Reverse mortgages and annuities are two quite different financial products, but both are generally used for the same purpose: to generate a steady, reliable stream of income for retirement. However, if you are considering either of these options, you should be aware that there are important differences between them.
The most fundamental of these is the fact that a reverse mortgage is a loan, and an annuity is insurance. Another is how both products are funded: With a reverse mortgage, you are using the value of your house to secure a loan, while an annuity requires a substantial amount of cash up front for purchase of the contract. There are also differences when it comes to the security offered by each product, as well as their tax implications.
In this article, we’ll take you through each of these factors and help you decide which option is best for you.
- Both reverse mortgages and annuities can provide a steady, reliable stream of income in retirement.
- You can put money into an annuity as either a lump sum or a series of regular payments.
- The money from a reverse mortgage is a loan that your lender eventually will demand to be repaid—and most people will sell their house to do so.
- Both products are complicated and come in several forms. Annuities, in particular, can be customized with a wide range of options. It’s important to understand either type of product before you buy it.
- If you can afford an annuity, you probably should choose one over a reverse mortgage. An annuity can provide reliable income without the risk of losing your home.
Reverse Mortgage vs. Annuity: Key Differences
Reverse mortgages and some types of annuity are typically used for the same purpose: They both provide retirees with a reliable source of income. However, this shared feature can mask the fact that there is a great deal of difference between the two approaches.
The most fundamental of these is that a reverse mortgage is a loan. This is often overlooked or deliberately not mentioned by unscrupulous providers who refer to loan payments as income. In contrast, an annuity is a form of insurance: a written contract in which you agree to invest a certain amount with a company and then accept a payout stream.
Another difference between these products is the way that they are normally funded. With an annuity, you invest money with a firm either over an accumulation phase or as a lump sum. This is money that you otherwise would be free to invest elsewhere or spend. With a reverse mortgage, you are using the money that you’ve invested in your home. This means that you don’t have to find the up-front money to buy the reverse mortgage—but it also means that your home is at risk should you default on the loan.
This is the third critical difference between reverse mortgages and annuities. When your reverse mortgage becomes due—that is, when you die or move away—you will have to pay the loan back. This is normally done by selling your house. This makes a reverse mortgage a bad option for people who want to pass on their house to their heirs.
Let’s look at these differences in more detail.
Depending on the exact product that you choose—either a home equity conversion mortgage (HECM) or a fairly standard fixed, indexed, or variable annuity—some recommendations may not apply to your specific situation. It may be wise to seek professional advice before you buy any financial product if you feel that you don’t understand it.
Annuity and Reverse Mortgage Risks
Most people take out a reverse mortgage or an annuity as a way of reducing their financial risk. Both products can be used to provide you with a guaranteed income stream for retirement. Both products protect you against stock market and house price fluctuations. And in this limited regard, both products are risk free.
There are many types of annuity, but a fixed annuity promises that you’ll earn a stated interest rate on your money, resulting in the same payout year after year. This type of investment is risk free. The insurance company assumes all the risk and guarantees that you’ll make the stated interest rate. Fixed annuities are not tied to the stock market in any way.
Similarly, when you take out a reverse mortgage, the value of your property will be appraised, and you will be able to borrow a certain percentage of this value. In the most common types of reverse mortgage, this value won’t change over the lifetime of the loan. It’s even possible—if you choose to have the loan paid out in even installments, and if you live a long time—that you can receive more in loan payments than your home is worth. But even in this case, you won’t owe the reverse mortgage lender anything extra.
However, that’s not quite the whole story. Keep in mind that with a reverse mortgage, you run the risk of losing your home. The residency rules for reverse mortgages state that if you are away from home for more than a year, even to go to a hospital, the lender can foreclose on the loan. This means that you might have to sell your house to repay the loan.
The Return on Annuities and Reverse Mortgages
If you are looking to use either of these products to provide yourself with a stream of income in retirement, you should also compare the return that each will generate for you.
