Considering a Reverse Mortgage? Be Aware of These Pitfalls

Photo to accompany story about reverse mortgages. Getty Images

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You may have seen the ads on daytime television, featuring friendly spokespeople from some of our favorite shows of yesteryear who tell seniors they can unlock home equity through a reverse mortgage. 

But what is a reverse mortgage, and how does it work? 

Also known as a home equity conversion mortgage, a reverse mortgage is a loan that allows seniors to turn the value of their homes into cash during their retirement years. But there are plenty of risks and downsides to the process—and even potential scams. Many seniors may find there are smarter alternatives. 

Before starting any application process, here are some things to consider about reverse mortgages and how they work. 

What Is a Reverse Mortgage?

Like the name suggests, a reverse mortgage is a loan taken out with real estate used as collateral. But instead of paying the bank over the course of a typical mortgage term of 15 to 30 years, homeowners receive money based on the value of their home. 

“Instead of you taking a large loan and making payments back to the bank, the bank actually makes payments to you,” says Juan Carlos Cruz, founder of financial planning firm Britewater Financial Group. “It works in reverse – so long as you have the equity.” 

The money comes from the equity you have built up in your home over the years. As homeowners make mortgage payments, their share of ownership – or equity – builds. When a mortgage is paid off in its entirety, homeowners have 100% equity in their home. Although homeowners don’t need to pay off their home in full to qualify for a reverse mortgage, it is easier to qualify with more equity. 

Is a Reverse Mortgage Right for You?

While a reverse mortgage offers an easy way to tap into your home equity, it’s still a mortgage –  which means you will still have to qualify. Homeowners must be 62 or older, and have a majority of the equity in their home. The property must be the homeowner’s primary residence, and can’t be used as a second home or investment property. 

The amount you can take in a reverse mortgage depends on your age, the loan interest rate, and the value of the home. For home equity conversion mortgages — one of the types of reverse mortgage — insured by the U.S. Department of Housing and Urban Development (HUD), the maximum loan amounts range from 47.9% to 75% of the home’s appraised value, based on the applicant’s age. 

Reverse mortgages could be an option for homeowners who don’t have enough money from retirement plans or Social Security to live comfortably in their older age. Owners can stay in their home and keep their title deed, while getting access to cash for covering living or medical expenses. 

Reverse mortgages also offer some tax benefits. Because they are considered a loan, the money is usually not taxable. They also won’t affect Social Security or Medicare benefits. 

There are some concerns to keep in mind as homeowners consider a reverse mortgage. Lenders may charge origination fees and closing costs, which must be paid up front. These fees could add up to thousands of dollars in upfront costs. For government-backed home equity conversion mortgages, borrowers may also be charged an insurance premium. 

Pro Tip

The Federal Bureau of Investigation has warned about several reverse mortgage scams that target seniors. Talk to a financial advisor or several mortgage experts before you make any moves.

Also important to note: a reverse mortgage will not absolve you of home maintenance costs. Seniors will still  be responsible for paying any taxes, insurance premium, and homeowner’s association fees for as long as they own the property. 

Types of Reverse Mortgage

There are three kinds of reverse mortgages available, each with its own advantages. 

Single-Purpose Reverse Mortgages

  • Offered by state and local government agencies or non-profit organizations
  • Homeowners with zero or little income may qualify
  • Money can only be used for one purpose (such as property taxes, home maintenance, or health care)
  • May not be available in all areas of the United States

Proprietary Reverse Mortgages

  • Offered by private lending institutions and banks
  • Both conventional and jumbo reverse mortgages (over $1 million) are allowed
  • May come with high origination fees and closing costs
  • Requires financial assessment to determine ability to pay taxes and fees

Home Equity Conversion Mortgages

  • Offered by lending institutions, insured and backed by HUD
  • Maximum borrowing power governed by age and available home equity
  • May come with high origination fees and closing costs
  • Requires financial assessment to determine ability to pay taxes and fees

Homeowners have the option of taking their money from a reverse mortgage in different ways: as a lump sum, a monthly payment, a line of credit, or some combination of all three. 

