The pros and cons of reverse mortgage

If you're a homeowner entering your retirement age, you've likely come across advertising or messaging relating to reverse mortgages. We've all heard the reverse mortgage pitch: the promise of condition-free cash that you can tap into without worry. But the reality is quite the opposite. 

With all its promises, a reverse mortgage can come with some serious downsides, from high fees to even losing your home. Indeed, reverse mortgages aren't all that bad. If most of your net worth is in your home, reverse mortgages may be an appealing option for you. They have also been one of the only ways that homeowners have been able to tap into their equity to help manage living expenses and maintain a dignified lifestyle into retirement. 

While reverse mortgages may seem like an attractive option, they have some particular downsides that you should be aware of before you sign up for one. If you've been considering one, take time to weigh all the pros and cons first. 

In this blog we dive into:

• Reverse mortgage basics
• Reverse Mortgages in the US
• How reverse mortgages work
• How to qualify for a reverse mortgage
• Pros and cons of reverse mortgages
  

Reverse mortgage basics

We've shared resources on reverse mortgages on our blog, but here is a simple breakdown of a reverse mortgage. To qualify for a reverse mortgage, you must be at least 62 years of age. From there, you must have a certain amount of equity built up in your home, meaning that you have paid down any existing loans or mortgages on your property.  Homeowners who meet these requirements can borrow against their equity to receive a lump sum of tax-free cash from a lender at a specific rate. 

Reverse mortgages are different from other loans or mortgages in that they do not require monthly payments. This means that you make no payments on the principal or any of the accrued interest until you pass away or your successors sell the property.

Reverse mortgages in the US

There are several types of reverse mortgages available to homeowners in the United States. The most popular is a home equity conversion mortgage (HECM). This type of loan is backed by the Federal Housing Administration (FHA). The main feature of this loan is that it allows borrowers to pay an insurance premium to access their FHA-backed loan.

The borrower pays the insurance, and the amounts paid are added to a reserve, which is used to pay back the lender. This is a great failsafe for borrowers, as it protects them from potential foreclosure due to the inability to pay back their FHA-backed HECM. 

How do reverse mortgages work?

A loan that doesn't require monthly payments may raise some alarms. But, it is not unheard of. Some home equity loans or home equity lines of credit (HELOCs) feature no or optional payment structures.

Typically, when you take out a mortgage, your lender provides you with a lump sum amount that you pay back with interest, monthly, over a set period. At the end of the term, your loan is paid down to $0, and the home should be entirely yours. 

Ultimately, a reverse mortgage works in, well, reverse. The lender effectively makes payments to you, which you can choose to receive:

• In a lump sum
• Via monthly payments 
• A line of credit
• Or a combination of those three options. 
  

Beyond the principal loan amount, any interest or fees connected to the loan are rolled into the balance month over month. Since your lender provides you with payments, the amount you owe back grows over time, and your overall home equity decreases. Despite running down your ownership in the home over time, you keep the title, and the balance of the mortgage is not due until you move out, die, or if your heirs sell the home. 

When that time comes, any proceeds from the home sale are used to pay the balance. The remaining home equity is handed to the estate. If the loan is worth more than the house, any survivors or heirs must pay the difference. 

There is also an opportunity to pay off the reverse mortgage or refinance if they want to keep the property in the family.

How do I qualify for a reverse mortgage?

To be considered for a HECM, homeowners must meet specific criteria: 

• You must be 62 years of age or older. 
• You are required to go through a credit check and other eligibility checkpoints.
• The home must be your principal residence.
• You must own the dwelling outright or have significantly paid down your original mortgage. You must be up-to-date on property taxes, insurance, and any homeowners association (HOA) fees (where applicable) 
• You cannot be delinquent on any other federal debt.
  

If you meet all the above requirements and are approved for a reverse mortgage via the FHA, you must also attend a U.S. Department of Housing and Urban Development (HUD) counseling session. These sessions are administered by an approved HECM counselor who will go over any potential risks and vital information you need to know before committing to a reverse mortgage. The session requirement may be waived depending on if you meet specific criteria.

Pros of a Reverse Mortgage

If you're struggling to keep afloat of payments, steady your income post-retirement, or are looking to pay down some significant, unexpected expenses, a reverse mortgage may be a fit.

Here are some benefits to committing to a reverse mortgage. 
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1. Stay in your home

When people run into financial troubles, they first liquidate their assets to free up cash. The most significant investment that many people own is their home. Reverse mortgages allow you to stay in your home without selling to access the capital you need to live your life. This can mean you don't have to worry about getting priced out of your neighborhood or having to downsize. 

Sadly, it comes at a price: loss of ownership and erosion of your equity. Other providers and loans allow you to stay in your home and won't erode or take any of your hard-earned equity.
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2. Helps secure your retirement

Reverse mortgages could be an ideal loan for retirees who may not have investments or cash savings but have a large amount of equity locked in their homes.  A reverse mortgage allows homeowners to take an illiquid asset and turn it into cash. You can use the money for whatever your needs may be at that moment, including retirement.
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3. You reduce your tax liability‍

The IRS views any money from a reverse mortgage as a loan advance vs. actual income. That means the funds are tax-exempt, and you will not pay taxes on any amounts you withdraw, unlike other retirement income such as distributions from an IRA or 401(k).

