The Reverse Mortgage: A Retirement Tool

If you own your home and are at least 62 years of age, a reverse mortgage provides an opportunity to convert some of your home equity into cash. In the most basic terms, a reverse mortgage allows you to take out a loan against the equity in your home that you do not have to repay during your lifetime as long as you are living in the home and have not sold it.

If you want to increase the amount of money available to fund your retirement, but do not like the idea of making payments on a loan, a reverse mortgage is an option worth considering. However, there are also some risks, costs, and pitfalls to be aware of.

How Reverse Mortgages Work 

With a reverse mortgage, a lender makes payments to the homeowner based on a percentage of the value in the home. When the homeowner dies or moves out of the property, one of three things can happen:

1. The homeowner or heirs can sell the home to pay off the loan.
2. The homeowner or heirs can refinance the existing loan to keep the home.
3. The lender can be authorized to sell the home to settle the loan balance.

While there are several types of reverse mortgages, including those offered by private lenders, they generally share the following features:

• Older homeowners are offered larger loan amounts than younger homeowners. More expensive homes qualify for larger loans.
• A reverse mortgage must be the primary debt against the house. Other lenders must be repaid or agree to subordinate their loans to the primary mortgage holder.
• Financing fees can be included in the cost of the loan.
• The lender can request repayment if the homeowner fails to maintain the property, fails to keep the property insured, fails to pay its property taxes, declares bankruptcy, abandons the property, or commits fraud. The lender may also request repayment if the home is condemned or if the homeowner adds a new owner to the property’s title, sublets all or part of the property, changes the property’s zoning classification, or takes out additional loans against the property.

HECM Loans 

Reverse mortgages have been around since the 1960s, but the most common reverse mortgage is a federally insured home equity conversion mortgage (HECM). These mortgages were first offered in 1989 and are provided by the U.S. Department of Housing and Urban Development (HUD).

HECMs are the only reverse mortgages issued by the federal government, which limits the costs to borrowers and guarantees that lenders will meet the obligations. The primary drawback to HECMs is that the maximum loan amount is limited.

Non-HECM Loans

Non-HECM reverse mortgages are available from a variety of lending institutions. The primary advantage of these reverse mortgages is that they offer loans in amounts that are higher than the HECM limit. One of the drawbacks of non-HECM loans is that they are not federally insured and can be significantly more expensive than HECM loans.

Total Annual Loan Cost on an HECM

Although the interest rate on an HECM is set by the government, and the origination cost of an HECM loan is limited to 2% of the value of the home, the total cost of the loan can still vary by lender. Furthermore, in looking for a lender, borrowers must consider third-party closing costs, mortgage insurance, and the servicing fee.

To assist borrowers in comparing mortgage costs, the federal Truth in Lending Act requires mortgage providers to present borrowers with a cost disclosure in the form of the total annual loan cost (TALC). Use this number when comparing loans from different vendors; just keep in mind that the actual costs of a reverse mortgage will depend largely on the income options selected.

HECMs Provide Several Income Options

HECM reverse mortgages provide the widest variety of income-generating options, including lump-sum payouts, credit lines, monthly cash advances, or a combination of these.

The credit line is perhaps the most interesting feature of an HECM loan, because the amount of money available to the borrower increases over time by the amount of interest. Non-HECM loans offer fewer income options.

Interest Rates on an HECM

The interest rate on HECMs is tied to the one-year U.S. Treasury security rate. Borrowers have the option to select an interest rate that can change every year or every month.

A yearly adjustable rate changes by the same rate as any increase or decrease in the one-year U.S. Treasury security rate. This annual adjustable rate is capped at 2% per year or 5% over the life of the loan. A monthly adjustable-rate mortgage (ARM) begins with a lower interest rate than the ARM and adjusts each month. It can move up or down 10% over the life of the loan.

Can Reverse Mortgages Help Seniors?

Research investigating the impact and utility of reverse mortgages for seniors has mixed conclusions.

In a 2019 study that summarized this research, the Brookings Institution noted that several studies have indicated that reverse mortgages can markedly benefit consumers. The percentage of households that would benefit from a reverse mortgage, however, is a cause of debate: Some studies argue that just 9% of seniors would benefit, while others put this same number as high as 80%. Most studies indicate that reverse mortgages benefit lower-income households the most. This is not just because the money that these households receive from a reverse mortgage can be used to cover otherwise catastrophic healthcare costs, but also because there are psychological and health benefits associated with being able to continue living at home.

The same Brookings study also argues that the dangers of foreclosures for reverse mortgages are often overstated in the media. Though local authorities may initiate foreclosure proceedings against homeowners for nonpayment of taxes, few do. In the years running up to 2019, about 18% of reverse mortgages ended in foreclosure, but 75% of these are because the homeowners had left the home. The remaining 25% were because the homeowners had not paid the property taxes. Often, lenders have an incentive to work with homeowners to remedy nonpayment of taxes because foreclosures are costly.

More recently, a study by the Financial Planning Association has concluded that including a reverse mortgage as part of a retirement portfolio may reduce seniors’ exposure to deleterious market fluctuations. Contrary to expectations, this study found that retirement strategies that use a reverse mortgage as an alternative source of cash flow to a traditional investment portfolio hold the greatest benefit for mass affluent Americans—generally defined as those with $100,000 to $1.5 million in investible assets. Rather than using reverse mortgages as a last resort, this research suggests, even wealthy retirees could benefit from a reverse mortgage.

Overall, the current consensus among researchers seems to be that there is a gulf between the potential benefits of reverse mortgages and the low demand for them. In other words, many retirees who may regard a reverse mortgage as a semi-predatory, risky proposition could actually benefit from one.

Seniors considering a reverse mortgage as a solution to credit card debt should evaluate whether the amount of home equity that they will lose in reverse mortgage fees and interest is worth it in terms of the amount of credit card interest that they will save. This is a complex calculation that is best performed by an accountant or financial planner. A reverse mortgage counselor may not be knowledgeable enough to answer this question.

The Bottom Line

Taking out a loan against your home is a big decision that will affect your current finances and the estate that you leave to your heirs. There are substantial costs involved, including loan origination, servicing, and interest.

You also need to remember that, with a reverse mortgage, your debt increases over time due to the interest on the loan. If you change your mind about the loan or need to move out of the property due to health reasons, proceeds from the sale of the property are used to pay off the reverse mortgage. Depending on the size of the loan and the value of the property, there may be little or no money remaining after the loan is repaid.

Before taking out a reverse mortgage, you should research the topic thoroughly, compare costs from a variety of lenders, and read all disclosure documents. While investing the proceeds from a reverse mortgage is generally not advisable because of the need to recoup the costs of the loan plus the interest, the income from a reverse mortgage may provide an opportunity to refocus other elements of your investment portfolio. Before assuming the mortgage, consider the cash flow that the reverse mortgage will provide and review the implications that this new source of income will have on your overall investment strategy.