Home equity is the largest source of savings for most people entering retirement. A reverse mortgage allows homeowners to access a home's equity to provide extra income during retirement. However, few people understand how reverse mortgages work and consider them as an option. Read on to learn more about reverse mortgages and determine if one might be the right choice for you.
Reverse mortgages: an overlooked and avoided solution
With many baby boomers entering retirement with underfunded retirement savings, tapping home equity may be a good solution to provide needed funds for daily living expenses. However, only 2% of eligible homeowers have taken out a reverse mortgage.
Reverse mortgages earned a bad reputation when first introduced, as some older homeowners were pressured to use loan proceeds to complete unnecessary home improvements or invest in risky financial products. This reputation, coupled with a poor understanding of the product, cause many who might benefit to not consider the product.
While reverse mortgages are unpopular, they may be the key to a comfortable retirement for many baby boomers. According to the Employment Research Benefit Institute, 41% of baby boomers have no retirement savings account. Even more troublesome is the fact that 44% of baby boomers entering retirement will not have adequate income for basic living expenses. However, 74% of baby boomers are homeowners, and tapping home equity may be the solution for unprepared baby boomers to acquire needed funds in retirement.
Reverse mortages 101
Here's some basic information about reverse mortgages. To be eligible for a reverse mortgage, also called a Home Equity Conversion Mortgage (HECM), a homeowner must be at least 62 years old and either own the home outright or be able to pay off the remainder of the mortgage with the proceeds of the reverse mortgage.
Unlike a home equity loan, no payments must be made on the reverse mortgage while the borrower is living in the home. The loan must be repaid when the borrower moves out of the home, sells the home, or dies.
The amount that may be borrowed depends on three factors: the value of the home, the borrower's age (or age of the younger spouse, if a couple is taking out the loan), and the interest rate. The loan is insured by the Federal Housing Administration (FHA), and the exact amount that may be borrowed is determined by an FHA formula.
The loan proceeds may be dispursed as a lump sum, a line of credit, lifetime income, or as a stream of payments for a specific period of time. There is no restriction on how the funds may be used. The homeowner is still responsible for paying real estate taxes and insurance and keeping the home in good repair.
Obtaining a reverse mortgage
Before a homeowner may apply for a reverse mortgage, the homeowner must complete housing counseling by an independent third party, like an agency approved by the Department of Housing and Urban Development (HUD) or AARP so the borrower understands the product. Next, the homeowner must work with a lender and must pass a financial assessment to ensure they have means to pay taxes, insurance, and other ongoing expenses.
A reverse mortgage has upfront costs just like a conventional mortgage, and interest rates are higher than for a conventional mortgage. The loan fees may be paid from the loan proceeds, so out-of-pocket costs can be limited to the fee for the counseling session (if the agency used charges a fee) and the required appraisal. The main reason individuals consider a reverse mortgage but ultimately opt not to proceed is the fees for obtaining a reverse mortgage, including the closing costs and higher interest rate.
By law, the borrower will receive disclosure notices from the lender, including a good faith estimate and a total annual loan cost (TALC) disclosure, so the borrower can understand the cost of the loan for different durations of time.
Pros and cons of reverse mortgages
Here are some of the advantages and disadvantages of using a reverse mortgage:
- Borrowers can use a portion of their home's equity while continuing to own and live in the home.
- Borrowers do not have to repay the loan as long as they live in the house.
- The borrower or heirs will never have to repay more than the value of the loan, even if the home value drops. If the sale of the home isn't enough to pay off the reverse mortgage, the lender must take a loss and request reimbursement through the FHA.
- A reverse mortgage has higher closing costs and a higher interest rate than a traditional mortgage. Some borrowers have complained that the variable rate increased too quickly.
- Borrowers are unable to leave the home as part of their estate to family members after death.
- It is difficult to change the loan terms once the loan closes. It cannot be assumed by a family member, so a reverse mortgage may be a poor choice for families living in a multigenerational home.
The ability to access home equity while retaining ownership makes reverse mortgages a good option for many seniors entering retirement. However, it is essential that borrowers understand the loan terms and conditions before signing on the dotted line so there aren't surprises later.