A reverse mortgage is a loan that can provide the homeowner (i.e., the borrower) access to the equity in his or her home without the burden of monthly mortgage payments. Borrowers do not have to repay the loan as long as they continue to live in the house. The bank recoups the loan principal and accumulated interest when the last living borrower dies, sells, permanently moves out of the home, or lives in a nursing home for more than 12 months. Thus, a reverse mortgage can create income for the owner without him or her having to sell the home. These loans can also allow borrowers to defer repayment of existing #mortgages. For seniors, reverse mortgages can be a way to “age in place” for as long as possible.
No Longer the Loan of Last Resort
Until recently, the candidate for a reverse mortgage was seen as the homeowner who is cash poor but house rich. Viewed as the loan of last resort, reverse mortgages were considered only after other resources had been tapped out. As a result, many seniors depleted their home equity to cover basic living needs and had nothing left to pay for upkeep on the home or for taxes and insurance. Because the borrower continues to hold the title to the home, he or she is responsible for all property taxes, insurance, repairs, and upkeep. If the borrower fails to keep up with these responsibilities, the lender can foreclose on the loan or reduce the loan advanced by the amount of these expenses.
If a borrower doesn’t have the resources to pay property taxes and homeowners insurance, money will be set aside from the reverse mortgage itself to meet those obligations. These rules reduce borrowing limits and increase mortgage insurance premiums. The amount that can be received as a lump sum in the first year will also be limited.
How Reverse Mortgages Work
A borrower of a reverse mortgage must be at least 62 years old, and the house to which the mortgage applies must be his or her principal residence. The amount of the loan depends on the borrower’s age, the market value of the home, the interest rate, the cost of the loan, and the program’s lending cap. In general, the older the borrower, the larger the loan. Although a line of credit is a popular payout option, these loans also come in the form of a lump sum, a fixed monthly income, or a combination of all three.
If the home has a current mortgage or home equity loan, the proceeds of the reverse mortgage will be used to pay down existing debt, and only the balance will be available to the borrower. Lenders may require part of the loan proceeds to be set aside for future taxes, insurance premiums, and anticipated home repairs.
The interest rate on a reverse mortgage is predominantly variable and can be adjusted monthly or annually depending on the program. Interest is accrued and paid at termination. Repayment will never exceed the final sale price of the home. Because of the variable loan rate, however, the final repayment amount cannot be determined ahead of time. In fact, it is possible that heirs will be left with no equity in the home.
Most reverse mortgages are home equity conversion mortgages (HECMs), which are insured by the U.S. government and available through lenders approved by the Federal Housing Administration (FHA). Loans must meet FHA standards, and borrowing limitations apply. State and local governments may also offer reverse mortgages, but their use is limited. Generally, money derived from these loans can be used only to pay property taxes or to make home repairs.
HECM loans. The amount that can be borrowed through an HECM loan depends on the value of the home, the borrower’s age, and the interest rate. As a general rule, the older the borrower, the larger the loan (all things being equal). The borrowing cap on HECM loans is currently the lesser of the home’s appraised value and the HECM limit of $765,600 and is subject to change. A borrower can access the greater of 60 percent of the principal limit and the sum of his or her mandatory obligations plus 10 percent of the principal limit (not to exceed the principal limit) in the 12 months after closing.
All HECM borrowers pay a mortgage insurance premium, which is designed to ensure that the borrower will receive the expected loan advances. Unlike with a traditional mortgage, the HECM up-front mortgage insurance premium is based on the value of the home rather than the amount of the loan. Currently, the premium is either 0.5 percent or 2.5 percent (depending on disbursements) of the home’s value. A lender can charge either $2,500 or 2 percent of the first $200,000 of the home’s value plus 1 percent of the remaining value after $200,000, whichever is greater. HECM origination fees are capped at $6,000.
Other fees include one-time closing costs, monthly mortgage insurance premiums of 5 percent of the outstanding loan balance, and annual servicing fees. The National Reverse Mortgage Lenders Association calculator (www.reversemortgage.org/about/reverse-mortgage-calculator) estimates that a 75-year-old borrower living in a $250,000 home would incur up-front costs of about $12,051 for a net $124,449 line of credit. Only $69,849 would be available within the first year of the loan.
Borrowers should review loan fees carefully. Some loan programs may appear to have lower fees, but they may come with higher interest rates that result in greater long-term costs.
Evaluating Costs: Looking Beyond the Facts and Figures
Evaluating the cost of any mortgage can be difficult. To help seniors understand and compare various programs, reverse mortgage lenders require counseling through agencies approved by the U.S. Department of Housing and Urban Development (HUD). AARP also provides extensive educational materials on reverse mortgages to help potential borrowers make informed decisions.
It is important to look beyond the facts and figures to determine if a reverse mortgage is a suitable choice. For instance, if a reverse mortgage will be a temporary solution, borrowers should consider other options. Because reverse mortgages are more expensive in the early years of the loan, the longer the borrower’s life expectancy (or the longer he or she expects to live in the home), the lower the overall costs.
Also, borrowers should consider whether they plan to apply for needs-based programs, such as Medicaid, in the future. Monthly reverse mortgage payments are loans and are not considered taxable income. If the borrower reinvests the cash advances, however, any amount retained after a month could affect Medicaid eligibility.
Borrowers should be aware that the younger a person is when he or she takes out a reverse mortgage, the longer interest will compound and the greater the total cost will be over a lifetime. Tapping into one’s equity early in retirement may reduce what is available later if a financial emergency should arise. Using reverse mortgages to raise capital for vacations or discretionary purchases is generally unwise and limits future options.
Alternatives to Reverse Mortgages
Home equity line of credit. Home equity loans require the borrower to have enough income to repay the loan, in addition to regular interest payments and sometimes principal. The borrower risks foreclosure if he or she falls behind in making payments.
Private annuity. If the objective is to keep the home in the family, consider a sale between children and parents in return for monthly income. Although this option triggers taxes on the gains from selling the house, there may be relief through the home sale exclusion rule of $250,000 ($500,000 for eligible couples).
Home sale. Although selling the home and moving elsewhere may not be the homeowner’s first choice, it may be the best choice. By looking at other options and the costs involved, the homeowner may be surprised by the variety of attractive housing opportunities. Here are some things to consider:
How important is it to stay in the home?
How long does the homeowner expect to live in the home?
Would a smaller home, an apartment, or an assisted living arrangement better suit the homeowner’s needs?
How much would the homeowner net if the home were sold?
What would it cost to buy or rent a new home?
What return can be expected on the reinvested sale proceeds?
HUD or HECM counselors can advise homeowners about getting a #ReverseMortgage, choosing an interest rate or a lender, understanding costs, and other concerns.
For a comprehensive look at reverse mortgages from the Federal Trade Commission, please visit www.consumer.ftc.gov/articles/0192-reverse-mortgages.
To compare program benefits, use the National Reverse Mortgage Lenders Association calculator at www.reversemortgage.org/about/reverse-mortgage-calculator.
To find an HECM counselor, visit https://entp.hud.gov/idapp/html/hecm_agency_look.cfm
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. © Copyright 2020 Commonwealth Financial Network®. Presented by Dan Romaine. Dan Romaine is a financial advisor at Blue Hills Wealth Management. BHWM is located at 300 Crown Colony Drive, Quincy MA. Dan can be reached at 617-471-6800 or firstname.lastname@example.org. Securities and advisory services offered through Commonwealth Financial Network, Member, FINRA/SIPC a registered investment advisor. Fixed insurance products and services and College Planning services offered by Blue Hills Wealth Management and College Funding Solutions are separate and unrelated to Commonwealth.