Older homeowners often use reverse mortgages to pay off their traditional mortgages so they can get rid of their monthly house payments. Is that a wise strategy?
Reverse mortgages have gained a bad reputation over the years, but they can be a useful financial tool to seniors when used appropriately, says David Johnson, associate professor of finance at the University of Wisconsin-Superior.
A reverse mortgage is a home equity loan in which the borrower is not required to make payments. The homeowner must be at least 62 years old. A reverse mortgage accrues interest and does not have to be repaid until the homeowner dies or moves out of the house. The Federal Housing Administration calls it an HECM, for home equity conversion mortgage.
“In years past, financial planners didn’t view reverse mortgages as a planning tool,” says Johnson, who recently co-authored a study discussing the growing importance of reverse mortgages in retirement. “It was viewed as a last resort and they assumed that the only people that do reverse mortgages are people that are desperate. Clearly that’s not the case, and I think they are starting to view it differently now.”
One of the most common reasons homeowners get reverse mortgages is to pay off their existing mortgage so they have more income to work with. Immediate cash flow relief results.
They already have this debt on the house, so instead of making their mortgage payments they are just paying it out of their equity before they leave the home.
To qualify for a reverse mortgage, the homeowner must be at least 62 years old and have sufficient equity in the house. The size of the loan depends on the value of the home, the age of the youngest borrower and how much is owed on the house. The owner must pay property taxes and insurance.
Robert is married to Linda, who is 62 and is the younger spouse. Their house is worth $200,000 and they owe $62,000 on the mortgage.
Based on their ages and the home’s value, they can get a reverse mortgage for up to about $104,800. This is known as the principal limit or maximum loan amount. Closing costs, including FHA initial mortgage insurance, reduce that available amount to about $97,800.
Senior homeowners with more equity will pay substantially less in closing costs. The examples cited here reflect the maximum 2.5% initial FHA insurance cost. A 0.5% initial FHA insurance cost is charged when the homeowner has more equity. Call Bob for the formula.
Under FHA rules, the amount they borrow is limited in the first year. Borrowing the $62,000 to pay off the mortgage, they can take out another $10,400 in cash during the first year. A year later, the remainder is available to them.
Barbara is a 75-year-old widow with a house worth $400,000. She owes $25,000 on a home equity line of credit, with no other mortgage debt.
Based on her age and the home’s value, she can get a reverse mortgage for up to about $245,600 (the principal limit). Closing costs, including FHA initial mortgage insurance, reduce the available amount to around $234,900. This is a case where the initial FHA insurance is 0.5%, not 2.5%.
Under FHA rules, she can get a reverse mortgage, pay off the HELOC balance and take out up to around $111,600 in cash during the first year. A year later, the remainder would be available to her.
With reverse mortgages, homeowners have three options for cashing out equity:
Many homeowners are conservative and just want to eliminate their mortgage payments, but they like having the credit line available.
Maybe they don’t need the money right now, but down the line they might have a medical emergency or another need, so it’s good for them to have the option.
That was the case with Barbara after her husband died. Their house was mortgage-free, but she knew her retirement income wasn’t enough to cover some of her expenses, including medical emergencies. She got a reverse mortgage but didn’t access the money until she had no other option.
Bob calls this version of a HECM a Standby Reverse Mortgage. Over 90% of his clients utilize this terrific financial tool. Call Bob and ask about the most amazing feature. The line of credit grows. And unlike the typical HELOC, this line can never be restricted or retracted. Its availability is guaranteed and it can never be reset like millions of HELOCs are about to be. Ask Bob for the HELOC Alternative for Older Homeowners flyer.
“I rely on it only when I need it,” Barbara says. Recently, she hurt herself after falling and spent more than $10,000 during her at-home recovery.
“I had people come in for three hours in the morning and at night,” she says. “It was expensive. I couldn’t have afforded it without the reverse mortgage.”
As with many other seniors, Barbara says she hesitated when she first heard of reverse mortgages because she wanted to leave her condo to her children.
“But they told me, ‘We don’t want you to think like that. We have money to take care of ourselves. We don’t want you to worry,'” she says.
In addition to the (unnecessary) guilty feeling, some seniors are confused about the process and worry that once they get a reverse mortgage they no longer own the house.
This is just one of many myths that have somehow found their way to certain media. After they get a reverse mortgage, they still have title. They can still do anything they want. A reverse mortgage is simply a lien on the property, just like any traditional or forward mortgage.
Once the homeowner/s dies, the heirs are given the option to pay off the loan and keep the house or sell it to pay off the loan. If the house sells for more than the amount owed, the heirs receive the balance. If the loan is bigger than the loan value, the bank takes the proceeds as partial repayment of the loan, but the balance of the loan does not have to be repaid by the estate or heirs. There is absolutely no personal or estate liability for any deficit.
Reverse mortgages are certainly shedding their bad reputation as costs have come down. In the past, many viewed them as too costly. But they are no different from conventional mortgages in terms of costs, says Peter Bell, president and CEO at the National Reverse Mortgage Lenders Association.
“It’s still going to be accruing interest on the house the same way as a conventional mortgage,” he says. “The question is whether you are going to be making those monthly payments now or let that be paid off later.”
Borrowers also are required to pay for mortgage insurance when they get a reverse mortgage. As with the interest, the mortgage insurance costs are paid with equity. The insurance protects lenders from losses. The FHA insurance also guarantees any monthly payments or draws against a line of credit that the lender is obligated to pay to the borrower/s. Yes…a borrower’s monthly payments and line of credit are protected by the US Government.
Because the homeowner isn’t making monthly payments to cover upfront costs, interest and mortgage insurance, the equity on the house will likely shrink as the loan balance gets bigger over time. Bob says this is “likely” because if the accruing interest and ongoing FHA insurance numbers exceed the appreciation rate of the property, then there is negative amortization. It’s designed that way. Typically the “crossover point” when the reverse mortgage balance exceeds the property value, comes in 15-20 years. If you have a case you are wondering about call Bob and get a free Amortization Schedule on any scenario. Note that payments are certainly allowed and there is no prepayment penalty.
Bob has some clients who determine from their monthly statement what was added to the reverse mortgage balance and they pay that amount. Using this simple method, the reverse mortgage balance does not grow over time. There is no obligation to do that of course, and payments may be made sporadically or regularly. It is always the borrower’s choice.
It’s crucial that seniors receive the required counseling before getting a reverse mortgage. There is a great deal of misinformation out there so search for facts not myths. Bob can send you a document citing the Top 10 Misconceptions and explanations of why they are simply wrong. Fortunately, more and more professionals who influence the financial strategies of our elderly Americans are waking up to the suitable applications of this government program. The myths are losing strength!
A reverse mortgage is not the solution for everybody, but clearly it’s an option for many people and the more accurate information they have, the better they can understand how the product works. Only then can they make an informed decision.