What Is a Reverse Mortgage?
An ordinary mortgage is when you borrow money to buy a home. From the first dollar you pay on the loan principal you start building equity, a fancy term for home ownership. A reverse mortgage is a loan product that generates payments to you based on your home's value and defers loan repayment until you move, sell, or pass away.
Reverse mortgages are useful to longtime homeowners under certain circumstances, yet they remain controversial. Detractors point to the risk of losing your home, but that's true of ordinary mortgages as well. All loans have a potential dark side. Let's run down the pros and cons of reverse mortgages.
Pros of a Reverse Mortgage
A reverse mortgage is an income strategy for older homeowners who want to stay in their home. A typical way for older homeowners to cash in on the appreciation of their home is to sell after retirement and downsize. This can mean not only buying a smaller home but also a home in a more affordable region now that proximity to jobs and schools is no longer a concern.
That's fine for older homeowners who want to relocate, but what if retirees are happy staying put?
Receive cash against the value of your home without selling it.
A reverse mortgage lets homeowners live in the home while getting cash payments based on the home's value at a future sale. Here is a simplified explanation for how this loan product came to be called a reverse mortgage. Whereas an ordinary mortgage begins with a home purchase followed by regular monthly payments to a lender, a reverse mortgage starts with regular monthly payments to the homeowner followed—eventually—by the home's sale. The homeowner does not need to make any payments on the reverse mortgage so long as he or she continues to live in the home.
A regular influx of cash can make all the difference to seniors having a hard time making ends meet. A reverse mortgage is but one strategy for retirement income, however. A financial advisor can tell you more options.
Homeowners are still responsible for paying property taxes and homeowners insurance and for regular maintenance. Failure to do so could trigger repayment of a reverse mortgage.
If the loan balance exceeds the home's value, you or your heirs may not have to pay the difference.
The loan balance grows every month and does not need repayment. Eventually the balance can eclipse the home's value, but borrowers (or their estate) are usually not required to pay back any loan balance in excess of what the home is worth.
This consumer protection comes with the most common type of reverse mortgage loan, known as a home equity conversion mortgage (HECM). Loans made through this FHA program carry the important consumer protection.
The government's Consumer Financial Protection Bureau (CFPB) writes: "When the last remaining borrower passes away, the loan has to be repaid. Most heirs will repay the loan by selling the home. If your loan balance is more than the value of your home, your heirs won’t have to pay more than 95 percent of the appraised value. The remaining balance of the loan is covered by mortgage insurance."
If your reverse mortgage is not done through the FHA program, it probably won't have this protection. If you are considering a reverse mortgage, look into the HECM type and forget the rest. One stipulation of the FHA program is that you must be at least 62, and so must your spouse (source).
The income is nontaxable.
As controversial as reverse mortgages are, an indisputable benefit of a reverse mortgage is that the payments are not considered taxable income. Because the IRS sees the money as a loan rather than income, it will not be counted in formulas that derive your income, such as Social Security and Medicare benefits.
Cons of a Reverse Mortgage
A reverse mortgage does not merely let homeowners keep living in their home, it requires it. Until a sale or a move the lender has been paying you, the reverse way a normal mortgage works. Well, after a sale or move the loan makes a U-turn and you need to start paying back the lender plus interest, origination fees, and any other charges rolled into the loan.
Limits your movability.
Since a move would trigger repayment, some homeowners can feel trapped by their reverse mortgage. Once certain that they would be happy living nowhere else, after three or four years of retirement they might view downsizing and relocating more favorably, especially if friends and family have moved away in that time. In order to keep from triggering the payback of the reverse mortgage, borrowers could remain in a home longer than they want.
Letting someone else live there while you roam in retirement won't work either. According to the CFPB, every year you must certify in writing that you occupy your home as your principal residence. You can lose your home to foreclosure if you have a reverse mortgage loan and:
- Are absent from your home for a majority of a year for a nonmedical reason; or
- Are absent from your home more than twelve months in a row for healthcare purposes.
Even though a reverse mortgage might look like it turns your home into an ATM, it is absolutely a loan, with interest and fees and a balance that grows every month. It's more like turning your home into a credit card.
The balance keeps growing.
Because a reverse mortgage requires no mortgage payments so long as the homeowner lives in the house, the interest on the loan gets added to the balance every month. It's like a credit card that you keep charging on and never pay, but unlike a credit card, someone will have to pay it after you're gone. Or after you move or sell.
While it is fortunate that borrowers (or their estate) will not have to pay back an FHA-program reverse mortgage loan balance in excess of the home's value, another way to look at it is that the lender may be entitled to the whole house as payment for the loan.
Your home probably won't stay in the family.
If you expected your heirs to live in the home after you're gone, a reverse mortgage makes that unlikely. Most reverse mortgages are repaid by the sale of the home.
"If you have to shell out big bucks for fees or create an unnecessary burden for your children, a reverse mortgage could be more trouble than it’s worth," wrote Rebecca Lake, a retirement and estate planning advisor for SmartAsset. "You may go through the reverse mortgage application process and find that the associated fees are quite high. If this describes your situation, you should likely steer clear of a reverse mortgage. There are other options for gaining money in retirement, so don’t feel overly attached to this option."
- If you have few other options for regular cash in retirement and are unconcerned about bequeathing your home, a reverse mortgage is worth considering.
- Don't rush into a reverse mortgage without carefully considering how your desire to stay in the home might change in a few years.
- Make sure any reverse mortgage you consider carries the FHA mortgage insurance so when the time comes you will never owe more on the loan than the home is worth.