no guarantee the line could get cut off (at least temporarily) in a credit crisis. Many Home Equity Lines of Credit (HELOCs) were frozen during the financial crisis, without any prior notice.
While the eligibility of Social Security and Medicare shouldn’t be jeopardized, there is the possibility that Medicaid could be since it’s need-based. This could occur if the money going into your bank account exceeds Medicaid’s $2,000 limit ($3,000 for a couple), presumably through a lump sum payment. Check with your reverse mortgage lender, tax professional or social security office for clarification.
If you are currently underwater in your home, you probably won’t qualify for a reverse mortgage. If you don’t have substantial equity in the home, you also may not qualify. You can talk to a lender to review your options.
A Final Word Reverse Mortgage
Here’s a final word on reverse mortgages. The equity in people’s homes is typically the vast majority of their net worth. If you’re considering a reverse mortgage, you may want to get the process going sooner than later since the amount you can borrow is based off the equity in your home. If we experience the bursting of another housing bubble, as home values drop, your equity could get erased very quickly-along with the chances of you receiving a reverse mortgage loan.