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Cons of a reverse mortgage

While there may be some benefits to taking on a reverse mortgage, there are definite risks. Here are a few to consider before signing on the dotted line.
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1. It comes at a price 

 While reverse mortgages tout a "payment-free" structure, along with the above ongoing costs, there are plenty of other fees associated with a loan of this nature.  

When you commit to a reverse mortgage, you're signing up to three ongoing and significant costs, from your own pocket, including:

• Purchasing homeowners insurance, typically at 2% of your home's appraised value. 
• Maintaining the dwelling to a certain standard.
• Ensuring property taxes, HOA fees, etc., are paid and up-to-date.
  

You can also roll all of these costs into your loan balance, but that results in you receiving less money. These things can be pretty costly, especially if your property taxes rise or you need to make extensive repairs such as foundation underpinning.

The reverse mortgage will immediately become due if you cannot keep up with those costs. If you fail to pay, which happens to many people, you'll risk foreclosure and the loss of your biggest asset to pay off the balance. Reverse mortgages may seem convenient, but a lot is at stake. Not being able to keep up with expenditures is one of the main reasons people lose their homes. It's also one of the primary reasons financial experts warn homeowners about when discussing the disadvantages of a reverse mortgage.  Make sure you read the fine print before you sign. 
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2. There is a risk of foreclosure

To qualify for a reverse mortgage, you're required to live inside the home as your principal residence for the better part of a calendar year.

If at any point during the loan period you become delinquent on any of the fees, taxes, expenses, or even if you spend the majority of the year living outside the property, you could default on the loan resulting in foreclosure.

3. Your survivors and heirs could receive less 

We all know that homeownership is a fundamental way to build generational wealth. A reverse mortgage is the opposite of this. You must sell your home to repay the debt to pay a reverse mortgage back. Upon your passing, any survivors or heirs will be required to pay the entire loan balance, or 95% of the property's appraised value, whichever is less. Unless you have that amount available in cash, it usually means selling or turning the property over to the lender to fulfill the debt terms.

A reverse mortgage also eats away at your hard-earned equity. By the time the debt is due, you may not even have any equity left to pass on to your heirs. 

4. It may impact other retirement benefits

While the IRS does not require any money you receive via a reverse mortgage to be taxed, it could still end up impacting you in other ways. Chiefly among this is your ability to qualify for other government programs, including Medicaid or Supplemental Security Income (SSI).  Make sure you chat with your lender or review the terms before signing to ensure that your eligibility is not compromised by committing to a reverse mortgage.

5. Reverse Mortgages can create headaches for your spouse if they are not named on the loan

If you've taken a reverse mortgage out alone, without including your spouse, things can get complicated. A spouse will not be included on a reverse mortgage if they are not yet of age to qualify (62 years of age or older) or if you have gotten married later on in life.  Whatever the reason, if they are not a co-borrower and you pass first, things can become difficult for your surviving spouse.

If you're still receiving payments from the reverse mortgage, these will stop coming. Your spouse will now have to find ways to make ends meet with what they have saved or find other sources of income. Suppose you are a homeowner who took a HECM reverse mortgage out after August 4th, 2014. In that case, your spouse may be allowed to continue living in the home if they can meet specific initial requirements and commit to meeting any ongoing obligations. They will not be required to make any additional payments on the loan.  For any HECM taken out before August 4th, 2014, or for proprietary reverse mortgages, there is no requirement that your spouse is allowed to stay in the home. Depending on the terms of the loan, the spouse may even be kicked out so that the lender can sell the house to satisfy the loan.

6. Reverse mortgages can be outlived

There are several ways that a reverse mortgage can be paid out to a borrower: a lump sum, through ongoing payments over a set period, or as a line of credit to draw on as needed. The funds from a reverse mortgage can sustain you for a long time, but not forever. There is a chance that you may outlive your reverse mortgage. The likelihood increases if you:

• Take out the reverse mortgage at a younger age
• Live a long time
• Take out a lump sum of cash against your house and don't manage your money well
  

This is especially important to remember. By tapping into your reverse mortgage early and not being mindful of your expenditures, not only will you be out of a source of income, but you will likely be less able to work. You may also have more expenses, including healthcare and more.  If you're not able to keep up with the ongoing expenses, and if you've already depleted your reverse mortgage funds, you risk losing your home to foreclosure. 

7. Reverse mortgages are complex 

Reverse mortgages come with many stipulations. Often, these aren't clearly articulated. This means that unless you know what to look for or ask before you sign, you may not get the complete picture of your commitment.  These loans come with many risks that may not be worth the cash you receive. There are many other loans that don't put the owner in a disadvantageous position. 

A reverse mortgage is not your only choice

Depending on your situation, reverse mortgages may work for you. Despite all their promises, there are many pitfalls to consider before committing to anything, hence why many people caution against them.  If you're looking for a way to live flexibly in retirement, pay off debt or make significant investments, a reverse mortgage is not your only option. 

Solutions such a Fraction Mortgage could give you access to the cash you need at a fairer and more reasonable rate.  When you apply for a Fraction Mortgage, you choose when and how you pay. We offer optional monthly payments* and no prepayment penalties. To learn more about the Fraction Mortgage, contact us today.