What is a reverse mortgage?
Reverse mortgages are loans you take out against the equity you’ve built up on your home. There are many types of loans based on home equity, one example being Home Equity Lines of Credit (HELOCs). The difference between a reverse mortgage and a HELOC or other equity-based loans is that those loans require you to make loan payments while you’re alive whereas reverse mortgages do not.
In a reverse mortgage, the loan repayment is due only after you pass away. This has the advantage of giving you access to cash without having to worry about monthly repayments, but the disadvantage of potentially reducing the size of the estate you pass on to your heirs.
Reverse mortgages are only available to seniors who are at least age 62, who either own their homes outright or have at least 50% equity in the property. There are several key ways a reverse mortgage will give you access to money.
A lump sum reverse mortgage does exactly what it says; it gives you a large cash infusion at the beginning of the mortgage. That money doesn’t get repaid until you pass away, at which point the loan comes due and your estate is responsible for paying it.
A term-payment reverse mortgage gives you equal payments every month for a set period of time. Once that time period, or term, is over, you won’t get any more money from the reverse mortgage, but you still don’t have to pay it back; the loan will be repaid by your estate or your heirs after you pass away.
A tenure-based reverse mortgage also gives you equal payments, but there’s no set end date. Instead, you’ll keep getting monthly payments as long as you continue to use the home as your primary residence. Once you move or pass away, the payments stop.
Tenure-based loans have a reputation in some circles as being a good chance to outsmart the lender, because if you live long enough the total monthly payments you get will be higher than the loan principal even though your estate or heirs will not have to repay that overage. While that can happen, tenure-based reverse mortgages are calculated based on the idea that you will live to celebrate your 100th birthday. If you do, you will indeed “beat the system,” but only about 1 in 5,000 people live that long.
Line of Credit / Modified
Line of credit reverse mortgages allow you to borrow money against the mortgage when you need it. Because your estate’s repayment will be based on what you actually borrow from the line of credit, this can be a good way to get access to cash when you need it without saddling your home with unnecessary debt. Some reverse mortgages combine lines of credit with term or tenure plans; you get a monthly payment and can borrow more if you need it.
So far, reverse mortgages sound like a sweet deal because you get a loan you never have to repay! But it’s important to remember that reverse mortgages are expensive, and even though you won’t have to repay the principal, they can still cost you money.
Most reverse mortgages have a number of associated fees, some up-front and some ongoing. You will also need to pay mortgage insurance premiums plus interest. While laws limit how much you can be charged for some of those expenses, the resulting bill can still be significant.
It’s also good to consider your estate plan when thinking about getting a reverse mortgage. While it’s true that you won’t have to pay the loan back, your estate will. This often means your home must be sold after you die to service the loan. Or, if your heirs wish to keep your home in the family, they will have to pay the loan off themselves. Reverse mortgages that aren’t carefully considered and structured can leave your heirs with less of an inheritance.
There’s a lot of abuse in the reverse mortgage industry to watch out for as well. People who sell reverse mortgages get commissions when you buy the products they’re selling. This incentivizes them to sell you products whether they’re a good fit or not.
The most common type of abuse I see is when someone has paid off their home, and a salesperson convinces them to take a lump-sum reverse mortgage, then invest that money in a high-commission product such as an annuity.
This will generate a lot of fees for the salesperson and the product originators, but it doesn’t make sense for the investor who transitions from having healthy equity in their home to having not only an expensive loan that has associated fees, but also an investment that carries high fees as well.
All that said, it doesn’t mean reverse mortgages should be avoided entirely; in the right circumstances, they can make sense. For example, if you still owe money on your house and have a lot of money in 401(k)s or IRAs which you are using to make your mortgage payments, a reverse mortgage could be an interesting tool to give yourself a more favorable tax picture by not having to pay capital gains on the money you distribute from your retirement accounts to service your mortgage.
Reverse mortgages can also be useful if you have made retirement planning mistakes such as over-spending, not saving enough, or making assumptions that your retirement accounts would always enjoy high market returns. If you find yourself short on cash in retirement, a reverse mortgage could be a way to help fund your expenses. If you think a reverse mortgage might be right for you, it’s very important to do your homework before making this decision.
Understand the reverse mortgage’s terms.
What is the interest rate? What fees or other costs will you have to pay on a recurring or one-time basis? Will your overall financial situation change for better or worse as a result of the reverse mortgage?
Choosing whether to get a reverse mortgage, and choosing a specific reverse mortgage, is very complicated. Treat a reverse mortgage like you would treat a major medical decision; always get a second opinion! The salesperson has a vested interest in lining their own pockets and those of their employers, and that interest frequently conflicts with your goal of being in the best financial situation possible.
Your second opinion should come from a financial professional who is a fiduciary, which means they are legally and ethically bound to act in your best interest, not theirs or anyone else’s. At Asset Preservation Wealth & Tax, we provide advice targeted at putting our clients in the best possible financial position. We don’t sell reverse mortgages, but routinely advise our clients as to whether or not they’re a good fit for their unique situations.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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