A reverse mortgage can be a good way for people 62 and older to turn their home equity into extra spending cash that can supplement Social Security and withdrawals from savings, making retirement more enjoyable than it otherwise might be. Typically, you can take the loan proceeds in a lump sum, monthly payments for life, as a credit line or a combination of these.
One of the big appeals of this type of arrangement — as opposed to, say, tapping your home equity by refinancing or opening a home equity line of credit — is that you don’t have to repay the loan until you die or sell your house.
Another plus is that the payments you receive from a reverse mortgage may not affect your Social Security benefits (although they could affect your eligibility for programs like Medicaid and Supplemental Security Income, or SSI, the program that provides income to people with low incomes and disabilities).
There is a practical problem for anyone who plans to use a reverse mortgage primarily as a line of credit that could be drawn upon when and if needed, versus taking out a large amount for some immediate need (renovating a home, replacing a car). In addition to interest expense and an annual insurance charge on the outstanding balance, the HUD’s popular Home Equity Conversion Mortgage (HECM) reverse mortgage program also levies an initial one-time insurance premium based on the amount of your withdrawal during the first year of the loan.
That amounts to $6,000 for a $300,000 mortgage. You don’t have to pay this charge out of pocket. Still, it boosts the overall cost of borrowing, and can significantly drive up the effective annual interest rate you pay if you wind up drawing very little against the reverse mortgage in the future or if you die or move from your home shortly after taking out the loan.
Additionally, you’ll have to pay closing costs on the loan, which can include such expenses as an appraisal, title search and insurance, credit checks, mortgage taxes and a loan origination fee. Lenders can charge an origination fee of as much as $2,500 if your home’s value is less than $125,000. If your home is worth more than that, lenders can charge 2% of the first $200,000 of your home’s value plus an additional 1% on the amount over $200,000.
That translates to a $5,000 origination fee on a $300,000 home. (The origination fee is capped at $6,000.) As my MONEY colleague George Mannes noted previously, some lenders may be willing to waive origination fees and pick up a portion of other upfront costs, such as the initial insurance premium.
No matter how enticing getting money on the house might seem, remember, a reverse mortgage isn’t something you should take on lightly. As part of the deal, you’re required to pay homeowners insurance premiums and property taxes and maintain the property. Though under new FHA rules, lenders can give applicants the option to set aside money to pay these costs out of the proceeds of the reverse mortgage. For those who don’t qualify for the payment, set-asides would be required.
Fail to pay these bills and you could be forced to repay the loan even if you’re still living in the house. If you don’t have other resources to do that and you did not opt for the set-aside, you would have to sell. So before signing up for a reverse mortgage, consider whether there are other options for you and your spouse. In some cases, Retirees can be better off tapping a cash-value life insurance or freeing up their home equity by downsizing to a less expensive home that has lower ongoing maintenance and utility costs.
Fortunately, HUD has beefed up the mandatory no- or low-cost counseling that borrowers must get before taking out a reverse mortgage. And to help people considering a reverse mortgage more fully understand the pros and cons of such a loan, counseling agencies must now provide potential reverse mortgage borrowers with a packet of information before the counseling session, including material for assessing these loans’ true costs and a booklet from the National Council on Aging that outlines how reverse mortgages work.
Remember too that, while HECM reverse mortgages are insured by the federal government, the loans themselves are made by private lenders who do not set identical terms. So, compare the offerings of lenders before settling on a loan. For example, peruse the material on the reverse mortgage section of AARP’s site. Don’t commit until you’ve thought about other options and you understand all the costs.
Note: this article was published in 2011 and was updated to reflect FHA’s new standards without changing the substance of the article.
