I mean, what other mortgage product allows you to make zero mortgage payments? It probably sounds too good to be true, right? Like anything, it can’t all be upside. There has to be some reverse mortgage cons . . . right?
I’ve been in the reverse mortgage industry for quite a while and have done hundreds of reverse mortgages. Stick with me and I’ll offer my honest assessment about the top potential reverse mortgage cons you need to look out for.
Before I get into that, let me first cover some basics about how a reverse mortgage works. Many of the reverse mortgage cons you may have heard are rooted in misunderstandings about how a reverse mortgage really works.
How a reverse mortgage (really) works
The most common reverse mortgage program in America today is the home equity conversion mortgage, or HECM. The FHA-insured HECM enables seniors 62 and older to convert a portion of their home’s value into cash.
You always remain the owner of the home and you’re free to leave it to your heirs. If your heirs wish to keep the home, they can either pay off or refinance the reverse mortgage balance. If they prefer not to keep the home, they can either sell it or allow the lender to sell it. The bottom line is your heirs will inherit any remaining equity regardless of what they choose to do with the home.
The HECM is a non-recourse mortgage; FHA will cover any shortage if the home is not worth enough to pay off the entire balance.
The HECM is a home loan, so naturally, it comes with an interest rate. Interest rates are usually pretty comparable to traditional 30-year mortgage rates. If you don’t make a mortgage payment, the interest is simply tacked onto the mortgage balance.
This is how the HECM converts equity into cash over time. It shifts the burden of a mortgage payment from you onto the equity in the home. In a sense, the home is now paying the mortgage payment for you.
Reverse mortgage borrowers commonly use the proceeds to get rid of existing mortgage payments or other debt payments, supplement income, supplement retirement assets, and finance home improvements. You can use the proceeds for pretty much whatever you like.
What a HECM reverse mortgage is not
Before I dig into some reverse mortgage cons, let me address and clear up some potential misconceptions. Many of the perceived negatives about a reverse mortgage are based on misunderstandings about what a reverse mortgage actually is and how it works.
First, I hope you noticed in the explanation above that you do not give up ownership of your home when you get a reverse mortgage. You are not selling your home to the bank for a discount. You always remain the title owner of your home. That’s why you must continue paying your property taxes, homeowners insurance, and remain living in the home.
Second, the bank does not get your house after you die. After the last borrower passes away, the home goes to your heirs. Your heirs can decide whether they want to keep or sell the home. Regardless, they will inherit the equity remaining in the home.
Third, a reverse mortgage does not use up your equity quickly. It can’t! Remember, the HECM is a non-recourse loan. That means FHA will cover any shortage if the home is not worth enough to cover the entire balance. If the HECM uses up your equity quickly, then FHA will be covering a lot of shortages, right? Obviously, that means the HECM program is not financially sustainable over the long term.
The top 3 reverse mortgage cons
Now that we’ve covered some basics and (hopefully) cleared up some misconceptions, let me address the top 3 reverse mortgage cons I can think of. Note that what I’m about to cover does not mean the reverse mortgage is a bad program. It’s a fantastic program for the right candidate. Depending on your goals and needs, it may or may not be the right option for you.
1) Closing costs
If there’s one single negative about the reverse mortgage, I would say it’s the fees. The costs to get a reverse mortgage can be stiff – sometimes 3% to 5% of the home’s value.
A big cost driver is the initial mortgage insurance premium (IMIP). FHA charges IMIP to fund its mutual mortgage insurance fund, which protects and insures the reverse mortgage. The IMIP enables FHA to cover the shortage if the value of the home isn’t worth enough to settle the entire mortgage balance.
Lenders typically charge other fees as well, including origination and third-party costs. Third-party fees cover the services the lender hires to get your loan done, such as appraisal, title insurance, escrow, government recording, credit, etc.
Regardless of what the fees add up to, note that the vast majority typically do not need to be paid out of pocket. They’re rolled into the loan and settled up when the entire loan is paid back in the future.
Note also that lenders sometimes have leeway to cover fees. If interest rate conditions are favorable and you’re starting off with a large mortgage balance (such as when you’re paying off an existing mortgage), lenders often have some flexibility to cover all or part of the closing costs.
2) Interest can pile up in the later years of the loan
The HECM is a mortgage, so naturally, interest accrues on the borrowed money. As I mentioned, HECM interest rates are usually comparable to traditional 30-year mortgage rates.
The lender calculates interest exactly the same way for both traditional “forward” and reverse mortgages. For example, if you have a 6% 30-year fixed mortgage and the balance is exactly $100,000, the current monthly interest is $500 (6%/12 months * $100,000 principal balance).
The difference with the reverse mortgage is that you don’t have to actually pay the interest due out of your pocket. Again, no mortgage payments are required as long as at least one borrower is living in the home and paying the required property charges. Any interest not paid out of pocket is added to the loan balance. This means that the principal balance on which interest is calculated is growing, which means interest is accruing on interest.
Note that this isn’t some dirty secret the banks try to hide from you. Reverse mortgage lenders disclose this on amortization schedules they provide to you.
In the early years of the loan, this isn’t a big deal because the balance is relatively small. But if you have the loan a lot of years and the balance grows substantially, it could mean that interest piles up rapidly in the later years of the loan.
Having said that, don’t forget that the reverse mortgage is a non-recourse loan. If for some reason the loan balance grows larger than the value of the home, FHA will cover the shortage. You won’t leave a big mess for your heirs to clean up.
3) The FHA lending limit
I’m sure you’ve noticed that many real estate markets have seen huge increases in home values over the last decade. Unfortunately, many homeowners in high value markets will only have access to a relatively small portion of their home’s value via a HECM. Much of their equity will never be available to them. The reason for this is the FHA lending limit, which caps the initial amount lenders are allowed to lend, regardless of home value.
The home value percentage you qualify for is determined by the age of the youngest borrower (or non-borrowing spouse) and the expected interest rate (EIR). Based on these two numbers, the lender looks up a principal limit factor from tables published by FHA. A principal limit factor is essentially a loan-to-value percentage. For example, if your home is worth $300,000 and the principal limit factor is 0.50, then you qualify for an initial principal limit (the initial pool of cash available through the HECM) worth 50% of the value of the home.
The lending limit comes into play when the value of your home is higher than the lending limit. The lender applies the principal limit factor to the lesser of the lending limit or the appraised value.
A lending limit example
Let’s assume the principal limit factor is 0.50, the lending limit is $726,525 (which it is as of this writing in June 2019), and your home is worth $1 million. Because the home value is higher than the lending limit, the principal limit factor is multiplied by the lending limit of $726,525. The result is an initial principal limit of $363,262.50, or 36% of the home value. The lending limit essentially caps the appraised value used to calculate the initial principal limit.
The lending limit, unfortunately, drastically limits the potential benefits of a reverse mortgage for homeowners in higher cost markets. If your home is worth less than the current lending limit, this won’t matter for you at all. However, if you live in a high value market, you’ll likely have access to a limited percentage of your home’s value.
Having said that, many lenders are now rolling out private “jumbo” reverse mortgages that enable homeowners with more expensive homes to tap into more equity than would be available through the HECM. These programs aren’t available everywhere yet, but they likely will be in the coming months and years.
A great program . . . for the right candidate
I hope this rundown of potential reverse mortgage cons helps you make a more informed decision about whether a reverse mortgage is right for you. Again, a reverse mortgage is not always the perfect solution for everybody. However, it’s a great program for the right candidate. Consider all factors, both pros and cons, when evaluating if a reverse mortgage is right for you.