EDITOR'S NOTE: This article was originally published in the September 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.
Get a large wad of cash! Never make a mortgage payment again! Stay in your home as long as you want! Sounds like a great deal, right? Well, for some older homeowners, it can be. For others, it's more perilous than promising. We're talking about a reverse mortgage, and if you’re considering one, there’s a lot you need to know before signing on the dotted line. This Q&A will help clarify how this complex transaction works.
What is a reverse mortgage? It's a loan on your house that lets you tap your home's equity. Like a cash advance, a bank fronts you the money -- either as a lump sum, a line of credit or monthly draws -- and you have to repay it eventually, with interest.
Unlike a traditional mortgage, you don't have to repay the loan during the term of the reverse mortgage. Instead, you pay it off all at once at the end of the loan. There are no income or credit qualifications, but homeowners must be 62 or older.
You retain title and ownership of your house. You are still responsible for paying the property taxes and the costs of insurance and repairs. If you still have a regular mortgage, you either have to pay it off before taking the reverse mortgage or use part of the proceeds from the reverse mortgage to retire it.
In this article, we'll focus on the most popular reverse mortgage: the Home Equity Conversion Mortgage, or HECM, which is insured by the Federal Housing Administration. Until the credit crunch, private reverse mortgages were also available. For now, lenders are not offering them.
When must the money be repaid? The money does not have to be paid back as long as the homeowner remains in the house and keeps up with taxes, insurance and repairs. Generally, repayment is triggered when the homeowner dies, sells the house or moves out for 12 months or more. If a couple owns the home and one spouse dies, the surviving spouse can stay in the home without having to pay back the loan until he or she dies, sells or moves out for 12 months.
When it’s time to repay the loan, you or your estate will pay the principal you tapped and the accrued interest. Be aware that the interest expense can accumulate mightily. If you take out the loan in your sixties and stay in your house until your eighties, the interest owed on the loan could be much greater than the principal amount you took out. After the loan is paid off, there could be little or no equity left to use, say, for a move to assisted living.
However, HECMs' "non recourse" feature means you never have to pay back more than the house is worth at the time of sale. If the debt exceeds the sales price, the insurance covers the shortfall.
As for taxes, because the reverse mortgage is a loan, the money you receive is not taxable income. But you can't deduct the interest on your tax return each year. In the year the loan is paid off, you or your estate can write off at least part of the interest (see IRS Publication 936, Home Mortgage Interest Deduction).
Can my heirs keep the house? Sure, if they pay off the reverse mortgage. If the debt is more than the house is worth, though, the heirs would have to come up with the difference. The insurance that covers such a shortfall only kicks in if the house is sold.
If your heirs decide to sell the house, they have at least six months to do so. "That can be extended to 12 months with a written request," says Eric Bachman, founder of Golden Gateway Financial, a reverse-mortgage broker in Oakland, Cal. If the heirs sell the house and money is left over after the reverse mortgage is paid off, they will inherit that cash.
How do I get the money from a reverse mortgage? You can take a lump sum, open a line of credit to tap whenever you choose or receive monthly payouts (either for a set number of months or for as long as you live in the house). Or you can choose a combination of those options -- say, a lump sum for part of the mortgage with the remainder in a line of credit.
"If all else is equal, the line of credit is more advantageous. You use it when you need it," says James Joseph, vice-president of Financial Services Advisory, in Rockville, Md. The money that's not tapped won't rack up interest. The unused portion also grows larger over time, generally at the same rate as the loan's interest rate. Unlike a home equity line of credit, which can be reduced or frozen by a lender, a reverse mortgage line of credit is safe, thanks to the FHA insurance.
Interest rates recently ranged from 5% to 6%, depending on the lender, the payout option and type of rate. A fixed rate is typically only available if you take a lump sum, which could be suitable to lock in costs for those who want to use all of the money at once. A line of credit or monthly payout comes with an adjustable rate, which can change monthly or yearly.
