Reverse mortgages are probably the most misunderstood loan product around. Depending on who you ask, they are described as abusive loans that prey on the old and poor or the panacea to all retirement problems. They are neither.
Let’s be clear. Reverse mortgages are an expensive way to borrow money. Senior citizens with good credit and enough income to make monthly payments should look into cheaper alternatives, such as a home equity loan, before even considering reverse mortgages.
They are a loan of last resort for senior homeowners who want to keep their homes and don’t qualify for anything better. But you could do much worse than a reverse mortgage. The interest rates on reverse mortgages have a lifetime cap of either 12.65 percent or 5.06 percent, depending on whether you choose a monthly adjustable or fixed interest rate. Although there are other fees and costs to consider, these are hardly predatory lending terms. In fact, in certain cases, they are the best financial option for elderly homeowners.
Let’s look at what reverse mortgages are; how much they actually cost; and in what circumstances they are a smart choice for homeowners.
What is a Reverse Mortgage?
Reverse mortgages provide homeowners with a way to tap into their home equity during retirement while keeping ownership of their home. Lenders use the value of the home as security but there are no mortgage repayments due until the borrowers die or the home is sold. Homeowners are required to remain current on property taxes, homeowners insurance and condominium fees, as they would if they didn’t have a reverse mortgage.
If the homeowner dies or decides to move, the property is sold and the proceedings are used to repay the loan. The balance either goes to the heirs or to the homeowner. Reverse mortgages are structured so the loan amount can never exceed the value of the home regardless of how long the borrowers live.
There are two types of reverse mortgages available: Home Equity Conversion Mortgages (HECM) and proprietary reverse mortgages. Home Equity Conversion Mortgages, which are insured by the Federal Housing Administration and represent around 95 percent of the market, are by far the most popular.
Proprietary reverse mortgages are offered by certain banks, credit unions and other financial companies and are usually offered only to borrowers with very high-value homes who exceed the home value limit of $625,500 set by the FHA. This article deals exclusively with HECM reverse mortgages.
Costs vary from lender to lender so it’s important to shop around. However, the Federal Housing Administration does set limits on the fees lenders can charge and these may be financed as part of the reverse mortgage.
The main costs include:
- Origination fee. The HECM program sets a maximum of 2 percent of the initial $200,000 of the home’s value and 1 percent on the remaining value, with a maximum of $6,000.
- Mortgage Insurance Premium. The Mortgage Insurance Premium is a fee paid to the Federal Housing Administration to fund the insurance they provide lenders. If you borrow less than 60 percent of the available fund in the first year, the charge will be 0.50 percent of the appraisal value of the home. If you take more than 60 percent in the first year, the fee will be 2.50 percent. Without this insurance, reverse mortgages would be more expensive and would have stringent credit requirements.
- Appraisal Fee. It varies a lot depending on where you live, but the average is $450. This is an important fee because it has to be paid upfront in cash. If the appraiser finds your home does not meet local building codes, you will have to make the necessary repairs and request a follow-up appraisal, which usually costs around $250. If the cost of meeting building code standards is less than 15 percent of the maximum claim amount, you can use the reverse mortgage loan to pay for the necessary repairs.
- Service Fees. This is a fee charged by the institution that takes care of the administration of the loan, which is not always the lender. The fee is capped at $35 a month.
- Closing Costs. As with all mortgages, there are many smaller charges related to processing the loan. These include a flood certification fee (around $20), a title search fee ($150 to $800), a document preparation fee ($75 to $150), a recording fee ($50 to $500), a pest inspection fee (around $100), and a property survey fee (less than $250).
According to a report by the AARP, which acts as a consultant for the Department of Housing and Urban Development, a reverse mortgage of $67,742 that goes on for 12 years, would typically cost $204,771. The breakdown of the loan expenses is $12,000 in upfront costs, $7,933 in total monthly insurance premiums, $5,040 in total monthly servicing fees, and $111,056 in total interest charges.
What Are the Advantages?
As you can see, reverse mortgages are an expensive source of credit, particularly when you consider lenders have the benefit of property as security and that home equity lines of credit can have interest rates below 4%. So why have over 879,700 homeowners signed up for reverse mortgages since the program started?
- The main benefit of a reverse mortgage is that the borrower’s credit is not relevant. In fact lenders often don’t even check it. This is because there are no monthly payments to make. The key factors are the value of the house, the loan amount and the age of the borrower.
- Even if the value of your home drops, you or your heirs will never owe more than the value of the home at sale. If the value of your home holds or rises, you or your heirs could be left with some equity when the house is finally sold.
- As long as you pay property taxes and insurance, you can never be forced to leave your home.
When Do Reverse Mortgages Make Sense?
A reverse mortgage may be a good option for you if:
- You need cash and you don’t qualify for cheaper sources of credit or any state and local programs that would help you meet your financial needs. Reverse mortgages can be useful to help pay for supplemental long term care insurance or to get from under a mortgage you can no longer afford.
- You plan to stay in your home for a long time. Reverse mortgages have high upfront costs and require you to pay mortgage insurance premiums. The insurance is there to protect you if your home value drops below the loan amount. However, if you only stay in your home a few years, you are paying for insurance you probably don’t need.
- You can’t or don’t want to downsize your home and move to a more affordable home.
- You have enough income or assets to pay for property taxes, homeowner’s insurance and home maintenance expenses. If you can’t afford to pay for these basic expenses, you could face foreclosure and lose your home.
- Your spouse or partner needs to be a co-borrower or understand she will need to move if you die. Spouses or partners who are not co-borrowers may have to leave the house but those who are co-borrowers can definitely stay in the house until they die or sell.
Reverse mortgages are a useful tool that should be part of every financial planner’s tool chest. This doesn’t mean it should be the program used by all senior homeowners in need of cash. There are cheaper loans for homeowners and there may be alternatives to borrowing money, such as applying for Supplemental Security Income. However, for those who don’t qualify for other sources of credit and financial assistance, reverse mortgages may be the best alternative available.