Pros & Cons of Reverse Mortgages & Alternatives
Reverse mortgages aren't for everyone. Homeowners should only consider them if they plan to remain in the property for several years, and if there isn't a cheaper way to get the money they need. Before you take out a reverse mortgage, make sure you evaluate the pros and cons.
Reverse Mortgage Pros
Qualifying is easy
Compared to the approval and underwriting of traditional "forward" mortgages, qualifying for a reverse mortgage is relatively easy. Because you don't make monthly payments to your lender over the life of the loan, your lender is a lot less concerned about your ability to repay, which means your credit rating is less important. Even if you have bad credit, a reverse mortgage lender most likely will approve your Home Equity Conversion Mortgage (HECM) loan.
Rates are competitive even with subprime credit
With most mortgage products, borrowers with subprime credit are charged much higher interest rates and fees - if they can get financing at all. That's not the case with a HECM. The HECM is no more expensive for borrowers with poor credit than it is for those with near-perfect scores.
Reverse mortgage proceeds are not taxable income
If you receive a $1,250 payout from your reverse mortgage loan, you keep all $1,250, no strings attached. That's because funds withdrawn with a reverse mortgage are not considered income, so the government doesn't collect income taxes on them. In comparison, the wages of a retiree who works part time for extra money are taxable. This means a retiree in the 25 percent tax bracket must earn $1,250 to increase spending money by $1,000.
You choose how to use reverse mortgage proceeds
How you use your reverse mortgage payout is entirely up to you, with no restrictions from the lender. For instance, you can use reverse mortgage funds to increase your standard of living with monthly income, take a lump sum for any purpose (including the purchase of a vacation home or world voyage) or simply set up a line of credit for emergencies.
You still own your home
Taking out a reverse mortgage doesn't mean you've signed away the title to your property. You still own your home even though you're reaping the monetary benefit of its equity. When reverse mortgage borrowers sell their homes, any proceeds beyond those needed to repay the loan are returned to the borrower. When reverse mortgage borrowers die, any funds remaining after the loan is repaid become part of their estate.
You can avoid foreclosure
Taking out a reverse mortgage can help you avoid foreclosure. If you find yourself with insufficient income to keep up the payments of a traditional forward mortgage, but you have built up plenty of equity in your home over the years, you can use a reverse mortgage to pay off and discharge your traditional mortgage.
You can't outlive reverse mortgage benefits
Borrowers who choose tenure payments — monthly income for as long as you live in the house — cannot outlive reverse mortgage payouts. If a reverse mortgage loan's balance exceeds the property value, you'll continue to receive tenure payments. It doesn't matter if the loan outstrips the home's value. No one, including you, your estate or your heirs, is responsible for any shortfall.
Reverse Mortgage Cons
Your reverse mortgage lender requires that you live in your home, and the lender will periodically verify your residency, which can pose a problem despite your good intentions. If you unexpectedly end up in a care facility for more than 12 months, you will not have fulfilled the requirement. Even if your health is fine but you want to accomplish your lifelong dream of taking a two-year jaunt around the world, your reverse mortgage may stand in the way.
Maintenance, insurance and taxes must be paid
Reverse mortgages require that homeowners take care of the collateral-protecting the lender by keeping the property livable and marketable. You must pay property taxes and hazard insurance and keep the residence in good repair. If the property value drops as a result of your poor maintenance or failure to pay taxes and insurance premiums, your mortgage lender may foreclose.
Reverse mortgages can be expensive
A reverse mortgage is certainly not the cheapest mortgage product. In fact, a traditional home equity loan will likely cost substantially less if you can qualify. The reverse mortgage's upfront fee and 1.25 percent annual insurance charge can be prohibitive, particularly for those borrowers choosing the highest possible lump sum payout. The upfront premium is a lot more expensive than it appears because it's not based on the loan amount but on the home value (or $625,500, whichever is less). A 72-year-old borrower with a $200,000 home, for example, can borrow up to $118,200, but the 2.5 percent upfront insurance premium of $5,000 is based on the $200,000 home value. You could avoid the steep 2.5 percent premium and lower the insurance cost by choosing a different payout for an upfront premium of 0.5 percent, or $1,000.
