Reverse Mortgages: Security or Hype
While reverse mortgages are sometimes advertised as providing a secure source of income for the rest of your life—and they can, under the right conditions—running out of proceeds sooner than you expected to is one of the major risks of taking out this type of loan. A reverse mortgage is a type of loan where homeowners who have considerable equity built up in their residence can use that value to borrow against.
There are six different ways to receive reverse mortgage proceeds, and the one you choose will affect how quickly and easily you can use up your ability to borrow against your home.
- Fixed-rate lump-sum reverse mortgage payment
- Reverse mortgage line of credit
- Term reverse mortgage
- The modified term reverse mortgage
- Tenure reverse mortgage
- The modified tenure reverse mortgage
All six payment plans pose varying levels of risk to borrowers. Here is a look at the various circumstances under which you could run out of reverse mortgage proceeds too early – and how to avoid that scenario.
#1. Fixed-Rate Lump Sum
Only one reverse mortgage payment plan, the single disbursement lump sum, has a fixed interest rate. Taking out a fixed sum with a fixed interest rate is normally a low-risk way to borrow. In essence, you will know exactly how much you will have to repay. However, with a reverse mortgage, this loan structure has unique risks.
Homeowners often take out reverse mortgages when their home equity is their only asset and they have no other options for getting the money they need. However, people who take out these loans but don't plan correctly can easily mismanage a large sum. Once they’ve used up that money, they might have no other monetary sources to draw upon. In an ideal world, mandatory reverse mortgage counseling would deter risky borrowers from choosing this option, but in the real world that doesn’t always happen.
The Consumer Financial Protection Bureau (CFPB) has identified the increasingly popular lump-sum option as potentially risky, especially for younger borrowers with longer lifespans who don’t have other retirement resources. These early-age retirees are at risk of using up the equity early in retirement.
A reverse mortgage makes it possible to stay in your home for life even after you have exhausted the proceeds. However, with no money left, the borrower will not only have trouble paying living expenses but might end up in foreclosure. That is because continuing to pay homeowner’s insurance and property taxes—and keeping the home in good repair—are all conditions of being able to continue to have a reverse mortgage.
The CFPB has found that fixed-rate borrowers do, in fact, default on their reverse mortgages more often than adjustable-rate borrowers due to not meeting these ongoing expenses. Taking out a lump sum also puts reverse mortgage borrowers at greater risk of being scammed, as the large sum they’ve borrowed is an attractive target for thieves—or greedy relatives.
#2. Line of Credit
Your chances of running out of money with a line-of-credit payment plan—whether used alone or in combination with a term or tenure plan as described in the following sections—depends on how you use the plan. Unlike a regular home-equity line of credit (HELOC), a reverse mortgage line of credit is irrevocable. The term irrevocable means it can’t be canceled or reduced because of changes in your finances or home value.
This irrevocable status means you aren’t in danger of losing access to the money. In addition, your available line of credit only goes down as you draw upon it, and you only pay interest and mortgage insurance premiums on the money you borrow. What’s more, with a line of credit you gain access to additional funds over time because the unused portion grows each year whether your home’s value increases or not. The unused part of your reverse mortgage line of credit grows at the same interest rate you’re paying on the money you’ve borrowed.
You can generally access up to 60% of your available principal limit in the first year you have your line of credit. In the second year and thereafter you can draw on the remaining 40%—plus whatever you didn’t use in the first year. Of course, if you use up your entire available credit line early on, you’ll have little to nothing left to use in future years unless you repay some or all of what you borrowed, which will increase your principal limit.
Yes, you can make payments on a reverse mortgage to reduce your loan balance during your lifetime, and there’s no prepayment penalty for doing so. Your lender is required to apply any partial repayment first to the interest you owe, then to any loan fees and last to your principal.
#3. Term Reverse Mortgage
Of the five payment plans with adjustable interest rates, the term and modified-term plans also put you at risk of outliving your reverse mortgage proceeds. Term payment plans provide equal monthly payments with a predetermined stop date.
With a term payment plan, you reach your loan’s principal limit—the maximum you can borrow—at the end of the term. After that point, you won’t be able to receive additional proceeds from your reverse mortgage. However, you will be able to stay in the home, with the caveats mentioned earlier—paying ongoing taxes and maintenance—in the lump-sum section.
