Many seniors have the impression that reverse mortgages are expensive – mainly because of the closing costs. Yes, depending on the scenario, reverse mortgage closing costs can sometimes be pricey, but not always. Regardless of what the closing costs are, the overall cost of a reverse mortgage is often comparable to other common retirement and home loan products.
I was prompted to write this article when I came across an old email from a gentleman critical of an article I wrote about the HECM line of credit. He believed I was painting too rosy of a picture about HECM line of credit growth and downplaying the “exorbitant” (his word) costs of the reverse mortgage. It’s unfortunate he felt that way, because the line of credit is one of the best features of a HECM reverse mortgage.
The purpose of the article in question was to point out the benefits of getting a HECM line of credit early in retirement even if the money isn’t needed right away. I wrote the article to seniors who owe little or nothing on their homes and already have at least adequate financial resources. Obviously, not every senior fits this profile. I wasn’t trying to paint an unrealistic picture of line of credit growth, I was simply explaining a great retirement strategy for seniors who fit a certain financial profile.
By the way, if you’re not familiar with how the HECM line of credit works, I encourage you to check out one of the several articles I’ve written about it. I think the line of credit is one of the best features of a HECM reverse mortgage.
Having said that, are the costs of a reverse mortgage “exorbitant”? Is my critic’s assertion valid? Well, first of all, it depends on what you’re referring to. If you’re talking about closing costs, then yes, a reverse mortgage can be expensive – but not always. However, if you’re referring to the overall cost of a reverse mortgage, including closing costs, then you may be surprised to learn that a reverse mortgage often isn’t any more expensive than many other commonly-used financial products.
By the way, if you’re not familiar with how a reverse mortgage works, you may want to cover some basics before reading further. There is a lot of misinformation floating around about reverse mortgages. Click here for some great introductory information about reverse mortgages.
Reverse mortgage closing costs
The most common objection I hear about the HECM reverse mortgage is the closing costs, so let’s first cover what those are.
The largest reverse mortgage closing cost is often the IMIP, which is collected by FHA to insure the HECM reverse mortgage and make it non-recourse. The IMIP is currently calculated as 2% of the maximum claim amount. For most people, the maximum claim amount is the appraised value of the home. For example, if your home is worth $300,000, then the IMIP will equal $6,000 (2% * $300,000). IMIP can get pretty steep if you happen to live in a high cost real estate market where homes are valued at $700,000 to $800,000 or more. IMIP in high cost markets can be $14,000 or more, but never more than $19,416 based on today’s FHA lending limit.
Lenders also charge origination fees, which can be as much as $2,500 to $6,000, depending on the value of the home. Third party closing costs often add another $2,000 to $4,000 to the overall bill for closing costs.
Obviously, these are not small numbers! The good news, however, is that the closing costs can usually be rolled into the new loan amount. They don’t have to be paid out of pocket. The exception is HECM for purchase; if you purchase a home with a HECM, the closing costs are paid out of pocket in addition to your down payment.
You also may be able to negotiate closing costs with your lender. This is particularly true if you’re starting off with a relatively large reverse mortgage balance.
So yes, the closing costs themselves can be pricey. But is the overall cost of a HECM reverse mortgage pricey when compared to other common financial products? Not necessarily! Let’s look at some of the most common financial products Americans use and see how the costs compare with a reverse mortgage.
How do 401(k) costs compare to HECM reverse mortgage costs?
Many Americans have 401(k) plans through their employers and don’t even think twice about investing their hard-earned dollars into them. Investing in a 401(k) at work is widely considered a wise financial move – especially if your employer offers a match.
According to Investopedia, the average fees on a 401(k) range from less than 0.5% for companies with large plans to north of 2% for smaller company plans. These fees are assessed as a percentage of the total dollars under management on an annual basis for as long as the 401(k) plan exists. In other words, if the 401(k) plan you’re invested in has a fee of 1%, that’s 1% deducted from the total annual return of your 401(k) for as long as you have it. Obviously, these fees can really add up if you have a 401(k) for 20 or 30 years over your working career.
To show you how much these fees can cost over time, let’s assume three different workers invest $100,000 at age 35. Worker #1 has a plan fee of 0.5%, worker #2 has a plan fee of 1%, and worker 3 has a plan fee of 2%. To keep things simple, we’ll assume all three workers make no further investments and earn a consistent return of 8% per year. Here’s what each worker would end up with after 30 years:
Worker #1 (0.5% management fee): $936,302
Worker #2 (1.0% management fee): $806,943
Worker #3 (2.0% management fee): $599,261
If there were zero fees, each of these plans would have a balance of $1,086,331. That means each worker earned $986,331 on their initial $100,000 investment over their working careers.