Monthly Payments

  • Homeowners receive regular monthly payments
  • Available over a period of time (term) or for the life of the homeowners (tenure)
  • Comes with a variable interest rate, which can change over time 

One-Time Lump Sum

  • Homeowners receive a one-time loan payment against their home equity
  • Comes with a fixed interest rate on the entire loan balance, which will not change
  • Has higher fees, and homeowners run the risk of outliving their money

Home Equity Line of Credit

  • Allows homeowners to draw money as they need it, and reserve some credit for later
  • Can be combined with a lump sum payment or monthly payment
  • Comes with a variable interest rate on the amount borrowed, which can change over time

Whether you should choose one method or the other “really depends on what your financial goals are,” says Paul Fiore, chief retail sales and operation officer of reverse mortgage lender American Advisors Group. “If you are trying to supplement your income, then certainly you can set it up as a monthly payment, much like Social Security. But sometimes, people just want to have access to a line of credit that they can utilize.” 

The Risks of Reverse Mortgages

Even with the key advantages of a reverse mortgage, it isn’t necessarily the right option for everyone. A reverse mortgage is a loan, which ultimately has to be paid back to the lender. When the homeowner dies, whoever inherits the property will be responsible for paying back the loan. 

“Once you pass, that property will go into their name, but so will the liability,” says Cruz. “The beneficiary will have to refinance so they can pay back the reverse mortgage lender completely out of the equity of the home, or sell the property.” 

When paying back a reverse mortgage, the heirs will not only inherit the borrowed amount, but also any interest that may have compounded over time. Considering that many options have a variable rate, the price of that money can increase significantly over time. 

“It’s compound interest against you,” says Michael Foguth, president and founder of Foguth Financial Group. “Meaning, if you don’t make that payment back on the interest, it will keep rolling up against itself.” 

In addition, the Federal Bureau of Investigation warns that there are several reverse mortgage scams that target seniors. Advertised on television, radio, or at church seminars as ways to get a “free home,” an investment opportunity, or an alternative to refinancing or foreclosure, these scams ultimately steal the equity from a home. In the end, the seniors get very little, and the home goes to the scammers. 

Before sitting down to talk about a reverse mortgage, the experts recommend families meet with their financial advisor or certified public accountant to determine all options. If you decide to move forward with a reverse mortgage, talk to at least three mortgage lenders to see multiple scenarios and determine the best possible path. 

Alternatives to Reverse Mortgages

Owning a home provides a lot of options, especially when there is a large amount of equity in the property. This presents plenty of options to use the investment later in life, and a reverse mortgage is only one option.

For homeowners who plan on staying in their home and only need to consolidate debts or other bills, a cash-out refinance could help roll up those liabilities into a monthly payment. The homeowners pay a lower balance and fixed interest rate, which can free up their money for other living expenses. 

Those with exceptional credit may qualify for a home equity line of credit, which works similarly to a reverse mortgage. Homeowners can use the equity in their home like a credit card, providing a line of credit they can access for any reason. In turn, they usually get a lower annual percentage rate than a credit card offers, and pay off exactly what they need to use over time. 

Finally, if real estate markets are right, some homeowners can sell their property outright for a profit and downgrade to a smaller home or assisted living facility. In addition to using proceeds from the sale to buy a more manageable space, the money left over can be put towards living expenses. 

“One of the best investments most people make is real estate,” says Noemi Bitterman, a real estate agent at Warburg Realty Partnership in New York City. “When they are able to buy, it’s a given that at the end of a mortgage, their property is going to be worth a lot more when they bought it 15 or 30 years earlier.” 

Before considering a home sale, Bitterman says homeowners need to understand their potential property value, understand the current market conditions, and meet with a real estate agent and financial planner to determine which options are best. 

Bottom Line

Reverse mortgages can sound like an enticing offer—a way for seniors to unlock value from their homes, and gain supplemental income for living expenses, spending time with kids and grandkids, or traveling the world. But it’s a complicated strategy that may not address every senior’s individual financial goals. 

As you consider a reverse mortgage, carefully look at the cost of borrowing, and make a plan as a family with the help of professional advice. Through careful planning and determining financial goals, you can make the best decision on whether or not a reverse mortgage is the right option.