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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 for cash or a line of credit. The most widely used reverse mortgages 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.
Reverse mortgage pros and cons
Pros
Provides supplemental retirement income
Allows you to pay off an existing mortgage
Offers tax-free proceeds
Cons
Risks home loss in the event of a default
Carries high upfront costs and fees
Limits the ability for heirs to keep the home
Pros of reverse mortgages
Can provide supplemental retirement income
Reverse mortgages are geared toward borrowers who are house-rich but cash-poor. Assuming you can keep up with the expenses of owning a home, such as home insurance coverage and property taxes, a reverse mortgage offers a way to tap into your equity to cover living 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 payouts, a line of credit or a lump sum.
Did you know...
The monthly payout and line of credit options carry an adjustable interest rate, while the lump-sum option comes with a fixed interest rate. 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.
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
Risk of default and foreclosure
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, homeowners insurance, or other property-related charges.
- 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 or combining households.
High upfront costs
Reverse mortgages are most helpful for long-term financing or income needs. That’s primarily because reverse mortgage loans require you to pay certain closing costs and fees, including origination fees and an initial mortgage insurance premium.
For HECMs, the initial mortgage insurance premium due at closing is 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. Other short-term financing options include:
Heirs may not be able to keep the home
With HECMs, here's what happens to your home when you die: Your heirs must 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
- Getting financing
- Selling the home
- Turning the home over to the lenders to satisfy the debt
If your heirs aren't able to buy back the home, the home wouldn't remain in the family.
Is a reverse mortgage worth it?
Assuming you qualify, a reverse mortgage could be a good solution if:
- You have a long-term need for additional income or credit, not a one-time expense you could easily pay off, and you’ve already taken advantage of benefits that are available to you, such as Medicare and Social Security.
- 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?
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