Obviously, these workers didn’t end up with a seven-figure 401(k) balance because of the management fees that were skimmed off the top every year. As you can see, worker #1 ended with a balance of $936K, which means he paid $50,000 in fees over the life of the 401(k). Worker #2 paid about $180,000 in fees and worker #3 paid a whopping $386,000 in fees!
Keep in mind that the management fees are collected regardless of your annual return. Even if your 401(k) loses money in a bad bear market, the management fees are still collected by the 401(k) custodian.
Now, does this mean that 401(k)s are bad? Not at all! I’ve invested in a 401(k) myself. Sure, nobody likes to pay fees, but they’re the cost of doing business when you invest in a 401(k). You’re paying for the benefits that a 401(k) offers: easy investing, company match, diversification, favorable tax treatment, and professional management.
Comparing the costs of a traditional FHA mortgage to a HECM reverse mortgage
Now, let’s take a look at the total costs of a traditional FHA mortgage, which are commonly used by Americans to purchase homes because they offer low down payments. Let’s assume a $300,000 purchase price, a minimum down payment of 3.5% (which means the financed amount is $289,500), and an interest rate of 3% for a 30-year fixed. In this scenario, FHA charges an upfront mortgage insurance premium of 1.75% of the loan amount and an annual mortgage insurance premium of 1.05% for the life of the loan. Third party closing costs can vary widely, but we’ll assume $5,000 for this example.
Let’s see how the costs of this loan add up over time:
Upfront mortgage insurance (1.75% of the loan amount): $5,066.25
Closing costs: $5,000
Interest (at 3% annually): $152,662
Annual mortgage insurance (1.05%): $49,000
Total cost: $211,728
As you can see, in this scenario it costs a whopping $211,728 over the life of the loan to borrow $289,500 via a traditional FHA loan.
Now, if you’re not a first time homebuyer and/or you have excellent credit, an FHA loan probably isn’t the option you would go with. Thus, let’s also take a look at a conventional loan and see how much it costs.
Comparing the costs of a conventional mortgage and a HECM reverse mortgage
If you have excellent credit and a large down payment, a conventional loan probably is the better option if you’re purchasing a home. Conventional loans don’t have mortgage insurance if you put down at least 20% of the purchase price, but the rates tend to be slightly higher than a comparable FHA loan. For this example, let’s assume the same $300,000 purchase price, a 20% down payment (which means we’re financing $240,000) and an interest rate of 3.50% for a 30-year fixed. We’ll assume $5,000 in closing costs as we did for the FHA example.
Let’s see how much the loan costs add up to:
Closing costs: $5,000
Interest (at 3.50% annually): $147,975
Total cost: $152,975
As you can see, in this example it costs a total of $152,975 to borrow a fairly modest $240,000 over 30 years. That’s a lot of money to pay for a loan, yet most people hardly think twice about doing it.
The costs of a HECM reverse mortgage with a line of credit payout
So how do the costs of the 401(k) and the traditional mortgages compare to the costs of a reverse mortgage? Let’s find out!
For this HECM reverse mortgage example, let’s assume a 62-year old borrower with a free and clear home valued at $600,000. I’m using a high home value so that the closing costs are about as stiff as they can possibly be. This borrower doesn’t need the money right now, so he plans to set up a line of credit and use it as a safety net. The goal is to leave the line of credit untouched as long as possible to maximize the growth.
Let’s assume this borrower qualifies for a principal limit equal to 45% of the value of the home ($270,000) and the total closing costs (which are rolled into the starting loan amount) add up to $20,000. What?? Twenty thousand dollars in closing costs?? I can hear my email critic gasping at the thought of paying $20,000 to get a mortgage. Let’s also assume the total initial interest rate and MIP add up to an annual rate of 5%. To keep the example simple, we’ll assume the interest rate never changes and the borrower doesn’t take any additional cash over 30 years.
Let’s see how the numbers work out if this borrower has his reverse mortgage until he’s 92:
Closing costs: $20,000
Interest and MIP: $68,984
Total cost: $88,984
Over 30 years, the reverse mortgage cost a total of almost $89,000. Obviously not chump change, right? But let’s also look at the other side of the equation: what is this borrower getting for that $89K? Remember, the line of credit has been growing and compounding over the 30 years he has had the loan. At age 92, the line of credit will have grown from a net $250,000 ($270,000 principal limit minus $20,000 in closing costs) to a whopping $1,112,301. This borrower has over $1 million at his disposal to use for whatever he needs on a non-recourse basis. Wow!