#4. Modified Term Reverse Mortgage
Modified term plans give you a fixed monthly payment for a predetermined number of months, plus access to a line of credit. The monthly payment will be smaller than if you choose a straight term plan, and the line of credit will be smaller than if you choose a straight line of credit plan.
With a modified term plan, you will only receive monthly payments for a predetermined period, but the line of credit will remain available until you’ve exhausted it. You can avoid running out of money with this plan if you use your line of credit carefully. You can also run out of money quickly if you exhaust the line of credit early on.
A safer choice is to rely primarily on the term payments until the term ends, letting your line of credit increase, and only then rely on that line of credit. If you never use the line of credit, you might have enough equity to give you future flexibility to sell your home, pay off the loan, and move.
#5. Tenure Reverse Mortgage
The plans with the least risk of running out of money are the tenure or modified tenure payment plan—as long as the borrower keeps up with homeowner’s insurance, property taxes, and home repairs. Failure to do any of these things means the loan becomes due and payable.
Tenure payment plans have an adjustable interest rate and provide equal monthly payments for life, as long as at least one borrower still lives in the home as their primary residence.
#6. Modified Tenure Reverse Mortgage
Modified tenure provides both fixed monthly payments for life and a line of credit. It gives you a smaller monthly payment than if you chose a straight tenure plan, and your line of credit will be smaller than if you chose a straight line of credit plan.
Again, if you never use the line of credit, you will owe less, so this combination option is a good choice if you want guaranteed income for life with less risk of using up all your equity and not being able to afford to move.
How to Avoid Running Out of Proceeds
Waiting as long as you can to take out a reverse mortgage is one way to limit your chances of outliving the proceeds. The CFPB warns that younger retirees with longer life expectancies have a greater chance of using up all of their home equity with a reverse mortgage. This isn’t a problem if they are able to age in place—stay in their homes for life—but it is a problem if they want or need to move later on.
After selling the home and paying what they owe on the reverse mortgage, early age retirees might not have enough money left to move or to pay for ongoing living and medical expenses.
Future increases in interest rates could decrease how much you can borrow even though you are older. Jack M. Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania, studied the issue. He found that a 62-year-old who waited until age 72 to get a reverse mortgage and who chose the line of credit payment plan could increase their credit line by 17% by waiting those 10 years if interest rates stayed the same. If interest rates doubled, however, that same borrower would have access to a 69% smaller line. Thus it can actually make sense to take out a reverse mortgage line of credit plan as early as possible, then leave the line untouched for as long as possible to maximize its growth potential.
Changing Your Current Plan
If you’ve already taken out a reverse mortgage and think you may be at risk of running out of proceeds, talk to your lender about changing your payment plan. As long as you didn’t go the fixed-rate, one-time-lump-sum route, you can change your payment plan—provided you can stay within your loan’s principal limit. The big question is whether you’ve already reached or are close to reaching the principal limit. Changing your payment plan is much simpler than refinancing and requires only a $20 administrative fee.
The Non-Borrowing Spouse’s Dilemma
Regardless of which payment plan you choose, if you have a younger, non-borrowing spouse, he or she is at risk of outliving the reverse mortgage proceeds if you die first. Laws that became effective in 2015 protect qualified non-borrowing spouses from having to move out if their borrowing spouse predeceases them. However, non-borrowing spouses aren’t allowed to receive any additional payments after the borrower dies. This rule makes it easy for surviving, non-borrowing spouses to effectively outlive the reverse mortgage proceeds.
The surviving spouse may be able to sell the house and pay off the reverse mortgage. However, depending on how much the house is worth and how high the loan balance is, selling may not leave the surviving spouse with enough of a nest egg to live on. If the surviving spouse has enough income to qualify for a regular, forward mortgage, it might be possible to refinance out of the reverse mortgage.
If the reverse mortgage balance is higher than what the home is worth, the best option is for the surviving spouse to keep living in the house—selling or letting the lender foreclose will leave the survivor with no place to live and no cash from the home.
The Bottom Line
Despite what some reverse mortgage advertisements lead seniors to believe, there are many ways to outlive the proceeds of a reverse mortgage. Before you or a loved one takes out this type of loan, it’s important to understand the circumstances under which a reverse mortgage may not provide financial security for life. Use that knowledge whether to take this kind of loan and which plan makes the most sense and provides the best security.