Reverse mortgage disadvantages and advantages
Wondering about reverse mortgage disadvantages and advantages? Reverse mortgages are perhaps better known for the former than the latter.
They can be hard to understand, the fees and interest consume a substantial portion of the homeowner's equity and they've been used in home repair and investment scams to steal money from unwitting seniors.
But when used by homeowners who understand what they're signing up for, reverse mortgages can be a valuable retirement tool.
The typical American's net worth is largely tied up in home equity. That's especially true for those 65 and older. Their average total net worth is about $171,000, and about $144,000 of that is home equity, according to U.S. Census Bureau data. That means the average senior has just $27,000 in liquid assets — hardly enough to fund a long, comfortable retirement.
A reverse mortgage, also called a home equity conversion mortgage (HECM), lets seniors who are at least 62 years old access the home equity from their primary residence in the form of a lump sum, a line of credit, a stream of monthly payments or some combination of these.
To qualify, seniors must own the home free and clear or have a small enough remaining mortgage balance that the reverse mortgage can pay off that balance and still provide enough money after fees to benefit the homeowner.
Seniors who have no other savings, however, might find that a reverse mortgage is not enough to meet their retirement needs.
Good candidates for a reverse mortgage include seniors with enough income to meet their monthly living expenses but not enough for emergencies or repairs, or those who have savings for emergencies and repairs but need to supplement their income, said Cara Pierce, a reverse mortgage counselor with Clearpoint Credit Counseling Solutions in Fresno, California.
Before taking out a reverse mortgage, you should thoroughly understand reverse mortgage disadvantages and advantages.
Reverse mortgage disadvantages
Reverse mortgages have many potential disadvantages. But these won't be a problem for all borrowers, especially those who educate themselves so they can accurately evaluate whether this type of loan is right for them.
Here are some reverse mortgage disadvantages:
1. Fees, interest and mortgage insurance eat up equity.
Just like regular mortgages, reverse mortgages have closing costs such as origination fees, an appraisal, title insurance and a home inspection. And because they are insured by the Federal Housing Administration (FHA), borrowers must pay mortgage insurance premiums. These costs get subtracted from the total amount you can borrow.
"The up-front costs of a reverse mortgage are generally much more expensive than a refinance," Pierce said.
The origination fee on a conventional mortgage is usually 1% of the loan amount. With a reverse mortgage, the origination fee can still vary by lender, but the maximums are 2% of the first $200,000 borrowed and 1% of the rest, with a limit of $6,000. A $250,000 home could have a $4,500 origination fee for a reverse mortgage, not the $2,500 that a refinance would likely have.
In addition, reverse mortgage borrowing limits are lower. Because the homeowner is using up the equity in the property, the lender limits how much the homeowner can borrow based on age.
"Since no monthly payments are required, but the interest is still accruing on a monthly basis, the lender cannot loan the full value of the property, or the homeowner would owe more than the property is worth the very first month," Pierce said.
Given the costs, why not just do a cash-out refinance to access your equity?
"Generally, people on a fixed income find it hard to refinance due to income or restrictions," Pierce said.
Mortgage insurance costs reverse mortgage borrowers 0.5% or 2.5% of the amount borrowed up front, depending on the loan type, and 1.25% of the loan balance annually.
While the mortgage insurance premiums are costly, Pierce said, they protect both the lender and the borrower against losses.
(Use our mortgage calculator to estimate your monthly principal and interest payment.)
2. Moving can be difficult.
Reverse mortgages are designed to help seniors age in place, but they don't require you to live in your home for the rest of your life.
However, if you want to move, you have to repay the reverse mortgage. Depending on the home's value at that time and how much in interest and fees the reverse mortgage has accrued, there might be little to no equity left after the sale.
The small upside is that if your house has dropped in value and is worth less than your reverse mortgage balance, you do not have to cover the shortfall.
"If the borrowers owe more than what the property is worth, the borrowers will only be required to pay 95% of the value of the property," Pierce says. "The lender will not go after any other assets the borrowers have to secure repayment of amounts beyond the value of the property. That is the purpose of the FHA insurance."
