Reverse mortgages: the pros and cons

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TV commercials and ads pushing reverse mortgages seem to be everywhere these days. How can you possibly question anything endorsed by Tom Selleck? So what is a reverse mortgage? Can you benefit from a reverse mortgage? Can a reverse mortgage be a good planning option for seniors?

A reverse mortgage allows a homeowner to withdraw the equity from a home without having to sell or move out of the house, or immediately repay the loan proceeds. The loan is called a reverse mortgage because instead of making monthly payments to a lender, as with a traditional mortgage, the lender makes payments to the borrower.

There are many types of reverse mortgages, with the Home Equity Conversion Mortgage (HECM) being the most common. An HECM is guaranteed by the Federal Housing Administration (FHA) and U.S. Department of Housing and Urban Development (HUD).

Amounts received by the homeowner through a reverse mortgage are treated for tax purposes as a loan. Thus, the amounts received are not subject to tax. To the extent none of the interest is paid by the homeowner, no mortgage interest deduction is allowed. And because reverse mortgage interest becomes part of the outstanding loan balance, the homeowner effectively pays interest on interest.

There are no restrictions on how the homeowner may use the loan proceeds and they can be paid out in a number of different ways, including:

  • A lump-sum payment
  • Installment payments (i.e., fixed monthly payment for the life of the loan or a specific number of years)
  • Line of credit
  • A combination of any of the above options

The loan amount depends on several factors, including:

  • The value of the home
  • The homeowner’s age (generally, the older the borrower, the larger the percentage of the home’s value that can be borrowed)
  • Interest rate
  • Programs offered by the lender

The loan is not required to be repaid until the earliest of when the homeowner:

  • Dies
  • Ceases to occupy the house as a principal residence
  • Is absent from the home for more than 12 months
  • Transfers ownership in the home
  • Defaults on the loan agreement (default is usually triggered by the failure to pay taxes or maintain the homeowner’s insurance)

An HECM loan is treated as a nonrecourse loan. That is, even if the homeowner has completely exhausted the equity in the house, the lender cannot force the homeowner from the home. The lender must continue making the payments provided for under the contractual arrangement even after the amount borrowed has exceeded the value of the house.

Upon the occurrence of one of the above repayment events, the lender recovers the outstanding loan principal and interest solely from the equity in the house. If the homeowner resides in the house until death, the home can be sold or refinanced by the heirs. Proceeds from the sale or refinance can be used to pay the outstanding mortgage with any remaining proceeds paid to the heirs. If the proceeds are insufficient to satisfy the outstanding principal and interest, neither the homeowner nor their estate is liable. Rather, HUD pays the lender the difference between the outstanding balance and the sale proceeds.

To qualify for a reverse mortgage, the homeowner must be at least 62 years old. There are no asset or income limitations. The reverse mortgage must be the first, or primary, debt against the house. While the homeowner remains in the home, they are obligated to pay property taxes, homeowner insurance premiums and make needed repairs; therefore, the homeowner needs to have funds available to keep up with maintenance and the other costs associated with the home.

Costs associated with obtaining a reverse mortgage are similar to those of a conventional mortgage. In addition, with an HECM, the borrower is charged two percent of the home’s value as an up-front payment. The homeowner is also charged one-half percent on the loan balance each year. The borrower can structure the loan to include these amounts in the principal balance. The amounts are used to pay insurance premiums that guarantee the borrower will continue to receive loan proceeds even if the lender goes bankrupt. Insurance also guarantees the lender will get its money back even if the homeowner outlives the longevity tables or if property values decrease. But buyers beware – the costs of obtaining a reverse mortgage can be high – as much as $10,000 or more on a loan of $138,000.

Prior to obtaining a federally insured HECM loan, the homeowner must receive, at no charge, housing counseling provided by a HUD-certified housing counseling agency. Counseling includes legal advice and practical information about reverse mortgages, as well as a discussion of alternative options available to the homeowner.

Reverse mortgages are not the solution for every senior but can be a great option in the right circumstance. Do your homework prior to entering into a reverse mortgage, shop around, compare fees and costs, be wary of sales pitches, and you may want to discuss your financial situation with a fee-only financial planner to see if the loan is appropriate for you.

Pamela Wheeler, EA