According to an August 2014 study conducted by Merrill Lynch, when it comes to homeowners, seniors tend to carry less mortgage debt, have more equity in their homes, and tend to have greater net worth. These trends make older Americans a favorable target for marketers of financial products and services, including reverse mortgages. These mortgages allow borrowers ages 62 and older to take advantage of the equity in their homes.
They can be a useful financial tool, but they aren’t without risks. If you’re contemplating a reverse mortgage or know someone who is, it’s important to understand how reverse mortgages work and the pros and cons you might face.
What is a reverse mortgage?
A reverse mortgage is a home equity loan or line of credit that allows homeowners ages 62 and older to borrow back money from years of equity they have built in their homes.
The Federal Housing Administration (FHA) insures most reverse mortgages, and these may also be called Home Equity Conversion Mortgages (HECM).
How do reverse mortgages work?
The main attraction of a reverse mortgage is that there is no monthly mortgage principal or interest payment obligation. The homeowner must continue to pay taxes and insurance on the home or risk defaulting on the reverse mortgage. Interest that accrues on the loan is added to the loan balance, and the loan is deferred until the borrower dies, sells the house, or moves out. Money can be taken in a lump sum or distributed monthly.
When HECMs first started in 1989, the typical consumer taking out this type of loan was a retiree looking for additional monthly cash flow during retirement.
In recent years, however, as a result of a number of factors—including rising costs of living, increased financial hardship, and increased medical costs—many seniors have chosen to take their payments in a lump sum. Doing so means seniors are basically tapping their full equity very early and depleting the value of wealth built through their home.
Pros and cons of reverse mortgages
Before you decide to take out a reverse mortgage, consider the following:
1. There’s a financial assessment requirement. HUD has rules that require a financial assessment before a borrower can tap equity. Things like a credit check, debt review, and equity analysis help ensure that qualified borrowers have the ability to pay their current debts, the taxes and insurance on the property, and other expenses. This means that even if you have equity in your home, you may not be eligible for a reverse mortgage.
2. Your spouse may not have to be a borrower. Many senior homeowners live with their spouses in the home, and that spouse may not be a borrower on the loan. Until recently, in the event of the borrower’s death, the surviving spouse had to pay back the loan or risk losing the home to foreclosure. Recent rules make it easier for the surviving spouse to stay in the home after the borrowing spouse’s death—but only if he or she meets certain requirements.
3. There are limits on payouts. Reverse mortgage payouts vary depending on the age of the borrower, the appraised value of the home, and interest rates. The maximum home value that can be used to calculate the value of the reverse mortgage is $625,000, even if your home appraises for more. This is a limit set by the government. In recent years, new rules also limit the amount that can be drawn in the first year, along with limits on the total percentage of total equity that can be taken out overall. Your lender and housing counselor can work with you to calculate your specific scenario and eligible amounts if you are considering a reverse mortgage.
Protect your two most valuable assets: Your home and yourself
Because reverse mortgages can be very complex, it is critical that you (and your adult children) be well informed about all of the options, considerations, and consequences associated with these products. One terrific resource for in-depth and understandable information about reverse mortgages is the Consumer Financial Protection Bureau.
You may also want to seek out the help of a qualified housing counselor or financial advisor. Be wary of any lender who does not let you choose your own reverse mortgage counselor, as this could be a sign of a scam.
Alanna McCargo is a housing and financial services executive and personal finance writer and advocate. She is a public speaker on hot topics in financial services and the housing market, and she writes a personal finance blog called “Matter of Money.” Follow Alanna on Twitter @myhomematters.