December 3, 2017 by HECM Pro
The FHA-insured HECM reverse mortgage is a fantastic mortgage product, but it’s not necessarily the perfect solution for everybody. Experts and pundits often point to certain reverse mortgage disadvantages that they believe make the program undesirable or risky for seniors. Some concerns are valid, but I think they’re a bit overblown.
Before we dig into the top three (supposed) reverse mortgage disadvantages I’ve heard over the years, let’s first cover a few basics. There are many misconceptions about reverse mortgages, so I want to lay the foundation before we get into some possible disadvantages.
HECM Reverse Mortgage Basics
The most common reverse mortgage product by far in America today is the home equity conversion mortgage, or HECM (often pronounced heck-um by industry insiders). If somebody you know recently got a reverse mortgage, it’s likely they got a HECM.
If you’re a homeowner 62 years of age or older, a HECM reverse mortgage can enable you to convert a large portion of the value of your home into tax-free and payment-free cash that you can use to fund your retirement without giving up ownership of your home.
As long as at least one borrower is living in the home and paying the property taxes and insurance, no repayment is required. The reverse mortgage only becomes due and payable when the last borrower permanently leaves the home, whether through selling, passing away, or moving into a nursing home.
You always remain the owner of your home, so you’re free to leave it to your heirs. If they wish to keep the home, they can pay off or refinance the reverse mortgage balance. If they prefer not to keep the home, they can sell it on their own or allow the lender to sell it.
Any remaining equity after the reverse mortgage is paid off will go to your heirs.
The HECM is a non-recourse loan, which means the most that will ever have to be repaid is the value of the home – even if it’s not enough to settle the entire loan balance.
The reverse mortgage is a home loan, so it has an interest rate associated with it. Interest rates are usually fairly comparable to traditional home loan rates. If you choose not to make payments on the reverse mortgage (which is the point), then any accrued interest is added to the loan balance over time.
The Top 3 Reverse Mortgage Disadvantages
I’ve worked with thousands of reverse mortgage clients over the years and I’ve pretty much heard every objection, concern, and misconception floating around out there. Of all the reverse mortgage disadvantages I’ve heard or read (that aren’t blatant misconceptions), the following three are the ones I’ve heard the most.
Yes, these supposed disadvantages are good to be aware of. However, I think they’re given far more concern than they deserve when you consider the benefits and protections built into the reverse mortgage.
Disadvantage #1: You’ll Eat Up Your Home’s Equity
This is one of the most common reverse mortgage disadvantages I hear. Remember, the whole purpose of the program is to convert home equity into cash. Using up equity is how it’s supposed to work. If your goal is to pass on as much home equity to your heirs as possible, then a reverse mortgage obviously doesn’t make sense for you.
Having said that, it’s worth noting that the HECM is designed to also preserve equity. It has to or the HECM program isn’t financially viable over the long term.
Remember, the HECM reverse mortgage is a non-recourse loan. FHA has to cover the shortage if there’s not enough value in the home to settle the entire loan balance. If the reverse mortgage used up equity quickly, FHA would be covering a lot of shortages, which would make the program completely unworkable from a financial standpoint.
Unless home values utterly crash in your area, it’s a good bet you’ll have a lot of equity in your home for many years to come even if you have a reverse mortgage.
Let’s take a look at some numbers to illustrate my point. For this scenario, we’re going to assume we have a 62-year old homeowner who’s borrowing the maximum possible at closing to pay off a large mortgage balance.
The following are the assumptions I’m making for this scenario:
Starting reverse mortgage balance: $200,000
Total annual interest and MIP: 5.00%
Starting home value: $450,000
Annual home appreciation rate: 3%
The amortization at left shows how the loan balance will grow over time if the borrower makes no payments (which is the point, right?).
As you can see, the balance grows pretty substantially as time goes on. If this borrower lives to age 90, the loan balance will have quadrupled to over $800,000. Wow!
However, let’s not forget that his home has likely appreciated over that time as well. Even though at age 90 he owes 4 times his original loan amount, his home’s value has appreciated to over $1 million. Even though he’s had the reverse mortgage for a whopping 28 years, he still has over $200,000 in equity!
Even better, he hasn’t had a mortgage payment for 28 years. Assuming the principal and interest payment on his original loan was around $900/month, he will have saved about $300,000 worth of mortgage payments since he got his reverse mortgage. Wow!
