A reverse mortgage is a new product on Main Street invented by banks and Wall Street. This new product offers the opportunity for homeowners to extract their home equity in retirement, allowing them to continue living in their homes while it generates a stream of “income” for the homeowner in retirement. A reverse mortgage is often a retirement income source of last resort. While a reverse mortgage may allow a borrower to maximize the value of their home during retirement, it does come with some drawbacks. We’ll evaluate both the pros and cons of a reverse mortgage.
How Does a Reverse Mortgage Work?
Many homeowners are unaware with how a reverse mortgage actually works. A reverse mortgage is something that resembles a traditional equity loan with a few minor differences. A traditional home equity loan works by the homeowner borrowing money on their equity. The homeowner will receive a check in the amount that they have borrowed on their equity. On the other hand, a reverse mortgage works totally different. For example, instead of making payments on an equity loan, a reverse mortgage makes payments to the homeowner.
Both equity loans and reverse mortgages require the homeowner to have equity in their home. Without equity, the homeowner will not be able to use a reverse mortgage. A homeowner who uses their equity for a reverse mortgage will receive monthly payments, much like if they were receiving additional income. Actually, a reverse mortgage is often viewed as another source of income to the homeowner. Reverse mortgages are more often used by those who are retired for a number of reasons. First, those who are retired are more than likely to have equity in their home.
Second, those who are retired will often receive a pay cut because they only receive a percentage of their income when retiring. Additional income like a reverse mortgage is the perfect solution for those who need some extra income every month. In fact, there are some eligibility requirements to be approved for a reverse mortgage, one of which is being at least 62 years old. There are other requirements as well, like the borrower must be a primary resident of the home they are applying for a reverse mortgage for. Another requirement is everyone who is on the mortgage or title must apply for the loan.
All owners must be able to be approved for the loan like the husband and the wife. Anyone else that is an owner of the home must be approved as well. Another requirement involves the amount in which the owners will owe on the home. The homeowners must have enough equity to pay off the remaining balance, or the homeowners must have the home paid off. If the home is paid off, and it’s valued at $300,000, the homeowners will receive monthly payments with a reverse mortgage to that amount. An easy way to look at a reverse mortgage is the bank is actually purchasing the home back from the homeowners.
1. Stream of income – A reverse mortgage is one in which a loan is slowly taken out against your home equity in comparison to traditional mortgages where a homeowner slowly builds equity. With a reverse mortgage, a borrower may receive $500 monthly payments from the bank, which is debited against the homeowner’s equity in their home. Over time, the retiree receives a stream of income which creates a negative balance on their home.
2. Tax benefits – A reverse mortgage offers a tax benefit in that loans are not taxable income. While the borrower is receiving the benefit of their home equity in retirement, there is no taxable gain, since the money is coming from a loan.
3. Non-market correlated – The returns of the stock or bond markets do not affect a reverse mortgage. There is limited correlation to the stock markets, and limited risk in drying up the stream of income. Compared to certificates of deposit, which may provide a 1-2% per year stream of income against the principal, some homeowners extract as much as 8-10% of their home equity in a reverse mortgage each year. The difference, as you can imagine, is huge.
1. Fees – Closing costs on a reverse mortgage can be expensive. These costs can be rolled into a reverse mortgage loan, but the costs will only grow over time as the balance grows at a pre-determined interest rate.
2. Limited Upside – In signing into a reverse mortgage, the borrower agrees to give up some of the appreciation in their home. Depending on the agreement, the upside can be capped at an annual rate equal to inflation, or it can be registered as a split-agreement where the lender and borrower each get half of the home’s appreciation. As always, these agreements can be modified to fit any borrower, but do keep in mind that the home’s value may not be all yours after death.
3. Running out of funds – It is possible that the reverse mortgage will hit a point at which the borrower has removed more home equity than exists. At this point, the bank may reject future cash flows and may even move to secure ownership of the property. Again, this depends on the particular contract; however, ownership rights and the guarantee of future cash payments should be explicitly stated in the agreement.
There are different types of reverse mortgages and different ways the homeowners can be paid with a reverse mortgage. For example, homeowners who are approved for a reverse mortgage can receive their payments in four different ways. Payments can be received in one large sum, monthly payments, as credit and a combination of all three. Homeowners will have no restrictions with how to use the money they receive from a reverse mortgage. There are two situations that will require the reverse mortgage to be due.
The lender will require payment when the homeowners move, or when all homeowners have passed away. The equity in the home will belong to the bank. Once the lender is paid, all remaining money will be paid to the proper borrower’s estate. Reverse mortgages are a way to tap in a homeowner’s equity to make retirement easier or more enjoyable. Homeowners will still be required to pay their property taxes and any insurance payments that are due as well. Homeowners who are considering on a reverse mortgage should be aware of the high closing costs that are associated with this type of mortgage.
Reverse Mortgage Alternatives
As stated previously, a reverse mortgage should be a “last ditch” effort to save a retirement plan. It should not be a part of any plan, and those who have several years until retirement should not plan for retirement on the basis of borrowing from their home.
Before evaluating the prospects of a reverse mortgage, it would be wise to consider other investment vehicles. An immediate fixed annuity, for example, is a great way to buffer returns on current cash stockpiles so as to avoid or delay the necessity of a reverse mortgage. Retirees in their 70s and 80s can generate annual cash flows of 10-15% on a fixed immediate annuity, far more than CD rates. Keep in mind that unless written into the contract a fixed immediate annuity will not provide for the ability to pass on the amount of the annuity to beneficiaries. However, it will provide for the opportunity to receive large monthly payments, of which a portion is considered a return of principal.
In this way, a fixed immediate annuity has many of the tax advantages of a reverse mortgage. The fixed immediate annuity provides income, and only a portion of it is taxable. Much of the money coming back to the investor is principal, which is not taxed. However, there is one major benefit in that the annuity pays until the investor dies. Meaning that at no point can the investor outlive a stream of income. Of course, this requires pre-planning, and most people who fall into reverse mortgages fail to preplan, and thus have to borrow from their home equity to pay the bills.