The HECM reverse mortgage is a great retirement tool, but it’s not perfect for every financial situation. Like any product, it comes with pros and cons. In this article, we’ll cover the possible downside of reverse mortgages and potential pitfalls to watch out for.
You’ve likely seen the TV commercials with famous pitchmen like Tom Selleck and Henry Winkler extolling the virtues of reverse mortgages. They make them sound pretty good, right? I think the reverse mortgage is a great product, but I’ll be the first to acknowledge it’s not perfect for everybody. There are some reasons a reverse mortgage may not make sense for some seniors.
Before we dig into the possible downside of reverse mortgages, let’s first cover what a reverse mortgage is and how it works. There is a lot of misinformation circulating out there.
First, a few basics
The most common reverse mortgage 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 likely was a HECM.
If you’re at least 62, the HECM enables you to convert a portion of your home’s value into tax-free cash. No mortgage payments are required as long as you live in the home and pay the required property charges.
You remain the owner of your home and can leave it to your heirs. If your heirs want the home, they’ll need to pay off or refinance the loan balance. If they don’t want the home, they can either sell it or let the lender sell it. Any equity left in the home goes to your heirs once the reverse mortgage balance is repaid.
The HECM is a non-recourse loan; the most you will ever have to pay back is the value of your home. FHA covers the shortage if your home isn’t worth enough to pay off the entire balance.
The HECM is highly versatile and can be tailored to your financial goals. Proceeds are available in the form of a lump sum, line of credit, term or tenure payments, or some combination of all of these.
The possible downside of reverse mortgages
Like many of my past clients, you may think the reverse mortgage sounds too good to be true. It might seem 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 come up with:
1) You will likely leave less (or perhaps zero) home equity to your heirs. In my opinion, this isn’t a downside per se, but it’s an objection I’ve heard many times over the years. The purpose of a reverse mortgage is to convert home equity into cash. This means your balance increases and your home equity decreases over time. A reverse mortgage obviously makes no sense if the goal is to leave the maximum possible equity to your heirs.
2) You will likely have less equity to purchase a new home in the future. A reverse mortgage is best for seniors who don’t plan to move. You may want to avoid a reverse mortgage if you plan to sell your home and buy a new one in the future. If you take a reverse mortgage now, you’ll have less equity available to purchase a new home later. I recommend waiting until you move into your “forever” home.
Having said that, a reverse mortgage doesn’t lock you into your home. If circumstances change and you need to move, there are no limitations or prepayment penalties.
3) Settlement charges. Closing costs are probably the most commonly cited downside of reverse mortgages. Yes, closing costs can be steep, but not always. Closing costs commonly include origination fees, third party fees (title, escrow, appraisal, etc.), and FHA’s IMIP.
The closing costs can add up, but you typically will not need to pay them out of pocket. Most lenders roll them into the new loan, which means they’re paid back when the entire balance is settled.
The exception is HECM for purchase; you’ll typically pay the closing costs out of pocket with your down payment.
Yes, the closing costs can be expensive, but it’s important to keep things in perspective. Many other common financial products are surprisingly expensive, yet people hardly think twice about using them.
4) The loan balance may increase rapidly in later years. The reverse mortgage is a home loan, so it has an interest rate like any other home loan. If you don’t make payments (the whole point, right?), the interest simply accrues onto the loan balance. Unpaid interest is considered borrowed money, which means interest accrues on interest over time. This isn’t necessarily good or bad, it’s just how it works. However, this means interest can pile up in the later years of the loan when the balance is relatively large.
Having said that, remember that the HECM is non-recourse. You’re fully protected if the loan balance grows larger than the value of your home. FHA covers the shortage if your home isn’t worth enough to settle the entire loan balance.
5) Loan-to-values are conservative. I’ve talked with numerous seniors over the years who thought a reverse mortgage offers 100% of the value of their home. Definitely not! A HECM offers a portion of the value of your home. Most borrowers qualify for about 45% to 60% of their home’s value. A reverse mortgage is probably not the right option if you need more equity than that. Other home loan products offer higher loan-to-values, but they’ll also come with a monthly mortgage payment.
What is the upside of reverse mortgages?
We’ve discussed the downside of reverse mortgages, but let’s not forget the upside. Yes, a reverse mortgage isn’t perfect for everybody, but it’s fantastic for many seniors.
According to US Census Data, the average American 65-year-old in 2019 had a household net worth of $268,700. Of that, $182,000 was home equity. As you can see, home equity is a significant part of the average retiree’s net worth.
Now, think about your home equity for a moment. How much does it impact your day-to-day life? Probably not much, right? After all, home equity isn’t liquid. You can’t trade it for a vacation, home upgrades, or critical medical care.
Whether your home equity equals $5 or $500,000, it’s just a number on paper. Here’s a case in point: there are seniors living paycheck-to-paycheck in the San Francisco Bay Area with free and clear homes worth over a million dollars. They’re technically millionaires, yet they’re barely scraping by on a meager Social Security check.
Yes, home equity is a good thing, but it has no practical impact on your retirement lifestyle unless you can convert it into cash.
The beauty of the reverse mortgage is that it brings home equity into the retirement planning picture. Home equity no longer has to remain a largely unusable resource. It can now be used to protect and enhance your retirement lifestyle and financial security. Seniors from all walks of life have used the reverse mortgage to:
- Eliminate existing mortgage payments
- Eliminate other debts, such as credit cards and auto loans
- Finance home improvements
- Supplement retirement income
- Pay off medical bills
- Increase liquid retirement assets
- Set up a rainy day or emergency fund
- Take a vacation
Folks, this kind of stuff is a retirement gamechanger for many seniors. A reverse mortgage could be a gamechanger for you as well!
If you’d like an estimate how much you can get, check out our reverse mortgage calculator.