The reverse mortgage is one of a number of financial tools the aging can use to gain access to the equity in their homes without selling them. That is, it allows them to remain in their home which, according to such studies conducted by AARP, is what 80 percent of seniors want to do. Here’s an explanation of what a reverse mortgage is, its pros and cons and other options seniors can leverage to manage their personal finances, on their own terms.
Reverse Mortgages vs. Traditional Mortgages
In essence, the reverse mortgage is a loan, based on the equity of the house. It is made to those 62 years of age or older for a specific purpose, such as a new roof or the more general purpose of simply freeing up the cash “stored” in their property, be it a single family or a multiple unit in which they have an apartment. It differs significantly from traditional mortgages in that the application, amount of loan and the interest rate do not depend on income and credit rating, but the age of the owner (the older the better), appraised value of the house, amount of equity and current interest rates.
Financially Challenged Seniors
Of course that no income/credit documentation makes it attractive to seniors, many whose financial situation is bleak because their retirement portfolios suffered losses during the stock market crash and have not bounced back. The MetLife study “Changing Attitudes, Changing Motives” found that 67 percent apply for these loans in order to reduce debt. In addition, borrowers do not make a monthly payment to the lending institution as with traditional mortgages and only have to pay off the principal and interest when the property is sold or they leave it or die. There is the option to prepay the principal and interest without penalty, through cash or refinancing, which is especially important since the interest is compounded. That means that each month interest is calculated on not only the loan balance, but also on the interest from the previous month. The property can enter foreclosure when the owner fails to pay the property taxes and/or insurance.
You Need To Shop Around
In general, reverse mortgages are more expensive than traditional mortgages, ranging from the closing costs to the interest rates. That is why, just as with conventional mortgages, borrowers must shop around since the upfront fees and interest rates can be negotiated. The loan can take the form of a lump sum, an annuity with a monthly payment to the owner, equity line of credit, or a combination of these, with the mode of distribution partly determining the interest rate. There is no tax paid on the loan. According to government statistics, in 2012, there were about 775,000 reverse mortgages outstanding.
The Different Kinds Of Reverse Mortgages
There are three types of reverse mortgages.
Single-purpose reverse mortgages: Not available everywhere, this is a kind of loan offered by some states, local government agencies and assorted nonprofits which are designated for a particular need such as paying off property taxes or doing urgent repairs. The amount of the loan is relatively small and those who apply tend to be low and have moderate income. Unlike the other two kinds, the processing procedure is not expensive.
Home Equity Conversion Mortgages (HECMs): Created in 1989, this is the most popular kind of reverse mortgage and is federally insured by the U.S. Department of Housing and Urban Development. Before you can apply, you have to undergo counseling with a third-party government-approved housing expert who explains the costs, what compounded interest is and the alternatives to the HECM.
According to government figures, there were 51,000 of these HECMs taken out in 2011 versus 115,000 in 2007. One reason for the decline is the negative publicity this product has received in general because of high upfront fees, compounded interest and, as the Consumer Financial Protection Bureau reports, the current default rate of 9.4 percent as opposed to two percent 10 years ago.
Proprietary reverse mortgages: These are financial vehicles crafted and backed by private-sector institutions. Usually they are more expensive in upfront fees than HECMs, but can provide the large amount of the loans which are appropriate for high value properties or those which carry “jumbo” mortgages worth more than $625,500. The danger here is that some of the profit-making entities mislead seniors about the terms and conditions. It is useful to compare those to what government-backed loans provide.
Pros Of Reverse Mortgages
There are solid reasons for a homeowner with lots of equity in a house, who can afford the property taxes and insurance, and could prepay part or all of the interest as it is due to get a reverse mortgage. These positives include:
- Ability to afford to stay in the house, which, as home owners know, is an expensive proposition.
- Immediate access to cash that is tax-free money and does not affect entitlement payments, such as from Social Security and Medicare.
- Interest rates can come down as time passes.
- No prepayment penalty on interest, which if you pay monthly you can deduct for tax purposes and avoid the ballooning of compounding interest.
- No prepayment on part or the entire loan, including through cash or refinancing.
- Maintaining the property to pass on to heirs, with no debt being inherited if it defaults.
- Leveraging the loan to purchase more suitable property, such as a smaller house or with a layout on one floor.
Cons Of Reverse Mortgages
For some, the negatives could outweigh the positives and lead you to consider alternatives.
- The process is complex and therefore confusing.
- Closing costs which could total about $8,000 versus about $5,000 for a traditional mortgage. Those could include the application fee, Mortgage Insurance Premium (MIP) of two percent of appraised value, title insurance, attorney and recording fees, appraisal, and survey. Some of these might be negotiated down or eliminated.
- Need to remain in the property for about five years for the upfront costs to be worth it.
- Monthly maintenance fee and an annual MIP assessed at 1.25 percent of the loan balance.
- Compounding of interest which can consume all the equity.
- If the owner is vacant from the property for 12 months, such as moving into a nursing home, the loan becomes due and if the heirs cannot afford to pay it off, they lose the property.
- Structure in which the loan amount and interest rate are computed on the basis of the younger owner, which often results in that person being left off the deed. What often happens when the person whose name is on the deed dies is that the younger spouse cannot afford the taxes and insurance, the loan becomes due and the house moves into foreclosure.
Alternatives To Reverse Mortgages
The financial sector is innovative in creating new products, especially for the growing aging population. Currently, some of the options to the reverse mortgage are:
- Equity line of credit called “HELOC” which requires only interest payments for 10 years. An obstacle can be that this requires verification of income and credit scores.
- Selling the house and relocating to a more affordable one. The negatives are the closing costs on both houses.
- Securing a family loan from those who will inherit the house.
- Selling the house to those who will inherit it and leasing it back. However, this contract could result in the renter being evicted.
The reverse mortgage is a solution for those who want to stay in their house and could use more money. The problem is that the products on the market are complex and require seniors to absorb concepts that they might not have encountered before. Therefore, time and patience have to be invested to give this option as well as others an accurate appraisal.