Obviously, there’s no guarantee that home values will appreciate steadily at 3% every year. Some areas appreciate rapidly then crash (looking at you, Las Vegas), others barely appreciate at all, and still others tend to appreciate steadily with the overall inflation rate. However, home values overall in the United States have averaged around 4% appreciation since the 1960s.
Disadvantage #2: High Closing Costs
This is probably the most valid of the reverse mortgage disadvantages I’m covering in this article. Yes, closing costs for a reverse mortgage can be higher – even substantially higher – than a traditional forward mortgage, but it doesn’t mean they actually will be. And even if they are, it’s important to note that they typically don’t have to be paid out of pocket. The vast majority of closing costs are just rolled into the new loan amount and repaid when the entire loan balance is paid back.
There are typically three categories of closing costs for a reverse mortgage:
- IMIP mortgage insurance
- 3rd party closing costs
Let’s take a look at each of these in more detail.
Origination fees are charged by lenders to cover underwriting and processing costs and pad their bottom line. They can range from a few hundred to several thousand depending on the lender, loan scenario, and interest rate conditions.
If your initial loan amount is very small, expect the lender to charge at least some kind of origination fee. If your loan amount is much larger (such as when you’re paying off a large mortgage balance), the lender may be able to discount or waive their origination altogether.
Because the lender controls the origination fee, you may be able to negotiate a little. It never hurts to ask if a lender is willing to discount or waive their origination fee. The worst they can say is no, right?
IMIP Mortgage Insurance
The IMIP mortgage insurance premium is what makes the HECM reverse mortgage a non-recourse loan, which means you’ll never pass a big debt to your heirs even if the home isn’t worth enough to settle the entire loan balance. FHA periodically changes the IMIP, so click here for the current IMIP rate.
3rd Party Costs
The 3rd party costs cover the services the lender needs to hire to get the reverse mortgage done, including appraisal, title insurance, escrow, etc. Note that lenders can only pass on the actual cost to you; it is illegal for them to apply a markup to third party costs.
Third party costs can range depending on the state and home value, but they’re usually in the range of $2,000 to $4,000 for most people.
The Good News About Closing Costs
Though closing costs are just part of getting a reverse mortgage, the vast majority typically don’t need to be paid out of pocket. They can usually be rolled into the starting loan amount.
The only costs that are typically out of pocket are the counseling fee (usually around $125) and appraisal (some lenders may be willing to roll this into the loan for you).
Disadvantage #3: Interest Can Pile Up in the Later Years
This is probably one of the most common reverse mortgage disadvantages I read in articles by financial experts and pundits. Yes, it’s true that interest can really start piling up if you have a reverse mortgage for many years. But even if the interest eats up all the equity in your home, you’re still not leaving a big debt to your heirs. Again, FHA will cover any shortage if your home isn’t worth enough to settle the entire balance.
To see how interest can accumulate in the later years of the reverse mortgage, let’s again take a look at the amortization from the example earlier. As you can see in the chart, the loan balance only grows by a little over $10,000 in the first year of the reverse mortgage. However, at age 90, the balance is growing by a whopping $40,000 per year. Wow!
Remember, any unpaid interest is considered a loan advance and tacked onto the loan balance, which means interest accrues on interest over time. This isn’t necessarily a good or bad thing, it’s just how it works.
If this borrower beats the odds and lives to age 98, his loan balance will be growing by nearly $70,000 per year and he will likely have run out of equity in his home.
But, so what? If getting rid of a $900 mortgage payment enabled this borrower to be more financially secure, see the world, and enjoy his grandchildren more, it was well worth it. For many seniors, such things are priceless.
Get Fully Educated
The three reverse mortgage disadvantages I’ve covered here are definitely valid concerns. But in my honest opinion, I think they’re only truly reverse mortgage disadvantages if the program isn’t the right solution in the first place.
Again, a reverse mortgage is a fantastic product, but it’s not perfect for everybody. Whether it’s right for you depends on your financial goals and situation. If you’re considering a reverse mortgage, just make sure you are fully educated and you get all your questions and concerns answered.
Yes, you may use up all your equity, the closing costs may be high, and interest could pile up rapidly at the end. But if the reverse mortgage enables you to more fully enjoy your retirement, then it’s probably well worth to get one.