Reverse Mortgages: What You Need to Know
For the many baby boomers entering retirement house-rich and cash-poor, reverse mortgages are an enticing alternative to supplement their income. For many, reverse mortgages can provide more flexibility than conventional home equity loans.
They can also be a more expensive form of borrowing, and they come with their own set of risks. If you or your spouse is at least 62 years old, a reverse mortgage can be a viable option, provided you understand the costs and the risks involves.
If you are considering a reverse mortgage, here’s what you need to know.
How a Reverse Mortgage Works
Unlike a conventional home equity loan, which requires that you make payments on the loan, with a reverse mortgage loan, payments are made to you from the home’s equity. Interest is accrued monthly on the amount borrowed and accumulates on top of the loan balance. Once the last borrower leaves the home, it is typically sold and the loan is fully repaid. If there is any equity remaining, it goes to you or your estate.
Most reverse mortgages offer three disbursement options:
- Monthly payments (for as long as you live in your home or for a set period of time)
- A one-time lump sum disbursement
- A line of credit
With a line of credit, you are approved for a maximum credit limit, which makes funds available to you as you need them. Unlike the other disbursement options, you can repay the amount you borrow on your line of credit to replenish your limit.
The disbursement option you choose should be driven by your needs, whether as an income supplement or as a safety net for unexpected expenses.
Check out this video from Consumer Financial Protection Bureau that sums up reverse mortgages and their pros and cons.
Most Reverse Mortgages Are Used as a Last Resort
Historically, reverse mortgages have been used by retirees who want to remain in their homes but have exhausted their other income sources. Reverse mortgages work well as a last resort because they can provide an income stream for as long you live in your home. In addition, they are nonrecourse, which means if your home declines in value, you or your estate are not responsible for any shortfall when the loan is settled. Retirees in this position accept the risk that once they leave their home, there may be little or no equity left for them or their heirs.
A big risk for cash-strapped retirees with reverse mortgages is their ability to keep up with property taxes or insurance premiums. Failure to meet those obligations can trigger a foreclosure on the home. This is one reason why there is a cap on the amount of equity that can be accessed through a reverse mortgage.
Additionally, mortgage lenders are required to perform a financial assessment to determine if the borrower has the financial capacity to cover these expenses. Despite that, circumstances can change, which could put your house in jeopardy.
There’s a Limit on How Much You Can Borrow
To qualify for a reverse mortgage, you need to have a minimum of 50% equity in your home. In addition, the amount of equity you can access is based on your age.
For instance, a 75-year-old retiree who owns a $300,000 home with no existing mortgage or liens might be able to access 62% of the home’s equity. A 62-year-old homeowner in the same situation might only be able to access 52%.
Reverse Mortgages Are Not Inexpensive
Although borrowing costs have come down on reverse mortgages, they can still be more expensive than traditional equity financing. Loan rates on reverse mortgages, both fixed and adjustable, are generally higher than traditional financing.
Ongoing mortgage insurance premiums have been reduced from 2.5% to 0.5% of the outstanding loan balance. These premiums are paid annually after an upfront premium of 2% of the outstanding loan balance.
Keep a Long-Term View
When used properly, reverse mortgages can open up your financial planning options. However, they should only be considered in the context of a long-term view. Because they are irrevocable, it is important to envision how your life in retirement will be impacted by their use. Most importantly, special attention must be paid to the potential risks outlined above.
- An increasing number of retirees rely on the equity in their home to supplement their income, and a reverse mortgage may be an effective way to tap it.
- A reverse mortgage can provide a supplemental stream of income and is repaid when the house is sold and you are no longer living in it.
- The biggest risk with a reverse mortgage is being unable to afford the ongoing property taxes and insurance premiums, which could trigger a foreclosure.
- The borrowing costs for a reverse mortgage can be higher than traditional equity financing, but unlike traditional financing, there are no payments required with a reverse mortgage.
- A reverse mortgage can open up more options for retirees who understand the costs and risks, and who take a long-term view of their retirement needs.