You may lose government benefits
You should consider the consequences of each reverse mortgage payout method before deciding on the method and amount of payout. One miscalculation and you could lose important government benefits you've been depending on. If you don't immediately spend a lump sum, for instance, you could easily lose eligibility for needs-based programs available to low-income borrowers. For example, eligibility for Medicaid or Supplemental Security Income requires that a single person only have $2,000 in cash on hand. A large enough reverse mortgage payout could unwittingly knock you out of eligibility.
Heirs may be upset
Heirs may express concern if you mortgage "the family home." If you care about the opinions of your heirs, discussing your reverse mortgage plans with family members, estate planners or attorneys may prove vital to maintaining happy, healthy family connections.
Understanding the pros and cons of reverse mortgages is just the start. As a potential HECM applicant, you must complete reverse mortgage counseling with a HUD-approved counselor before you can proceed with an application. However, you may still desire to consult other professionals — such as your financial advisor or attorney — even after completing your required counseling session. Consumers Union, publisher of Consumer Reports, recommends that homeowners shop carefully for a reverse mortgage and sign up only when they understand all of its terms and conditions.
Reverse Mortgage Myths (and Truths)
Alternatives to a Reverse Mortgage
Reverse mortgages are not the only source of ready cash for homeowners 62 years of age and older, and they're most certainly not the cheapest. You may want to consider these other options highlighted below before heading down the reverse mortgage path.
Traditional Cash-Out Refinance
New guidelines for traditional refinances might allow the inclusion of retirement savings in a borrower's qualifying income — referred to as "asset depletion" or "asset dissipation" — for purposes of loan approval. The lender takes 70 percent of your qualifying retirement savings and divides it by the number of months in the loan term. If you have $500,000, for example, you add $1,944 per month to your income to qualify for a 15-year loan term or $972 per month to qualify for a 30-year loan.
In addition, underwriting for a traditional cash-out refinance allows "grossing up" Social Security benefits and other non-taxable income by 25 percent. For instance, if your monthly Social Security benefit is $1,000, for loan approval purposes you'll get credit for receiving $1,250. If you keep the loan-to-value ratio relatively low and you have a good credit rating, you have an excellent chance of getting approved. If you find out your outstanding bills are hindering loan approval, you can choose to "pay off debt to qualify,"—which means applying some or all of your loan proceeds to outstanding debts at closing.
Home Equity Loan or HELOC
You may qualify for a home equity loan or home equity line of credit (HELOC) if you have a fairly low loan-to-value ratio and decent credit. Taking out a home equity loan or HELOC involves significantly lower closing costs than those of reverse mortgages or cash-out refinances, a good reason to make either alternative your first choice in home loans.
Selling Your Home
Downsizing to a smaller home with a lower market value may help free up the funds you need. In general, downsizing makes more sense if it leaves you with a large sum after:
- Paying off any mortgages against the old home.
- Purchasing the new home with cash and covering commissions.
- Moving expenses and closing costs.
On the other hand, if downsizing doesn't free up that much cash, you might be better off borrowing with a HECM.
Selling Other Assets
Go through your valuables, including investments, art, jewelry and other collectors' items. You may prefer to sell these other assets before parting with or mortgaging your home. If this is the case, you can have them appraised and see if they'll provide enough funds to carry out your goals. Doing so also delivers the side benefit of decluttering your home.
Taking in Boarders
If your home has more space than you need and you believe you can handle the change in dynamics that comes with inviting strangers into your living space, consider renting out a portion of your home for regular, monthly supplemental income. Of course, you'll need to confirm that applicable rules or regulations permit you to take on boarders. Home-sharing firms can help novice landlords screen prospects and find good matches.
Have you considered going back to work? Some retirees miss the work environment and their jobs even more than they miss the extra money from employment. Working a job may involve a dramatic lifestyle change at this stage of your life, but it's one worth entertaining. A part-time job might be the solution for those retirees who miss the social benefits or sense of accomplishment that comes from working. Before you go job-hunting, however, make sure you determine how employment would affect your tax situation and Social Security benefits.
With some creativity, you can find additional alternatives to a reverse mortgage that just might accomplish your goals. For example, if you're having trouble making payments on an existing mortgage, you could approach your lender for assistance. It might agree to a loan modification or forbearance. If you're dealing with burdensome debt, you could hire a credit counselor to help you create a debt management plan or even consider asking family members for assistance. Filing for bankruptcy is a less attractive option, but one that you may want to consider. Numerous alternatives to reverse mortgages exist, so you'll need to take some time to consider each one before you make a decision that will affect your financial future.
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