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For older homeowners struggling to cover basic expenses, a reverse mortgage could provide much-needed relief.
Effectively, such a loan allows you to stay in your home while trading fees, interest and home equity — that's the current market value of your home minus what you owe — for cash or a line of credit. The most widely used loans are Home Equity Conversion Mortgages, or HECMs, which are federally insured and available to applicants 62 and older who meet certain requirements.
These loans aren't a cure-all for retirement money problems, though. You could default and risk losing your home if you don’t meet certain ongoing requirements. And if your cash shortfall is temporary, there may be lower-cost and lower-risk alternatives.
Pros of reverse mortgages
Can provide supplemental retirement income
"There’s a group of people who are house-rich and cash-poor, and that’s the original idea of [who] the reverse mortgage was good for," says Stephanie Moulton, associate professor of public policy at Ohio State University. Assuming borrowers can keep up with the expenses of owning a home, such as homeowners insurance and property taxes, "the reverse mortgage provides a way for those individuals to liquefy a portion of that equity to cover expenses."
This could be helpful, for instance, if an unexpected job loss or health issues move up retirement plans and you have limited savings. Generally, you have the option to receive the proceeds from a reverse mortgage in monthly payments, a line of credit or a lump sum.
Some financial planners have also used reverse mortgages to diversify investment portfolios for well-off clients, although this has become a less appealing choice recently due to increased upfront costs.
Can be used to pay off an existing mortgage
Even if you're still making payments on a regular mortgage, you might have enough home equity to qualify for a reverse mortgage. In that case, you could use the proceeds to cover those monthly payments and free up money for other expenses.
This move can be appealing to older homeowners whose budgets are strained by monthly bills. And it's a fairly common use of reverse mortgages, too.
"You may be surprised at the number of seniors who … actually obtain a reverse mortgage, pay off that existing mortgage and no longer have that monthly payment," says Jackie Boies, senior director of housing and bankruptcy services at Money Management International, a nonprofit firm that provides reverse mortgage counseling, among other services.
Proceeds are tax-free
The IRS considers proceeds from a reverse mortgage to be a loan, not income, so you won't face taxes on it. For older homeowners living on a fixed income, that could come as a relief.
There are still plenty of costs to consider, though. In addition to drawing on your equity, there are origination fees, mortgage insurance premiums (for HECMs) and interest charges. Until the loan is paid off partially or in full, this interest isn’t tax-deductible.
Cons of reverse mortgages
You could default — and potentially lose your home — if you don’t meet certain requirements
With a reverse mortgage, you default when you fail to meet the ongoing requirements of the loan. That can lead to eviction and foreclosure, if unresolved. And it's possible to do this accidentally if you're not careful.
There are three main ways you might default:
Living outside the home for most of the year or failing to certify that your home is your principal residence each year.
Not paying property taxes or homeowners insurance.
Not making maintenance repairs to your home required by your lender.
If you don’t think you’ll be able to meet these requirements long-term, consider alternatives, such as selling your home and downsizing.
It’s not a good short-term option
Reverse mortgages are most helpful for long-term financing or income needs.
"If you need money in the short-term … and you’re going to be able to pay it off, then a reverse mortgage could be quite expensive," Moulton says. Specifically, she notes, the upfront costs for reverse mortgages are higher than other forms of borrowing, in part due to the federal mortgage insurance premiums.
For HECMs, the initial mortgage insurance premium due at closing is now generally 2% of the house’s appraised value. While you can use your loan to cover the cost, that would reduce the amount of money you receive.
You could potentially keep more of your home equity and meet your financing needs by borrowing money in a different way. Good short-term financing options include credit cards, personal loans, home equity lines of credit (HELOCs) and home equity loans (HELs).
Heirs may not be able to keep the home
With HECMs, here's what will happen to your home when you die: Your heirs will have to pay either the full loan balance or 95% of the home’s appraised value, whichever is less. They can do this by paying out of pocket or getting financing, selling the home or turning the home over to the lenders to satisfy the debt.
If heirs aren't able to buy back the home, the home wouldn't remain in the family. But for many these days, that's not a top concern.
"Honestly, we’re not seeing as much of that as we did in years gone by," Boies says, referring to borrowers who want to pass down family homes to heirs. "And it doesn’t seem to be much of a hindrance for folks taking out a reverse mortgage."
Is a reverse mortgage worth it?
Assuming you qualify, a reverse mortgage could be a good solution if:
You’re willing to give up equity in your home for income, even if it means your heirs might not be able to keep the home in the long run.
You plan to stay in your home for the rest of your life and can meet the requirements of a reverse mortgage, such as keeping up with property taxes and homeowners insurance.
If that’s not you, consider other options, such as moving to a less-expensive home or borrowing money in other ways.
» MORE FOR CANADIAN READERS: What is a reverse mortgage?