May 5, 2018 by HECM Pro
I’m sure you’ve seen the commercials on TV with famous pitchmen extolling the virtues of reverse mortgages. They make reverse mortgages sound pretty good, right? So, what is the downside of reverse mortgages? What are some possible pitfalls you need to look out for?
The HECM reverse mortgage is a great financial tool, but it’s not necessarily perfect for every person and financial situation. Like anything else, it has it’s pros and cons.
Before we dig into the downside of reverse mortgages, let’s first go over what reverse mortgages are and how they work. There is a lot of misinformation floating around out there, so I want to cover the basics before going over some reasons they may not make sense.
What is a Reverse Mortgage?
The most common reverse mortgage product in the United States today is the FHA-insured home equity conversion mortgage, or HECM (often pronounced heck-um by industry insiders). If somebody you know recently got a reverse mortgage, it’s a good bet it was a HECM.
The HECM reverse mortgage is designed to give homeowners 62 or older the ability to convert a large portion of their home’s value into tax-free cash without taking on a mortgage payment or giving up ownership of the home. As long as you live in the home and stay current with property taxes and homeowners insurance, no monthly payments are required and the loan balance does not have to be repaid.
You always retain title ownership of your home, which means you’re free to will it to your heirs. If your heirs wish to keep the home, they need to pay off or refinance the reverse mortgage balance. If they’d rather not keep the home, they can sell it on their own or let the lender sell it. Any equity left in the home after the reverse mortgage is repaid will go to your heirs.
The HECM reverse mortgage is very versatile and can be tailored to your financial needs and goals. Proceeds can be received in the form of a lump sum, line of credit, term or tenure payments, or some combination of all of these.
The HECM is a non-recourse loan, which means you’ll never leave a big financial mess to your heirs. If the home isn’t worth enough to settle the entire balance, the shortage is covered by the FHA insurance fund.
The Possible Downside of Reverse Mortgages
Like many of my clients over the years, you might be thinking the reverse mortgage sounds a little too good to be true. It might seem a little crazy that you can borrow against your home’s equity without a monthly mortgage payment, right?
So what is the downside of reverse mortgages? Well, here are a few possible downsides I can think of:
1) You will likely leave less (or perhaps zero) home equity to your heirs. I’m not sure this is truly a downside of reverse mortgages per se, because the whole purpose is to convert home equity into cash. This means your balance increases and your home equity decreases over time. If your goal is to leave the maximum home equity possible to your heirs, then the reverse mortgage doesn’t make sense for you.
2) You will likely have less equity to purchase a new home in the future. The reverse mortgage is best suited for seniors who don’t plan on moving. If your plan is to sell your home and buy a new one at some point, it’s probably best to avoid the reverse mortgage for now. Do the reverse mortgage once you’re settled into a home you plan on living in for the rest of your life.
Having said that, understand that the reverse mortgage doesn’t lock you into your home. If circumstances change and you need to move, simply sell the house, pay off the reverse mortgage, and keep the remaining equity.
3) Settlement charges. Expensive closing costs is probably the most commonly cited downside of reverse mortgages. Yes, closing costs can be steep, but not always. Many lenders charge origination fees, there’s 3rd party services to cover (title, escrow, appraisal, etc.), and FHA assesses a mortgage insurance premium called IMIP.
Though these fees can add up to a substantial amount, they’re typically not paid out of pocket. Most lenders can roll them into the new loan and they’re paid back in the future once the entire balance is settled.
4) The loan balance can increase substantially in later years. The reverse mortgage is a home loan, so it has an interest rate associated with it (rates are comparable to traditional home loan rates). If you choose not to make payments on the reverse mortgage (which is the whole point, right?), then any accrued interest is added to the loan balance. Unpaid interest is considered borrowed money, which means interest can accrue on interest over time. This isn’t necessarily good or bad, it’s just how it works. However, it does mean that the interest can really pile up in the later years of the loan when the balance has gotten fairly large.
Now having said that, remember that the reverse mortgage is a non-recourse loan. You’re fully protected if the loan balance grows larger than the value of the home. FHA will pick up the shortage if the home isn’t worth enough to settle the entire loan balance.
5) Loan-to-values (LTV) are very conservative. Because there’s no payment required, the reverse mortgage is a very conservative loan program. Most borrowers qualify for about 45% to 60% of their home’s value. If you need more of your home equity, the reverse mortgage is probably not the right option. There are other home loan programs available to tap a higher proportion of your equity, but they will usually require a payment.
What is the Upside of Reverse Mortgages?
We’ve discussed the downside of reverse mortgages, but don’t forget the upside. Yes, the reverse mortgage isn’t perfect for everybody, but it is a fantastic option for many seniors. Many seniors from all walks of life have used the reverse mortgage to:
- Eliminate existing mortgage payments.
- Pay off other bills, such as auto loans and credit cards.
- Add to retirement income.
- Supplement existing retirement assets (and help them last longer).
- Do home improvements.
If it would be helpful to add home equity to your retirement plan, be sure to have a reputable reverse mortgage lender run some estimates for you.