As the Federal Reserve continues its policy of near-zero interest rates, many people approaching retirement are earning insufficient income to support their retirement years. As such they are either delaying retirement, making riskier investments, or searching for other methods to supplement their income. An increasingly popular option is a reverse mortgage.
What is a reverse mortgage?
A reverse mortgage is a method of extracting equity out of your home. In essence, you are borrowing money against your home.
There are three types of reverse mortgages:
1. Single-purpose reverse mortgages – these are offered by some state and local agencies. This is the least expensive type of reverse mortgage.
2. Private loans – offered by banks or other private financial institutions. These types of loans are not restricted. Therefore, the higher the value of your home, the higher the amount of mortgage funding you can obtain.
3. Federally insured home equity conversion mortgages (HECMs) – this is the most popular type of reverse mortgage. The amount of the reverse mortgage you can obtain is limited to $726,525 or the market value of your home, whichever is less.
The money you get is usually not taxable and will not affect social security or medicare benefits.
There are several payout options available.
a) Single Payment Option. The borrower receives a one-time lump sum payment. This option is usually only available at a fixed interest rate.
b) Term Option – The borrower receives monthly payments for a fixed period of time.
c) Tenure Option – The borrower receives a monthly payment for as long as he lives in the home.
d) Line of Credit – This option allows the borrower to access money at any time for any amount up to the limit of the mortgage.
e) Combination of Monthly Payments and Line of Credit.
In order to qualify for a HECM, you need to:
1. Own your home outright or have only one primary mortgage.
2. Be at least 62 years of age.
3. Reside in the home as your primary residence.
4. Maintain your property.
5. Remain current on property taxes, insurance, and HOA fees.
Your home can be either a single-family residence, condo, a manufactured home built after 1976, or an apartment building of 4 units or less. Co-ops do not qualify.
Let’s take a look at the pros and cons of a reverse mortgage.
1. The biggest advantage of a reverse mortgage is that you do not make monthly payments.
2. You can use the funds for any purpose; paying off other debt, living expenses, medical bills, etc.
3. Your spouse can remain in the home after the borrower has deceased.
1. You are still required to pay all other expenses of homeownership, namely, property taxes, insurance, and maintenance. Some lenders may stipulate other requirements. This can be particularly risky for borrowers on a low fixed income. In the event that property taxes increase substantially, or a major repair such as a new roof is required that the borrower cannot afford, he runs the risk that the property will be foreclosed upon.
The latest data shows that there are more than 636,000 reverse mortgages outstanding. Of these, 90,000 are in arrears on property taxes and insurance payments and are likely to end in foreclosure. That is a 14% default rate, compared to 3% for traditional mortgages.
2. Fees and closing costs can be high. Fees are usually twice as high as compared to a traditional mortgage.
Here’s a breakdown of HECM fees and charges as described by HUD ;
Mortgage Insurance Premium (MIP).
The borrower pays a 2 percent initial MIP at closing, as well as an annual MIP equal to 0.5 percent of the outstanding loan balance. MIP can be financed into the loan.
Lenders charge the greater of $2,500 or 2 percent of the first $200,000 of your home’s value to process your HECM loan, plus 1 percent of the amount over $200,000. The FHA caps HECM origination fees at $6,000.
Lenders can charge a monthly fee to maintain and monitor your HECM for the life of the loan. Monthly servicing fees cannot exceed $30 for loans with a fixed rate or an annually adjusting rate, or $35 if the interest rate adjusts monthly.
Third parties charge their own fees for closing costs, such as the appraisal, title search and insurance, inspections, recording fees, and mortgage taxes.
3. Interest rates on reverse mortgages are almost twice as high as the rate on traditional mortgages. Rates can vary depending on your lender, your home value, your creditworthiness, and other factors.
4. With the exception of the single payout option, the interest rate on reverse mortgages can be variable. If interest rates increase, the interest component of your payout increases and the limit of your mortgage amount will be reached must faster.
5. The borrower can only borrow up to 55-60% of the value of the home, including any existing first mortgage. With a traditional mortgage, the borrower can borrow up to 85% of the home.
Based on the above information, it would appear that reverse mortgages are not an attractive option. Unfortunately, for people who are on a low fixed income, there are few other options.
Before initiating the reverse mortgage process, you should explore other options to reduce their monthly expenses.
1) Contact your municipality and ask if there are property tax discounts for seniors.
2) Investigate if there are Supplemental Security Income (SSI) or Medicaid that you might qualify for.
3) Discuss your financial situation with family members and explore other solutions with them.
For those of you who have sufficient incomes and credit scores, there are more attractive and less expensive options available.
Depending on the amount of the mortgage you currently have on your home, it might make sense to refinance your mortgage. Interest rates are still at historic lows. An increase in the mortgage amount will not make a significant difference in the monthly payment.
2. Home Equity Line of Credit (HELOC).
Instead of refinancing, you might want to consider a HELOC. This is essentially a type of second mortgage but you only pay interest on the money you use and for the period of time that you use it.
3. Home Equity Loan.
A home equity loan is essentially the same as a HELOC. The difference is that the second mortgage is taken out in one lump sum. This type of financing is ideal for anyone who wants to pull equity out of their home and use the proceeds for a down payment on a vacation home or income property. There are no age restrictions as to who qualifies for either a HELOC or Home Equity Loan.
4. Sell and Downsize.
For many seniors, this can be a very difficult decision, especially if they have lived in the home for most of their lives. However, this can be the most sensible decision. As people get older, they are less capable of maintaining a larger property. A smaller property is also less expensive in terms of monthly operating expenses.
5. Sale and Lease Back.
This might be the most attractive of all the available options. A homeowner may have family members who are willing and able to purchase the home and rent it back for as long as the homeowner is able to live there. The homeowner pays sufficient rent to cover the monthly costs that can be paid out of the proceeds of the sale. The family member can enjoy significant tax benefits if the sale and leaseback are structured properly.
For more information on other types of financing available, read my post What Is The Best Type of Mortgage Loan.
No one wants to borrow money to pay for monthly living expenses. Often there is little alternative. If after considering all other possible options, you decide to obtain a reverse mortgage, make sure that you calculate all expenses that come with a reverse mortgage. Make sure that you understand all the terms and the costs of the reverse mortgage itself.
If you are still not clear, discuss it with a HUD counselor. Subsequent to your discussion with the counselor, you might want to contact an accountant or financial planner. Explain your situation and what your goals are. They may have other options that you might not have considered.
Always shop around for the best deal. Terms, fees, and interest rates vary among lenders.
If possible, set aside a reserve fund for unexpected repairs or expenses. The last thing you want is to fall in arrears on insurance and property taxes. You could lose your home as a result.