Retiree Portfolio Adding to Retirement Income

A reverse mortgage provides a way to supplement retirement income without having to sell one's home or incurring a debt that's immediately repayable. For those who are house rich but cash poor, a reverse mortgage may make the difference between a comfortable retirement or one filled with stress. Nevertheless, due to the expense involved in such contracts, the issue requires close examination and evaluation before a retiree enters into such a contract. This column was first published on July 3, 2000.

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By David Braze (TMF Pixy)
April 9, 2001

Most retired homeowners have an untapped source of cash represented by the equity they own in their homes. Equity is the difference between the current market value (i.e., selling price) of the home and any indebtedness (i.e., mortgage) still due on that property. For previous generations, home equity was largely untouchable. To convert equity into cash, those retirees had to either sell their homes outright or secure a line of credit using the home as collateral against which they could borrow. The first option meant leaving the homestead while the second resulted in a debt subject to immediate repayment. To those living on restricted incomes and who did not wish to relocate, neither alternative was attractive.

Today's retirees, though, have a third option they may use to tap into home equity for income. Called a reverse mortgage, this option does not force relocation nor will it cause the immediate repayment of debt that could deplete a sparse checking account.

A reverse mortgage is a special, complex type of home equity loan available to homeowners age 62 or older who have no existing mortgage debt and who occupy the property as their principal residence. In this type of arrangement you don't pay the lender as you would in a normal mortgage. Instead, the lender pays you. In that sense the reverse mortgage is the direct opposite of a standard conventional mortgage, and that's how it got its name.

Payments to the homeowner(s) by the lender may be made in three ways: 1) a lump sum, 2) in a series of regular monthly payments for life or over a fixed term, or 3) when desired by the homeowner, as irregular cash advance withdrawals against a line of credit. The total amount available for a reverse mortgage depends on the age of the homeowner(s), the value and location of the home, and the current interest rate used by the lender. In general, older homeowners may borrow a greater percentage of a home's value than younger homeowners.

Proceeds from a reverse mortgage are not considered income for tax purposes, so they are untaxed on receipt. Additionally, the interest due on a reverse mortgage may not be claimed as an itemized deduction on an income tax return until the borrower(s) or the estate repays the loan. Reverse mortgage cash advances do not have an impact on Social Security or Medicare benefits, but they may affect a recipient's eligibility for Supplemental Security Income (SSI) or Medicaid benefits. SSI and Medicaid recipients should determine what impact a reverse mortgage may have on those benefits prior to entering the contract to avoid any unpleasant surprises.

Typically, a reverse mortgage is not repaid until the last living borrower dies, sells the home, or fails to reside in that home for over 12 consecutive months. The loan may also be called for repayment should a borrower fail to provide necessary maintenance or to pay the property taxes and homeowner's insurance when due. In some contracts (see below), repayment may be due when cash advances have been made over a fixed period and the term of those payments has ended. The amount of the repayment will be the sum of all the cash advances made to the borrower(s) plus the accumulated interest on those advances.

Reverse mortgages are considered "nonrecourse" loans, which means a lender may only seek reimbursement based on the value of the home. If that amount is not enough to retire the loan, the lender has no further recourse to other available assets or income of the borrower(s) or heirs. Thus, the maximum amount due on a reverse mortgage is the market value of the home at the time of repayment. If the home is sold to settle the debt and the sales proceeds are more than the loan amount, that equity will be paid to the original borrower(s) or to the estate.

There are three basic types of reverse mortgages: Federal Housing Administration (FHA)-insured, lender-insured, and uninsured. Each type differs, so the amount of money available in a reverse mortgage depends on the program selected. In general, the FHA-insured Home Equity Conversion Mortgage offered through the Department of Housing and Urban Development provides the lowest cost, highest mortgage for homes with modest market values. Advances from lender-insured loans may be larger than those provided by FHA-insured loans, but they will also tend to be more costly, which leaves the borrower(s) and/or heirs less equity over time.

Uninsured loans provide income over a fixed term only that's determined when the loan begins. When cash advances stop, the reverse mortgage becomes due and payable. For uninsured loans, then, careful consideration of the loan amount and the means of repayment is an absolute necessity.

All three types of reverse mortgage programs charge origination fees and closing costs similar to those found in conventional mortgages. The insured plans also charge premium costs for that coverage. Additionally, some lenders will impose service fees for administering the mortgage. In some cases, there may even be an agreement to share future equity growth with the lender. While many of these costs may be added to the loan amount so they don't come out of pocket, they will add to the loan expense and reduce the equity remaining in the home. As with regular mortgages, all contracts are not created equal. All of these charges and fees can make a reverse mortgage very expensive. Thus, no reverse mortgage contract should be entered into without a careful evaluation and an examination of all available options.

The National Center for Home Equity Conversion (NCHEC), an independent, not-for-profit organization dedicated to reverse mortgage analysis and consumer information, provides extensive services for those interested in these vehicles. The site includes a calculator to determine projected reverse mortgage amounts and costs as well as sources for detailed guidance and personal reverse mortgage analyses. In my opinion, the site is a "must" for all interested in pursuing a reverse mortgage as a source of retirement income.

Are you living on a fixed income? Is your unmortgaged home your only major asset? Do you need an additional and continuing source of retirement income? Do you have no plans or desires to leave your home as a legacy to your children or others? If you can answer "yes" to all of those questions, then a reverse mortgage may be appropriate for you, particularly if you are of advanced years. But if you wish to leave your home to others or if you have other assets to turn to for support, a reverse mortgage could be an expensive route to take for extra income.

Examine the issue carefully, read the materials available at the NCHEC, do the necessary analysis, and then decide what's right for you and yours. Who knows? For those who are house rich but cash poor, a reverse mortgage could make all the difference between comfort and unceasing stress.

See you next week. Until then, post away as usual on the Retired Fools or Retirement Investing boards.

Best to all...Pixy