Now, granted, it’s probably not realistic that he won’t use the money for three full decades. Let’s see how the numbers work if he pulls out $150,000 at age 77. This means his available line of credit will drop by $150,000 and his interest and MIP costs will increase because the loan balance will be larger. Let’s see how the numbers end up at age 92:
Closing costs: $20,000
Interest and MIP: $253,414
Total cost: $273,414
Yes, the costs are definitely much higher because the loan balance increased substantially at the 15-year mark. But let’s also not forget that this borrower still has his line of credit, which has grown to a whopping $797,871 despite the $150,000 he took out at age 77.
An expensive reverse mortgage example
Now, let’s check out an example where the costs for a reverse mortgage will be pretty expensive over time. For this example, we’re assuming a large existing mortgage balance, which means the starting loan amount is going to be relatively high and will accrue a lot of interest over time. Let’s assume this borrower is 62, has just retired, and has a 30-year fixed mortgage at 3.50% that was taken out a year ago (which means he has 29 years left to pay). The existing mortgage balance started at $350,000, so after a year’s worth of payments, it’s now down to a balance of $342,383. The principal and interest payment is $1,571.66/month (we’re leaving out taxes and insurance because they’re paid regardless of the type of mortgage or whether there is a mortgage balance at all).
Let’s assume $20,000 in closing costs will rolled into the new reverse mortgage after paying off the existing mortgage balance. Let’s also assume the same annual combined interest and MIP rate of 5% as before and that the principal limit is completely used up at closing. The starting reverse mortgage loan amount would be $362,383 (the pay off of $342,383 plus $20,000 in closing costs).
Let’s see how things look at age 91 when the 30-year fixed mortgage would have otherwise been paid off:
Closing costs: $20,000
Interest and MIP: $1,263,243
Total cost: $1,283,243
Wow, that total cost figure is pretty ugly, right? It’s possible the reverse mortgage balance is even larger than the value of the home. However, the HECM is non-recourse, so FHA will be on the hook for the shortage if the home is worth less than the loan balance.
Now, let’s also not forget that this borrower hasn’t had a mortgage payment for 29 years. Twenty-nine year’s worth of mortgage payments at $1,571.66/month adds up to a massive $546,938. That’s almost $550,000 that this borrower saved and was able to spend on fun activities with grandchildren, home improvements, travel, covering medical expenses, etc. When you figure in the savings on mortgage payments, the total cost of the reverse mortgage drops to a net $736,305. That’s not an insignificant number, but we’re also assuming this borrower had the reverse mortgage for 29 years – which is a pretty long time frame. Most seniors have their reverse mortgages for about 7-8 years.
Yes, the total cost of the reverse mortgage was pretty high in this scenario, but this borrower was able to save $550,000 that would have otherwise gone to a mortgage payment for a loan he may not have lived long enough to pay off anyway. That’s $550,000 he was instead able to use to enhance his retirement lifestyle and financial security.
It’s all about cost versus benefit
Folks, like anything, it’s all about cost versus benefit. A HECM reverse mortgage has costs like anything else. When you look at the total picture, as we’ve done here, the costs are often not that different compared to the total costs of the 401(k)s and traditional mortgages that most Americans don’t even think twice about using.
The upfront costs on a reverse mortgage tend to be higher because the loan balances tend to start off lower than the typical traditional mortgage. Not much interest accrues on a small balance, so the costs of the loan have to be paid in the form of closing costs.
Traditional mortgages have lower upfront costs because they have higher starting loan balances. Larger loans generate more interest, which means traditional lenders have more leeway to absorb costs that would otherwise be charged as fees.
It’s worth noting that downsizing to another home has a lot of costs as well. Many seniors downsize to save money, but that has some pretty stiff upfront costs, too. If you sell your home for $400,000, you’ll probably pay your realtor somewhere between $12,000 and $24,000 for commissions. Then, you’ll have to pay movers another $10,000 to $20,000 to move your stuff. The upfront costs of a reverse mortgage are a bargain compared to the costs and hassles of moving.
It’s important to look at cost, but it’s also important to look at benefit. What does a reverse mortgage offer you? What are you getting in return for the costs? If you’re getting a substantial improvement in your retirement lifestyle and financial security, the costs of a reverse mortgage are probably worth it. But that’s a judgment call that can only be made by each individual senior. For some, the costs may not be worth it. That’s OK! That doesn’t mean the reverse mortgage is bad, it just means a reverse mortgage isn’t perfect for everybody.
