What You Need to Know About Reverse Mortgages
A reverse mortgage can really turn things around for seniors who are struggling to get by. But, when does (and doesn't) it make sense to cash in on your home equity?
As one of my friends puts it, "There's nothing worse than being old -- except being old and being broke."
It's a simple fact: As we live longer, we may find ourselves outliving our savings accounts. Pensions and social security often don't keep up with inflation, and then there are the kids who need help, the new roof, the prescriptions not covered by medical insurance, and all those other expenses that keep coming long after a regular paycheck has stopped fattening the savings account every month.
Many seniors make daily sacrifices to live within a limited budget while sitting on a large amount of equity in their home. For the right situation, a reverse mortgage, also known as a home equity conversion mortgage (HECM), is a safe way to tap into that equity and supplement a monthly budget.
On the Rise
In recent years, the reverse mortgage market has grown 500 percent. Just under 8,000 applications were taken in 2001, but 43,000 applications were taken in 2005. Wow. Even more amazing is the number of seniors eligible for RMs. Anyone over 62 with equity in a home is eligible. There are more than 20 million potential applicants out there according to AARP, and that number is growing, because we just can't stop getting older. But like the joke says, getting old is not a bad option, considering the alternative.
Source: O'Brien Group Mortgage Consultants and AARP
A reverse mortgage is a loan that lets you convert part of the equity you have in your home into income. This is similar to a standard mortgage, but with a reverse mortgage you don't need an income to qualify and there are no monthly loan payments. Because you retain title to your home, you remain responsible for property taxes, insurance, utilities, maintenance, and other expenses. When you sell your home or no longer use it for your primary residence, you or your estate repay the cash you received from the reverse mortgage, plus interest and other fees, to the lender. The remaining equity in your home, if any, belongs to you or to your heirs.
Before I made an effort to research this new hot topic, what I didn't know about reverse mortgages could have filled an encyclopedia, and I call myself a mortgage banker. After my research, I went from thinking of RMs as a last-resort loan for desperate borrowers to seeing them as a helpful financial tool. I even recommended a reverse mortgage to one of my dear friends. For the right person, a reverse mortgage can be a life-changing godsend. But don't jump in without doing your research. As with any major financial decision, it is important to learn all the facts before signing on the dotted line.
Show me the numbers
CAUTION: The ever-changing finance and real estate markets might make your situation very different from the examples in this article -- better or worse. And by the time you pursue a reverse mortgage, details might be different yet again. So, don't assume anything -- get your specific facts together and talk with reputable, established companies. And be prepared to walk away from a bad deal. -- Editor
Let's look at how a reverse mortgage works. It helps to review the math on a regular real estate loan, because they are similar in many ways. A standard fixed-rate loan is a lump sum advanced from a bank to you, the borrower, secured against your home. You agree to pay the loan back over time, and payments are based on the size of the loan, the rate, and the term. The bank charges you interest on the outstanding balance. The longer the term, the lower the payment, but the more interest you pay.
If I exaggerate the terms, it is easier to understand. For instance, if the bank lends you $100,000 at six percent for one month, your one and only payment would be $100,500. That's your $100,000 principal, plus the interest due. If you borrow the money for a term of two months, you'd owe two payments of $50,375. In contrast, if you borrow that same $100,000 for 100 years, your payments would only be $501 per month, but at the end of 100 years you would have paid more than $500,000 in interest.
With a reverse loan, the bank pays you the money and the debt grows as it is disbursed. Like a regular mortgage, the longer the term, the lower your payment, because there will be more interest accrued on the balance over time. In the above example, you could theoretically take a $500 payment for a long time, or a much larger payment for a shorter time. The more equity you have in your house, the longer you can receive a payment from the bank. It also helps to be older -- the minimum age for a reverse mortgage is 62, but the older you are, the more you can borrow.
There are two basic options: You can take fixed monthly payments with a defined term, (like $1000 a month for 15 years, for example) or a lump-sum dispersal. The longer the term, the less money you get each month.
A common misunderstanding is that the payments will continue forever, or until the borrower dies. That's partially true -- the payments do stop if the borrower passes away, but the payments will also stop after a predetermined amount of time. One of the uncomfortable questions you must ask is, how long do you think you will need the money?
Regardless of the terms, however, you will never have to make a payment or pay off the loan as long as you (or a surviving spouse) occupy the property as your primary residence. The payments might stop, but you won't be forced to move or sell. However, even though the payments stop, the loan will continue to accrue interest until the day it is finally paid off.
Let's look at my friend and her situation. Marge is 77, owns a home in San Diego worth about $600,000 with $100,000 owed on the mortgage. She would like to fix up her house, spoil the grandchildren, and travel.
