Reverse mortgages allow older homeowners to turn part of their home equity into tax-free cash, using a loan that doesn't have to be paid back until they die, sell or move out.
That sounds good to a lot of seniors navigating financial fallout during the coronavirus pandemic. Stay-at-home orders may have taken away jobs needed to make ends meet, while low interest rates and a volatile stock market have endangered income from retirement savings.
A reverse mortgage could be exactly the right tool at the right time. Or it could be an expensive mistake. It's important to understand exactly how these loans work and to explore alternatives before you commit.
Reverse mortgage basics
Most reverse mortgages are Home Equity Conversion Mortgages (HECMs), which are insured by the federal government. Borrowers must be 62 or older and have substantial home equity.
The amount you can borrow depends not only on your equity and the home's value, but it also varies based on your age, current interest rates and HECM program limits. The higher your age and the lower the prevailing interest rate, the more you can typically borrow. Currently the program will let you borrow against a maximum of $765,600 in home value.
Borrowers can get a lump sum, a line of credit or a series of regular payments. Reverse mortgages can also be used to pay off an existing mortgage or to buy a home.
You don't have to make payments on a reverse mortgage, even if you end up owing more than the house is worth. You can, however, wind up in foreclosure if you fall behind on property taxes, homeowners insurance or homeowners association fees.
Reverse mortgages aren't cheap
Most of the costs are taken from your loan proceeds, so you don't pay them out of pocket, but it's still an expensive way to borrow. HECM loans require a 2% upfront mortgage insurance payment, plus an additional 0.5% annual charge, on top of origination costs and lenders' fees. Any amount you borrow, including these fees and insurance, accrues interest, which means your debt grows over time.
Many borrowers don't realize this, or that the debt can grow to the point where they may not have anything left to borrow against in an emergency or to leave to their kids, said Barbara Jones, a senior attorney for the AARP Foundation.
"They don't quite understand what compounding interest means," Jones said. "So they don't have the equity in their home that they thought they did."
Look elsewhere for short-term needs
If you have a short-term need for cash, consider other options first, Jones recommended. Many low-income seniors don't realize they qualify for the earned-income tax credit, a refundable tax break that can put cash in your pocket. You also could use BenefitsCheckUp, a site run by the National Council on Aging, to see what other help you may qualify for. People of any age can ask for forbearance, or the ability to skip payments, from their mortgage company and other lenders.
Another possibility is a regular home-equity loan or line of credit. This type of borrowing requires you to make payments, and lenders can freeze or lower limits on lines of credit, but the borrowing costs are much lower.
Reverse mortgages as a relief valve
Although financial planners long considered reverse mortgages to be a last resort for struggling seniors, researchers in recent years found a potential use for more affluent people: as a relief valve to take the pressure off investments in bad markets. Tapping a reverse line of credit for income instead of selling beaten-down stocks gives investment portfolios a chance to recover along with the market. That can allow people to spend more with less risk of depleting their portfolios, said Wade Pfau, professor of retirement income at The American College of Financial Services.
A reverse mortgage also can provide monthly guaranteed income that isn't dependent on stock market swings or a healthy labor market, said Steve Resch, vice president at Finance of America Reverse, a reverse-mortgage lender. So can an income annuity, which is an insurance product that gives you a stream of payments, typically for the rest of your life, in exchange for a lump sum.
Before you proceed with either a reverse mortgage or an annuity, you would be smart to consult a certified financial planner or other fiduciary adviser. Most people promoting these products get paid to sell them, and you will want to check in with an objective adviser committed to putting your interests first.
Liz Weston can be reached at firstname.lastname@example.org. Twitter: @lizweston.