By Jamie Johnson, WCI Contributor
You may have been contacted about taking out a reverse mortgage if you're nearing retirement age. At first glance, these loans can sound pretty appealing, and it's easy to overlook the possible drawbacks.
A reverse mortgage is a loan that lets you borrow from the equity in your home. Instead of making monthly mortgage payments, your lender pays you. It can be a good option for anyone who wants to access the equity in their home without selling first. However, reverse mortgages come with some considerable downsides. So before applying for a reverse mortgage, it’s essential to understand the pros and cons of that decision.
How Does a Reverse Mortgage Work?
When you take out a traditional mortgage, you agree to a loan term and pay your lender every month until the balance is paid off. A reverse mortgage works the opposite way—you’ll take out a loan on the equity in your home, and your lender will pay you every month.
Home equity conversion mortgages (HECM) are the most common type of reverse mortgage. The U.S. Department of Housing and Urban Development (HUD) backs HECMs, and you can use them for any purpose.
To qualify for a HECM, you must meet the following requirements:
- You’re at least 62 years old
- You either own your home outright or have built up considerable equity
- The house is your principal residence
- You can’t be delinquent on any federal debt
- You can afford to continue paying your property taxes and homeowners insurance
Reverse Mortgage Pros and Cons
No matter your situation, it’s important to weigh your options carefully before making a significant financial decision. A reverse mortgage loan can add financial stability to your life when used correctly.
But when misused, you could put your home and even your retirement at risk. Let’s look at the five pros and five cons you need to know about.
Pros of Reverse Mortgages
- Get rid of your monthly mortgage payments: You stop paying your monthly mortgage payments when you take out a reverse mortgage. However, you will have to maintain the property and pay your taxes and homeowners insurance.
- Access to regular income: If you own your home outright or have a considerable amount of equity built up, a reverse mortgage allows you to tap into it. This can help provide financial security, especially for retirees who don’t have a lot of savings or investments.
- No tax liability: According to the IRS, reverse mortgage payments are not considered taxable income. Instead, the money you receive is considered loan proceeds while you’re still living in your home.
- You can’t exceed your home’s balance: The value of your home changes depending on market conditions. As of this writing in early 2022, homes are valued very high, but this could change quickly in an economic downturn. However, the amount you owe on your reverse mortgage can never exceed the value of your home, even if home prices fall.
- No payments: When you take out a reverse mortgage, you don’t have to make any payments until you move, sell the house, or die.
Cons of Reverse Mortgages
- It can come with hefty costs: A reverse mortgage may eliminate your monthly payments, but it isn’t free money. The exact cost will depend on the type of loan you take out, but you can expect to pay an initial mortgage insurance premium, origination fees, and closing costs. And ongoing costs like interest fees and servicing fees will be added to your loan balance each month.
- You can’t pass on your home: One of the benefits of owning your own home is that you can pass it on to your children or heirs after you die. This inheritance can be a good way to build generational wealth. However, a reverse mortgage will slowly chip away at the equity in your home, and you have to sell the house to repay the debt. If you die, your heirs may get stuck repaying the loan for you.
- Scams are common: Seniors are often the target of reverse mortgage scams—for instance, a contractor might recommend a reverse mortgage for a home improvement project. The individual will overstate the price of the project and explain away the reverse mortgage as “free money.”
- You could lose your home: If you’re unable to afford your property taxes and homeowners insurance, you could default on your reverse mortgage. If that happens, you risk losing your home to foreclosure.
- You could jeopardize your retirement: By receiving funds from a reverse mortgage, you could lose access to certain government benefits like Medicaid. It’s a good idea to speak to a financial advisor to understand how it could impact you.
Is a Reverse Mortgage a Good Idea?
Reverse mortgages have earned a bad reputation over the years, but when used correctly, they can help you improve your cash flow and reduce your tax liability. If you have a lot of equity in your home and don’t plan to move, it could help you build a more secure retirement.
However, it’s important to think long-term when it comes to your finances. Your financial situation could change, and if you eventually decide to move, you’ll have less equity available.
Reverse mortgages aren’t a good option if you eventually want to pass on your home to your kids. In fact, if you die unexpectedly, you could put your children in a position where they have to repay the loan.
It's also wise to remember this: if somebody is trying to sell you on the idea that your home equity isn't actively making you money, that's the wrong mindset to have. The home is providing “dividends” in that you're not paying rent (which could be costing you somewhere between $2,000-$10,000 per month on the house you're currently living in) and you're not paying interest on a mortgage. If you have a paid-off home and the 30-year fixed mortgage rate is 2.8%, you're earning a guaranteed 2.8% on your money in the home. That's much better than other guaranteed investments, like treasury bonds (0.4%) or a one-year CD (0.65%).
The Bottom Line
Reverse mortgages can be a good move for seniors looking to take advantage of the equity in their homes. Make sure that you don’t have any plans to move and that you can afford to maintain your home and pay the property taxes and homeowners’ insurance.
As a general rule, your home equity should be one of the last sources of retirement money that you should tap. If you've still got money in tax-deferred or Roth retirement accounts, taxable investments, whole life insurance, or annuities, you probably ought to spend that first. But there is no sense in you eating Alpo so your kids can inherit a million dollar house they probably don't even need. Don't forget there are other ways to spend that home equity too. You can sell the house and rent. You can do a cash out refinance. You can also take out a HELOC on the home. They're probably a better deal than a reverse mortgage most of the time, but you will still have a payment and there are fewer guarantees.
If you’re considering taking out a reverse mortgage, make sure you do your homework. If you apply for a HECM, you’ll have to meet with a housing counselor at a government-approved counseling agency. In addition, it can be a good idea to meet with a financial advisor and an attorney who can explain the possible financial consequences. But remember: making a wrong move with a reverse mortgage could also end up being a disastrous decision.
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