The Reverse Mortgage: A Retirement Tool

If you own your own home and are at least 62 years of age, a reverse mortgage provides an opportunity to convert your home equity into cash. In the most basic terms, the reverse mortgage allows you to take out a loan against the equity in your home, but you don't have to repay the loan during your lifetime as long as you are living in the home and have not sold it. If you want to increase the amount of money available to fund your retirement, but don't like the idea of making payments on a loan, a reverse mortgage is an option worth considering. (For more, read Is A Reverse Mortgage Right For You?)

With a reverse mortgage, a lender makes payments to the homeowner based on a percentage of the value in the home. When the homeowner dies or moves out of the property, one of three things can happen: (1) The homeowner or his/her heirs can sell the home to pay off the loan' (2) the homeowner or heirs can refinance the existing loan to keep the home;  or (3) the lender can be authorized to sell the home to settle the loan balance.

While there are several types of reverse mortgages, including those offered by private lenders, they generally share the following features:

• Older homeowners are offered larger loan amounts than younger homeowners. More expensive homes qualify for larger loans.
• A reverse mortgage must be the primary debt against the house. Other lenders must be repaid or agree to subordinate their loans to the primary mortgage holder.
• Financing fees can be included in the cost of the loan.
• The lender can request repayment in the event that the homeowner fails to maintain the property, fails to keep the property insured, fails to pay its  property taxes, declares bankruptcy, abandons the property, or commits fraud. The lender may also request repayment if the home is condemned or if the homeowner adds a new owner to the property's title, sublets all or part of the property, changes the property's zoning classification, or takes out additional loans against the property.

Reverse mortgages have been around since the 1960s, but the most common reverse mortgage is a federally-insured home equity conversion mortgage (HECM). These mortgages were first offered in 1989 and are provided by the U.S. Department of Housing and Urban Development (HUD).

HECMs are the only reverse mortgages issued by the federal government, which limits the costs to borrowers and guarantees that lenders will meet the obligations. The primary drawback to HECMs is that the maximum loan amount is limited.

Non-HECM reverse mortgages are available from a variety of lending institutions. The primary advantage of these reverse mortgages is that they offer loans in amounts that are higher than the HEMC limit. One of the drawbacks of non-HECM loans is that they are not federally insured and can be significantly more expensive than HECM loans.

Although the interest rate on an HECM mortgage is set by the government, and the origination cost of an HECM loan is limited to 2% of the value of the home, the total cost of the loan can still vary by lender. Furthermore, in looking for a lender, borrowers must consider third-party closing costs, mortgage insurance and the servicing fee.

To assist borrowers in comparing mortgage costs, the federal Truth in Lending Act requires mortgage providers to present borrowers with a cost disclosure in the form of the total annual loan cost (TALC). Use this number when comparing loans from different vendors; just keep in mind that the actual costs of a reverse mortgage will depend largely on the income options selected

HECM reverse mortgages provide the widest variety of income-generating options, including lump-sum payouts, credit lines, monthly cash advances, or any combination of these.

The credit line is perhaps the most interesting feature of an HECM loan because the amount of money available to the borrower increases over time by the amount of interest. Non-HECM loans offer fewer income options. (For other home-financing options, read Home-Equity Loans: What You Need to Know.)

The interest rate on HECM reverse mortgages is tied to the one-year U.S. Treasury security rate. Borrowers have the option to select an interest rate that can change every year or one that can change every month. A yearly adjustable rate changes by the same rate as any increase or decrease in the one-year U.S. Treasury security rate. This annual adjustable rate is capped at 2% per year or 5% over the life of the loan. A monthly adjustable rate mortgage (ARM) begins with a lower interest rate than the ARM and adjusts each month. It can move up or down 10% over the life of the loan. (To learn more about ARMs, see ARMed and Dangerous.)

Almost half of seniors age 70 and older who have a credit card don’t pay off their balance in full each month, but reverse mortgages can help with that problem. In “How Home Equity Extraction and Reverse Mortgages Affect the Credit Outcomes of Senior Households,” a working paper funded by the US Social Security Administration and published in September 2016 by the Michigan Retirement Research Center of the University of Michigan, researchers Stephanie Moulton, Donald Haurin, Samuel Dodini and Maximilian D. Schmeiser found that revolving credit card debt drops when seniors take out reverse mortgages.

Foreclosures and debt payment delinquencies also become less common, at least in the three years after the reverse mortgage is taken out. Seniors who experienced a credit shock in the two years before taking out the reverse mortgage benefited most. (The researchers defined a credit shock as a credit score drop of 25 points or more.) These seniors might not have qualified for another type of home equity loan because of their credit; qualification for a reverse mortgage doesn’t depend on a senior’s credit score.

The study found that reverse mortgage borrowers reduced their credit card debt more than borrowers who took out other types of home equity loans (closed-end home equity loans, home equity lines of credit and cash-out refinancings). The up-front sums and increased monthly cash flow provided by reverse mortgages helped seniors pay down their credit card debt.

According to the study, seniors who initially withdrew $10,000 using a reverse mortgage reduced their credit card debt by $2,364 in the first year after borrowing that sum. Additional borrowing resulted in minimal additional debt paydowns: for every additional $10,000 withdrawn up front, seniors paid off another $166, and for every additional $100 in monthly cash flow the reverse mortgage generated, seniors paid off an additional $45 in debt for the whole year. 

It’s worth noting that this study covers borrowers who took out a reverse mortgage between 2008 and 2011, a uniquely bad period in financial history. A similar study conducted during a period of economic prosperity might have different findings.

Seniors considering a reverse mortgage as a solution to credit card debt should evaluate whether the amount of home equity they will lose in reverse mortgage fees and interest is worth it in terms of the amount of credit card interest they will save. This is a complex calculation that is best performed by an accountant or financial planner. A reverse mortgage counselor may not be knowledgeable enough to answer this question

Taking out a loan against your home is a big decision that will affect your current finances and the estate that you leave to your heirs. There are substantial costs involved, including loan origination, servicing, and interest. You also need to remember that, with a reverse mortgage, your debt increases over time due to the interest on the loan. If you change your mind about the loan, or need to move out of the property due to health reasons, proceeds from the sale of the property are used to pay off the reverse mortgage. Depending on the size of the loan and the value of the property, there may be little or no money remaining after the loan is repaid.

Before taking out a reverse mortgage, you should research the topic thoroughly, compare costs from a variety of lenders and read all disclosure documents. While investing the proceeds from a reverse mortgage is generally not advisable because of the need to recoup the costs of the loan plus the interest, the income from a reverse mortgage may provide an opportunity to refocus other elements of your investment portfolio. Before assuming the mortgage, consider the cash flow the reverse mortgage will provide and review the implications this new source of income will have on your overall investment strategy.

For more insight, see Reverse Mortgage Pitfalls.