Older homeowners who want to tap the equity in their homes typically have three options. They can sell their house and downsize, take out a home equity loan or get a reverse mortgage.
Retirees who want to stay in their homes sometimes take out reverse mortgages if they are having trouble making mortgage payments or have no other funds to pay expenses.
Some financial institutions market reverse mortgages as an easy, cost-free way for retirees to pay for expensive lifestyles or risky investments. This decision can jeopardize their financial futures.
If you’re thinking about a reverse mortgage, weigh your options carefully. And if you do get a reverse mortgage, be sure to use the loan prudently.
What Is a Reverse Mortgage?
A reverse mortgage is an interest-bearing loan secured by a home’s equity. To be eligible, in most cases, you must own your home and be 62 or older.
Like a home equity loan, a reverse mortgage allows you to convert your home equity to cash to use for any purpose—even to buy a new home. With a reverse mortgage, you make no interest or principal payments during the life of loan. Instead, the interest is added to the principal, which is why reverse mortgages are often called "rising debt" loans. Unless you opt for a fixed-term loan, the loan is due when you die, sell your home to move or leave your home for more than 12 months—to enter a nursing home, for example.
If any of those events occur, you or your heirs must repay the loan, including compounded interest, in full. Normally, that means the house must be sold, and the loan will be repaid from the proceeds of the sale.
Since interest accrues during the life of the loan, you may owe more than you borrowed. And if home values have fallen or you live longer than expected, you may even owe more than your house is worth. But since reverse mortgages are non-recourse loans, the lender cannot go after your other assets.
4 Facts About Reverse Mortgages
1. Reverse mortgages may seem like "free money," but in fact, they are quite expensive. Interest rates are generally higher than traditional mortgages and home equity loans. Fees and costs are often much higher, too—sometimes up to 8 percent of the total loan amount.
2. Reverse mortgages must be the primary mortgage on your home, so if you have a second mortgage, you will have to borrow enough to pay that off, too. That may also reduce the amount of cash left for you to use.
3. As the owner of your home, you must still pay for property taxes, insurance and home maintenance. If you cannot meet these obligations, the lender may foreclose on your home, leaving you with no place to live and no home equity to draw on.
4. If you want or need to move into a smaller home or an assisted living facility, your loan will come due. With compounded interest, you may owe more than you expect, which may restrict your future housing choices.
Using Your Loan Wisely
Taking out a reverse mortgage is a very serious decision. For many borrowers, a reverse mortgage is a last-resort way to secure additional monthly income in retirement. Whether it’s the right decision for you depends on several factors:
• Your health, as well as your spouse's.
• Other sources of income.
• The reason you're tapping your home equity.
• Your timing.
• How wisely you use your loan proceeds.
Unfortunately, some financial professionals who profit from selling reverse mortgages aggressively urge homeowners to obtain them to take dream vacations, buy a second home, or invest in risky or illiquid investments. And the person who sells the mortgage may also profit from the sale of the investment, giving them twice the incentive to talk you into a loan you may not need.
When you get a reverse mortgage, you have several options for receiving the funds. You can take a lump-sum payment, set up a line of credit or set up regular periodic payments. Depending on the lender, you may also be able to set up a combination of these options. For example, you may decide to get a portion of the loan amount in monthly payments and leave the remainder as a line of credit that you can use for unexpected expenses.
Whichever you choose, make sure you use your loan wisely. Even though you don't have to pay it back as long as you live in your home, don’t treat it as "mad money." After all, you may need your home equity some day for something far more pressing than a vacation, only to find that it has already been spent.
If you’re approached by a financial professional to get a reverse mortgage to fund a particular investment, remember that all investments carry risk and costs—and the higher the promised return, the higher the risk. It's best to steer clear of risky investments as well as those that make it expensive, if not impossible, for you to access your money if unexpected expenses arise.
The Bottom Line
Reverse mortgages can be a useful tool for certain older Americans who might otherwise lose their homes. But for anyone else, they are an expensive option that may prematurely deplete home equity.
Homeowners should consider all the risks and explore all of their options before taking out a reverse mortgage, and even then, should use the loan funds wisely.
FINRA: Six Tips When Considering a Reverse Mortgage
U.S. Department of Housing and Urban Development: Reverse Mortgages for Seniors
U.S. Department of Housing and Urban Development: Fact Sheet about SAVER Loans
Gerri Walsh is Senior Vice President of Investor Education at the Financial Industry Regulatory Authority (FINRA).
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