EDITOR'S NOTE: This article was originally published in the September 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.
Reverse mortgages were once considered a last-resort option for cash-strapped seniors in their late seventies and eighties. Now many recession-battered baby boomers are looking to these loans to shore up savings and pay off credit cards and other debt. New products -- in particular, fixed-rate lump-sum loans -- are a big lure.
But while the shifting landscape offers opportunities for younger borrowers, it also poses risks. Over time, these large loans could devour home equity, leaving borrowers short on cash in their later years. "It's very important that people think strategically and ensure they aren't just solving immediate problems," says Barbara Stucki, vice-president of home equity initiatives for the National Council on Aging.
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A reverse mortgage lets you tap your home equity in the form of a lump sum, line of credit or monthly draws. Applicants must be 62 or older, and there are no income or credit requirements. The loan does not have to be repaid until the homeowner dies, sells the house or moves out for at least 12 months.
Nearly all reverse mortgages are insured by the Federal Housing Administration. With the Home Equity Conversion Mortgage, the government pays the lender if the house sells for less than the loan's balance. When the loan comes due, the homeowner will never owe more than what the home is worth. Any leftover equity will go to the homeowner or to the heirs.
Consumers can choose between two types of reverse mortgages: the HECM Saver and the HECM Standard. One of the downsides of reverse mortgages had been their large upfront fees. But the Saver, launched in October 2010, charges just 0.01% for an upfront mortgage insurance premium. The Standard charges 2%. Both have an annual 1.25% premium.
However, the Saver offers a lower loan amount than the Standard. Depending on one’s age, a Saver borrower will receive 51% to 61% of the home’s appraised value or of the FHA loan limit of $625,500, whichever is lower. The Standard’s loan amount ranges from 62% to 77%. With both products, the older the homeowner, the more money he or she can borrow.
Historically, most consumers, many of them widows, took reverse mortgages as monthly draws or a line of credit. "The money was used to supplement income," says Stucki.
Although lenders were allowed to offer lump-sum loans in the past, few lenders offered them. That switched in 2008 when new federal rules changed how lenders could structure lump-sum loans, boosting the demand in the secondary market. Plus, many lenders have slashed fees on fixed-rate lump-sum products. Today, 68% of reverse mortgages are taken as fixed-rate lump-sum loans compared with less than 3% in 2008, according to a report by the new federal Consumer Financial Protection Bureau.
The large payouts have lured younger homeowners. By 2010, 21% of the seniors in reverse mortgage counseling were 62 to 64, compared with 6% of borrowers in 1999, according to a study by the MetLife Mature Market Institute and the National Council on Aging.
The Pitfalls for Younger Borrowers
But younger borrowers taking lump-sum loans could lead to big problems. In 10 or 20 years, with the compounding of interest, little or no home equity could remain. Many borrowers may not be able to raise enough funds from a home sale to move to a retirement community or an assisted-living facility. Or they could run into trouble if they're short on cash for health expenses, home repairs or property taxes in later years -- traditional uses of late-in-life reverse mortgages. "There may be some folks who will struggle," says Megan Thibos, a policy analyst at the Consumer Financial Protection Bureau and author of its report.
For extra cash, a borrower could refinance the existing reverse mortgage, says Peter Bell, president of the National Reverse Mortgage Lenders Association. But more money may be available only if the home value rises or interest rates drop. The borrower's older age would help provide a boost.
Besides wanting the payout, many younger borrowers are choosing a lump sum because it offers a fixed interest rate. The line of credit and monthly-draw options require an adjustable rate, which generally comes with a 10% cap.
According to All Reverse Mortgage's online calculator, a 62-year-old borrower with a $400,000 home could take a fixed-rate Standard loan with no fees at an interest rate of 4.99% and get a lump sum of $250,000. After nearly $12,000 in fees are wrapped in the loan amount, the same borrower could get a credit line of $238,050 at an initial adjustable 2.48% rate.
But while a fixed-rate loan may be fine for a regular mortgage, the interest on a reverse mortgage eats into home equity. With a fixed-rate reverse mortgage, the lump-sum loan starts accruing interest from the start. On the $250,000 lump-sum example above, in ten years that balance will climb to $465,841. Assuming 3% home price appreciation, that would leave about $72,000 in equity based on the home's $537,566 value. In 20 years, the loan balance would reach $868,031, exceeding the home's $722,444 value.
Borrowers may be better off with the adjustable-rate loan and its flexible payout. With the line of credit, you only accrue interest on the amount you tap. Any unused amount grows at the loan's rate.
Let's say the borrower above takes $12,000 a year from the credit line. After ten years, even with the fees, the loan balance grows to $164,824, and after 20 years, it reaches $385,309. Assuming 3% home price appreciation, the borrower is likely to have a significant amount of equity left when the loan comes due.
A borrower must pay off an existing mortgage when taking out a reverse mortgage and can use the proceeds to do so. Younger borrowers are more likely than older borrowers to have a traditional mortgage and many are considering a reverse mortgage to pay off an existing loan, according to the MetLife study. But while you'll be released from monthly mortgage payments, you haven't reduced your debt, says Stucki. "You're really just transferring the existing forward mortgage into the reverse mortgage," she says. "You are deferring the date it has to be paid until you move."
The consumer bureau's report also notes that some homeowners, who may not have needed all of the borrowed money, may be tempted to invest part of the proceeds. They could be earning less on the money than the interest they are paying on their loans, and would be better off with a line of credit.
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