What Are The Pros And Cons of a Reverse Mortgage?
We all know about traditional mortgages, but have you heard of a reverse mortgage? Don’t worry, it’s more straightforward than it sounds. And if you’re a retiree or pre-retiree with a lot of home equity, you might even want to get one. In this post, we’ll go over the pros and cons of having a reverse mortgage, and whether it could be right for you.
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What Is a Reverse Mortgage, Exactly?
A reverse mortgage is basically a normal mortgage in reverse.
Typical mortgages, or forward mortgages, involve a home buyer taking out a loan to purchase a home and paying that loan off over 15–30 years. They purchase a house now with the help of a lender they’ll pay back later, with interest.
In a reverse mortgage, on the other hand, the lender pays the homeowner. The deal is that the homeowner—who must be at least 62 years old—borrows against the value of the house they already own outright, receiving payments from the lender on the understanding that when the homeowner dies or moves out of the house, the lender becomes its new owner.
Types of Reverse Mortgages
There are six types of reverse mortgages, which differ according to the means by which the homeowner receives payments from the lender. They are:
- Lump sum: The homeowner receives all their money at once when the loan closes.
- Equal monthly payments (annuity): The lender makes steady payments to the borrower for as long as at least one of the borrowers uses the home as their principle residence. Also known as a tenure plan.
- Term payments: The lender pays the borrower in equal monthly payments for a fixed period established by the borrower, such as 8 or 10 years.
- Line of credit: The homeowner can spend money as needed via a line of credit opened by the lender. While all of the reverse mortgage is available on this credit line, the homeowner only pays interest on the money they actually spend using it.
- Annuity + line of credit: The borrower receives equal monthly payments for as long as at least one borrower uses the house as a primary residence. If the borrower needs more money at any time, they can access it on a line of credit, and will pay interest on whatever they spend that way.
- Term payments + line of credit: The lender pays the borrower in equal monthly payments for a set period chosen by the borrower. If the borrower needs more money, they can access it through the credit line, paying interest on what they spend that way.
Advantages of Having a Reverse Mortgage
A reverse mortgage provides an opportunity for pre-retirees and retirees sitting on significant home equity to exchange that equity for cash.
More Americans belong in that category than you might think. According to the National Reverse Mortgage Lenders Association, homeowners ages 62 and older held $11.2 trillion in home equity in the first quarter (Q1) of 2022.
The number marks an all-time high since the NRMLA started taking these measurements in 2000. More than ever, home equity is a central source of wealth for retirement-age adults.
The problem is, equity isn’t immediately available to homeowners. It’s tied up in their house, and they’d have to sell their house to access it—unless they took out a reverse mortgage, that is. A big draw of reverse mortgages is that after taking one out, homeowners can still live out the rest of their lives in their homes.
Plus, borrowers don’t have to pay off their reverse mortgage during their lifetimes. Instead, the loan becomes due when the borrower dies. The federal government structures reverse mortgages so that borrowers can never take out a loan that exceeds the value of their house. Or, if it somehow does, the program’s mortgage insurance will cover the difference.
There are all sorts of reasons pre-retirees or retirees might suddenly need large amounts of cash at their immediate disposal, such as medical or family emergencies, or unexpected layoffs.
What’s more, reverse mortgages don’t require monthly debt payments like normal loans do because payment is covered by the eventual transfer of the home. This makes a reverse mortgage appealing to homeowners who:
- Don’t want the hassle of keeping track of monthly debt payments.
- Can’t afford to pay monthly debt payments on a normal loan.
- Can’t qualify for a home equity loan or a cash-out refinance because of limited cash flow or poor credit.
Disadvantages of Having a Reverse Mortgage
Reverse mortgages can be a godsend for some seniors, but they aren’t right for everyone. In fact, in some cases they can be a genuinely bad financial decision, so it’s important to know the risks of taking out a reverse mortgage before committing to one.
- Variable interest rates: Except for lump sum reverse mortgages, all reverse mortgages come with adjustable interest rates because lenders are paying borrowers over time. This adds a layer of unpredictability that could drastically increase the fees a borrower incurs thanks to interest.
- Taxable interest: While the payments homeowners receive from the lender for a reverse mortgage aren’t taxable, the interest borrowers pay on their loan is taxable, and there’s no deduction for it.
- Equity reduction: Because a homeowner borrows against the value of their home with a reverse mortgage, they’re actively reducing the value of their home over time. A reverse mortgage provides short-term returns, but at the cost of long-term gains for the next generation of your family.
Common Mistakes Borrowers Make with a Reverse Mortgage
There are also some things all borrowers should avoid if they do decide to take out a reverse mortgage. Any of the following mistakes can have steep financial and social costs, so be wary of them:
- Withdrawing more equity than you need: All the equity you withdraw must be repaid with interest, so withdrawing more than you need will make you pay more interest than you really should.
- Failing to pay property taxes and insurance: Failure to pay property taxes will force the homeowner to pay off their loan immediately (i.e., sell their house while they still want to live in it). Make sure you have enough cash on hand to be able to pay property taxes before taking out a reverse mortgage.
- Not planning for a spouse’s needs: It’s important to consider your spouse in the event that they outlive you—especially if they’re not classified as a borrower on the reverse mortgage. If they’re not, and you pass away before they do, they’ll be forced to move out of the house.
- Not telling heirs about a reverse mortgage: Aside from the unpleasant surprise heirs will get when they learn about a reverse mortgage, failure to disclose one could force your heirs to sell the house when they would otherwise wish to keep it if they can’t pay off the loan in full.
- Not shopping around for a reverse mortgage: Fees and interest rates differ among issuers of reverse mortgages. Additionally, some companies that claim to offer reverse mortgages are actually scams, so it’s good to verify a potential lender on the Better Business Bureau (BBB) before signing anything.
Is a Reverse Mortgage Right for You?
Whether a reverse mortgage is right for you depends on your needs and financial outlook. It’s important to consider the risks. But if you’re over 62 years old, have lots of home equity, and need some cash, it’s an option worth considering.
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