You’ve seen the commercials with celebrities touting reverse mortgages; ever wonder what they are? Actually, they are just what they sound like: It’s a loan; but the lender pays you and they don’t get their money back until you (or the last surviving borrower) die, sell the home, or `permanently’ move out of it (usually for a year or more). You or your heirs keep the difference between the value of your home and what you owed on the loan.
Reverse mortgages aren’t for everyone. Consumer Reports, their booklet, 50 Steps to A Richer Retirement, reports one study that found less than one percent of the people who would be eligible have signed up; but, these loans do allow many retirees to stay in their homes and get some of the accumulated equity out of it.
In most cases, you must own your home as your principal residence and usually be 62 or older. You also can’t have any other outstanding mortgages on your home unless you intend to use part of the proceeds to pay them off.
There are two types of reverse mortgages:
- The Home Equity Conversion Mortgage (HECM) is insured by the Federal Housing Administration (FHA) and governed by FHA rules concerning loan amounts, costs, and eligibility.
- Proprietary Reverse Mortgages are just what they sound like: They are proprietary reverse mortgage products offered by private lenders. These are generally more expensive than FHA insured mortgages, but they may also have higher loan limits – you need to do your homework on any increased benefits vs. costs.
How they work. Here’s a purely hypothetical and admittedly oversimplified example just to give you an idea of the reverse mortgage structure. The numbers aren’t as important here as the concept:
Suppose your home is worth $500,000. A reverse mortgage is basically a refinancing providing you cash for a portion of your equity. It’s only a ‘portion’ because the new lender needs to have a `cushion’ for repayment that comes from your equity. Confused?
Hypothetically, your reverse mortgage lender could lend, say, $350,000 on your home, less any pay-off required by your current mortgage holder. If none, you’d receive the $350,000 less other fees and expenses required to initiate the loan. Under this scenario, you’d go from $500,000 equity and no loan to a $350,000 (less fees, etc.) loan and about $150,000 in equity. You don’t have to make payments. The “payments” plus interest are now added to your loan balance, thereby reducing your equity, each month.
As you can see, your equity could be reduced to zero and your loan balance could eat up all your equity at some point in the future. It’s also possible that equity could grow at a faster pace than your loan balance; but, you intend to stay in your home forever, it may not be an issue, especially if you don’t intend to pass your home along to your heirs. You could, for example, replace the equity you wanted your heirs to receive with a life insurance policy and have the money pass tax-free.
Watch your step! Reverse mortgages can often come with high fees; so you need to do your homework and get everything spelled-out in writing. It would likely pay to have an objective third party, a CPA or CFP professional actually run the numbers for you.
For more information about reverse mortgage pros and cons, see the AARP website and the National Center for Home Equity Conversion.
Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning processcoupled with a cost-conscious objective and non-conflicted risk management philosophy.
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