Unfortunately, this is an area in which it is difficult to give general recommendations. There are so many different types of annuity, each paying out in a different way, that there is no typical rate of return on the money that you invest in one. You should shop around, and pay particular attention to the fees associated with any annuity that you are considering—high charges will significantly reduce your benefit.
When it comes to reverse mortgages, you should remember that you are unlikely to make a profit. The money that you will be paid—as either a lump sum or a monthly stipend—is your money in the first place. Unless you live much longer than the bank expects you to, they are unlikely to pay out more than they will receive when the loan becomes due.
Reverse Mortgage and Annuity Fees
When calculating the return that you will get from either a reverse mortgage or an annuity, you also should be wary of fees. Again, these vary too much across lenders and products to be able to say that either type of product has higher fees. But keep in mind that the vast majority of lenders will charge fees for either product, and that these can be steep.
For annuities, these fees come in many forms. Many annuities have a surrender period during which an investor can’t withdraw funds without paying a penalty. The surrender fee is a cost to you that is paid if you withdraw your funds early. In some cases, there are also fees paid yearly to the company, and there could be up-front fees that the company will charge.
The costs you will pay to take out a reverse mortgage can be very high compared to other forms of borrowing against your home equity. Borrowers must pay an origination fee, an up-front mortgage insurance premium, ongoing mortgage insurance premiums, loan servicing fees, and interest. The federal government limits how much lenders can charge for these items, but the origination fee in particular can be high—it’s capped at $6,000.
These fees might not be immediately obvious to seniors contemplating a reverse mortgage, because they are often paid from the money that you borrow. This means that you won’t necessarily receive the money and then have to pay it to the lender, which can hide the fact that you are paying it. In practice, this process means that fees and interest are taken out of your home equity.
Reverse Mortgage and Annuity Taxes
Finally, there are also some differences between these products in terms of their tax obligations.
A reduced tax bill is, in fact, one of the primary benefits of an annuity over a standard savings account. Annuities offer several tax benefits. In general, during the accumulation phase of an annuity contract, your earnings grow on a tax-deferred basis. You pay taxes only when you start taking withdrawals from the annuity. Withdrawals are taxed at the same tax rate as your ordinary income. If you fund an annuity through an individual retirement account (IRA) or another tax-advantaged retirement plan, you also may be entitled to a tax deduction for your contribution. This is known as a qualified annuity.
When it comes to reverse mortgages, the money that you receive isn’t taxed at all. But that’s because it’s already your money. The idea of a “tax-free income” is often mentioned in reverse mortgage advertising as a benefit of these loans. But you should remember that you already paid tax on this money when you earned it, and that it’s not income. Instead, these payments are an advance on the money that your lender will get back when the loan becomes due.
Is a reverse mortgage or an annuity better?
It really depends on your personal circumstances. However, if you have the money to buy an annuity, this can provide a regular income in retirement without putting your home at risk. If you don’t have another source of retirement savings, then a reverse mortgage can be a good last resort.
Can I use a reverse mortgage to buy an annuity?
You can, but it rarely makes sense. In fact, you should be wary of any salesperson who encourages you to take out a reverse mortgage to pay for another product—home repairs, annuities, or anything else. Every financial product comes with fees, and the more you convert your retirement savings, the more they will be reduced by these charges.
Are annuities and reverse mortgages safe?
Both are very safe in terms of investment risk, because your lender assumes this risk. However, you should be aware that if you take out a reverse mortgage, you could lose your house if you have to leave to live in a healthcare facility for more than a year.
The Bottom Line
Both reverse mortgages and annuities are strategies that can be used to provide a steady, reliable stream of income during retirement. However, the two methods have some fundamental differences.
You put money up front—either as a lump sum or a series of regular payments—into an annuity. In contrast, a reverse mortgage is a loan based on the equity built up in your home that your lender eventually will demand to be repaid. Most people will sell their house to do so.
Both products are complicated and come in many forms. Annuities in particular can be customized with a wide range of options. It’s important to understand either type of product before you buy it. However, if you have the money to afford an annuity, you should generally choose one over a reverse mortgage—an annuity will provide a reliable income without the risk of losing your home.