Right now, Marge receives about $2,000 per month in retirement benefits. Her mortgage payment is $1,000 per month. After making her mortgage payment she has $1,000 per month to pay for all her other expenses. After working up a budget, she found she really needs about $3,000 a month to maintain the lifestyle to which she has grown accustomed. Marge is a perfect candidate for a reverse mortgage.
Isn't it risky to put myself into debt when I live on a fixed income?
There are certainly things to look out for; but in general the answer is "not usually." Think of it this way: When you bought your home, you depended on money you didn't yet have to pay off the loan (your income). With a reverse mortgage, the loan is paid by money you already have (the value of your home). The lender cannot require more than that. You could think of it as a loan that has already been paid.
California Department of Real Estate, http://www.dre.cahwnet.gov/consumers_sub.htm
I ran Marge's numbers into the actuarial calculator, the engine behind all reverse mortgages. The calculator tells me how much money she can take in a lump sum or in monthly installments. The calculations are based on her age, the amount of equity in her home, the interest rate, and how long she wants to get the money.
I found Marge could take out $1,500 per month for 10 years before her payments would stop. Or, she could choose a one-time disbursement of $200,000. If she takes the $200,000 and puts it in the bank, she can withdraw $1,500 per month for 133 months (just over 11 years) while earning interest on the balance. Either way, she doesn't have to make monthly mortgage payments which increases her bottom line by $1,000, and she receives $1,500 per month from the reverse mortgage, so her net gain is $2,500 per month. Marge would go from having $1,000 per month to spend, which just barely makes ends meet, to having $3,500 per month to live on.
At this point, Marge is trying to decide between the lump-sum disbursement (which gives her a little more money and control of the asset) and the monthly payments. Which is better? In my opinion, the only hazard to taking the lump sum over the monthly installments is the risk of losing it. I would hate to see Marge make a mistake down the road and lose the money in a bad investment, or get talked out of it by a needy relative. But even a catastrophic loss like that wouldn't be the end of the world. As long as Marge lives in the property, she never has to make a payment on the loan or pay the money back.
The programs are designed to be very conservative so the borrower will never end up owing more on the house than the house is worth. Most of the scenarios we evaluate never exceed 50-60 percent of the value of the home. In Marge’s case, the projected value of her home in 10 years will be $900,000 and the total debt will be $500,000. That means that after 10 years, she can sell the home or leave it to her children and it will still have about $400,000 of equity left.
Not for everyone
A reverse mortgage is not for those who want to leave a free and clear house to their children. I have one client whose own parents left him nothing but debt and problems, and he refuses to use any equity to supplement his monthly income because he wants to leave the house debt-free to his own children. Both of his kids are financially sound and don't need money from their father's estate. They have pleaded with him to look after his own happiness now, but he is stubborn and so he finds a way to scrimp and sacrifice while trying to get by on less than $700 a month. He's a perfect candidate for a reverse mortgage, so I hope he changes his mind.
A reverse mortgage is for folks who are going to stay in their house for a long time. If you are considering moving in the near future, a reverse mortgage is not right for you. Also, consider what might happen if your spouse either dies or goes to an assisted living community. Would you stay in the home? If not, you might not want to take out a reverse mortgage, because it must be paid back once both borrowers move out. Reverse mortgage funds are not taxable, but they may count against government assistance programs. Don’t give up $500 a month in assistance to get $500 from a reverse mortgage.
As a banker, my biggest fear is that I will fund a lump sum reverse mortgage for one of my clients, only to find they later lose the money. That's why, in most cases, I prefer the monthly payments or the line of credit rather than a lump sum disbursal. There can be a lot of pressure from relatives or friends to "invest", but a Senior should not put the proceeds from a reverse mortgage at risk in the market or lend it to relatives. Resist the urge to part with money for any reason other than your own benefit. A vacation? Yes! A new car for Junior? No way.
If you are interested in a reverse mortgage, make sure you deal with a reputable, experienced organization. Be prepared to take notes during your meeting, and make a list of questions. (Believe me, you need to bring food and water with you when you sit down to learn about these loans for the first time.)
Be sure to ask how much you can get in a lump sum disbursement, in monthly payments, a line of credit, or a combination of these. Ask about the difference in rates between the programs and how it affects the amount you can borrow. Compare the closing costs of the different loan programs, and ask how much the lender is charging for each loan. Closing costs can take a bite out of your proceeds, so make sure you look closely at an itemized breakdown of closing costs. Ask which fees are charged by the lender, and which fees are charged by others. The lender fees may be negotiable. Fortunately, competition is driving the costs of these mortgages down, but different lenders may charge different fees.
If possible, involve another trusted member of your family, especially if you have children who are helping with your financial planning. Look at all your options, and discuss them with your loan officer. After you decide on a reverse mortgage, you will be contacted by an independent, certified counselor to make sure you understand the process. This extra step really protects the borrower from making mistakes. After you have all the facts, it will be clear whether a reverse mortgage is right for you.