Are there non-interest costs? There is an origination fee, which is 2% on the initial $200,000 loan and 1% on the balance, with a cap of $6,000. (This cap will be adjusted for inflation.) You'll also pay closing costs, such as title insurance and recording fees, that will likely run several thousand dollars.
You must also pay insurance premiums. The FHA insurance guarantees that you will receive your money and that the lender later receives its money. You'll be charged an upfront premium of 2% of the home value (or the lending limit, whichever is less) plus an annual 0.5% premium of the mortgage balance.
Finally, the lender sets up what's known as the "servicing fee set aside." This is a pool of your money that the lender sets aside to ensure the loan's servicing fee, which typically is $30 to $35 a month, will be paid for.
Drew Tignanelli, president of The Financial Consulate, in Hunt Valley, Md., says these costs could run upward of 10% of the loan. If you have a short-term need for the cash or you plan to move within the next five years, consider other options. Alternatives might include a home equity loan, a home equity line of credit, or selling the house and buying a cheaper one.
It pays to shop around. Fees set by the government won't vary, but some costs, such as the interest rate and the monthly servicing fee, can differ by lender. Compare reverse mortgages from at least three lenders. Lenders will issue you a "total annual loan cost," or TALC, for each option to help you compare costs.
How much equity can I tap? That's based on a calculation that factors in your age, the interest rate and the value of your home. The older you are, the lower the interest rate and the higher the house value, the more money you'll be able to tap.
There is a limit on the amount of home value that can be taken into account for HECMs: $625,500 until the end of 2009. So if your home appraises for $1 million, a HECM will cap the home value in the calculation at $625,500. (That limit is scheduled to fall to $417,000 in 2010.)
You can't tap 100% of your equity. The calculation leaves plenty of room for accrued interest. Instead, you get a portion of the equity in your home and you pay interest on that, says Joseph.
A reverse mortgage must be set up at the maximum amount the homeowner is eligible to receive, says Rick Harper, vice-president of program services for the Consumer Credit Counseling Service of San Francisco. For example, if you qualify for $250,000 in loan proceeds, you can't just set up a loan for $50,000. In this situation, Harper says, you could choose the line of credit option, which will let you tap $50,000 now and keep the remainder in the line for future use. If you truly only need $50,000, your best option may be to find an alternative to a reverse mortgage because many of the fees are based on the maximum loan amount.
Reverse mortgages can be refinanced. You will pay loan costs for the new reverse mortgage, which will pay off the old reverse mortgage.
Do consumers have any protections? You can back out of the loan within three days of signing the paperwork. "It's a three-day cooling-off period," says Jeff Lewis, chairman of reverse-mortgage lender Generation Mortgage. Ask if you can repay the reverse mortgage early without penalty -- usually you can.
The government requires borrowers to attend a counseling session, either in person or over the phone. The counselor will explain how the reverse mortgage works, including the costs.
Your lender will likely provide you with a list of counselors approved by the Department of Housing and Urban Development, but the lender should not direct you to a specific one. You can find a counselor on your own; HUD (www.hud.gov; 800-569-4287) can help direct you to approved counselors in your area.
How do I know if a reverse mortgage is right for me? Reverse mortgages are generally a last resort for seniors who have no other option to cover expenses. Think about what you plan to do with the proceeds. For instance, a reverse mortgage might be a good fit for a senior who wants to age in place, with the loan proceeds paying for home health care, instead of moving to assisted living, says D. Steve Boland, a senior vice-president at Bank of America.
Where can I get more information? Start your research with these organizations: HUD (www.hud.gov/buying/rvrsmort.cfm), the National Council on Aging (www.ncoa.org/reversemortgagecounseling) and AARP (www.aarp.org/revmort). Try out a reverse-mortgage calculator to get an estimate of costs and loan proceeds. Find online calculators at AARP's Web site and at Golden Gateway Financial's site (www.goldengateway.com).