If you move within a few years of taking out the reverse mortgage, it wouldn't be worth it to pay closing costs and mortgage insurance premiums.
"If the consumer plans to sell the home and relocate soon, there may be better short-term options," said Scott Hanson, co-founder of California-based Liberty Reverse Mortgage.
"Given the costs of setting up a reverse mortgage, using a line of credit might be a less costly option," he said.
3. You can't leave your home to your heirs.
If you take out a reverse mortgage and remain in the home until you die, the reverse mortgage lender will sell the home to recoup the money it lent you. Any profit goes to the heirs.
The only way your heirs will be able to take ownership of the house is by paying off the reverse mortgage balance. That's why Pierce says reverse mortgages are best suited to people who have no heirs or people who are not concerned about what their heirs will receive.
Fortunately because of the mortgage insurance premiums, you won't have to worry about leaving your heirs a bill if you end up borrowing more than the house is worth.
4. The lender can foreclose.
If you stop using the home as your primary residence for more than 12 months, the lender can foreclose.
That might happen unintentionally if you have an extended stay in a nursing home, if you don't keep up property taxes, insurance and homeowners association dues, or if you fail to maintain the home according to the FHA's habitability standards.
However, protections exist to minimize borrowers' risk of foreclosure. For example, before approving the loan, the lender must do a financial assessment of the borrower's credit history and income. If the borrower has shortcomings, the lender must set aside part of the reverse mortgage proceeds to pay the homeowner's property taxes and homeowners insurance for the life of the loan.
5. Spouses can get stranded.
If a married couple owns a home together and they want to take out a reverse mortgage when one spouse is 62 or older and the other isn't, the younger spouse won't qualify as a co-borrower on the loan. This can lead to serious problems.
"If one of the homeowners is under the age of 62, the property owner under age 62 may have to deed off the property in order for the older homeowner to qualify for the loan," Hanson said. "Having a homeowner deed off the property is dangerous, and I don't recommend it as a general rule.”
People can lose their homes this way, Hanson explained. If the spouse who holds the deed dies, the surviving spouse must either pay back the reverse mortgage in full or lose the house.
Reverse mortgage advantages
There are plenty of reverse mortgage disadvantages, but there are certainly some advantages as well.
Here are some of the advantages of reverse mortgages:
1. Home equity is more accessible.
A home equity loan or a home equity line of credit (HELOC) require the borrower to make payments, and if a senior is struggling to make ends meet, adding another payment might be a burden, said Greg Cook, vice president of Reverse Lending Experts in Temecula, California.
In addition, seniors with low credit scores and high debt-to-income ratios may not be able to qualify for a home equity loan or HELOC. And these lines of credit can also be frozen if there is an economic downturn, as happened in 2008.
The line of credit you can get with a reverse mortgage, by contrast, does not require monthly payments. And a reverse mortgage cannot be frozen. Funds will always be available as long as the borrower uses the line wisely.
If you can qualify for a home equity loan or HELOC, Hanson says consumers should evaluate whether downsizing is a more realistic option and a better way to access home equity.
"For those who live in expensive cities, such as San Francisco or New York, it may be better to purchase a newer home outside of the city for a fraction of the price," he said. "This could free up the equity to do other things," he added.
2. Qualification is easier.
Reverse mortgages can be easier for seniors to qualify for than other loans.
"Because there are no monthly payments required, even borrowers with limited income may be eligible," Pierce said. "Credit is not usually a restriction, either, and doesn't affect the interest rate."
3. It's flexible, tax-free income.
Reverse mortgages are technically considered a loan advance, and loan advances are not taxable.
You can also change the way you receive your proceeds. For example, if you initially chose to receive equal monthly payments but decide you'd prefer access to a line of credit instead, you can make that change for a small fee.
The bottom line
Reverse mortgages have their disadvantages, but they can be the right tool for certain seniors who want to gain access to their home's equity without selling or having to make monthly payments.