Even though things are correcting right now, a lot of people have seen the value of their home double or more over the last eight years, creating an interesting alternative retirement plan for those who did not previously have one.  Great, if you are in that position.  The money train is arriving.  But the most important question for those who are planning not only to live in their house, but to live off of it is, what is the best way to get to my equity?  An interest only home equity is no good, that adds another bill and the interest rate is going to be higher than my rate of return on the money I pull out.  It also doesn’t get rid of any existing mortgage debt.

For some of the more “senior” Americans in this position, the reverse mortgage has become a popular solution to all of these questions.  But what is a reverse mortgage, how does it work, and is it really a good idea?

What is a Reverse Mortgage?

A reverse mortgage is, “a special type of loan used by older Americans to convert the equity in their homes into cash. The money from a reverse mortgage can provide seniors with the financial security they need to fully enjoy their retirement years.”

Just like a traditional mortgage it is a loan against your house, but unlike a traditional mortgage, it is not used to purchase the property, but to extract the equity in either the form of a line of credit or a monthly payout.

How does a Reverse Mortgage Work?

The concept of a reverse mortgage is surprisingly simple.  It is the opposite of a traditional mortgage (forward mortgage).  In a traditional mortgage a loan is issued to the homeowner, generally for the purchase of property, and payments begin immediately, allowing the homeowner to pay the principal down over a period of time.  Assuming we are talking about fully amortizing loans, the homeowner will be able to pay the mortgage off in full at some point in the future, commonly 30 years.

A reverse mortgage also issues a loan to the homeowner, however the homeowner does not make payments on this loan.  Ever.  Instead a first position lien is placed on the property, and the homeowner may receive either a line of credit for some portion of the equity or annuity like payments that will be guaranteed for life.  Interest accrues on the loan and is never paid off.  Rather the balance continues to grow every month.  Upon the death of the homeowner, the mortgage company takes possession of the house unless the heirs make arrangements for repayment of the debt.

What are the benefits to a Reverse Mortgage?

1. If the homeowner is at or near retirement age and continues to struggle to make end meet due to the burden of a mortgage payment, this will relieve them of the monthly payment.  This is a big relief to many retirement age homeowners wanting to retire, but worried about their mortgage payment.
2. This allows the homeowner to use the equity in their house as a retirement fund without having to sell and move.  Many older homeowners have spent the greater part of their lives in their final house.  Many have seen their children grow up there, and have deep roots in the neighborhood.  Selling the house would be a painful option.

What are the drawbacks to a Reverse Mortgage?

1. The interest rate is typically 1.5-2% higher than traditional mortgage rates.  Anyone thinking about using a reverse mortgage should consider comparing the cost and benefits of using a cash out refinance traditional mortgage.
2. The other costs are fairly high.  There is an origination fee which will be the greater of $2000 or 2% of the maximum qualifying amount.  There is typically a mortgage insurance premium equal to 2% of the lesser of the value of the house or the maximum qualifying amount in the first year and 0.5% of the loan balance annual after that.  There are also appraisal fees and a litany of closing costs.
3. The likelihood of keeping the house in the family after the death of the homeowners is unlikely.  However, for anyone considering a reverse mortgage, the likelihood is low under any other option as well.

Is a Reverse Mortgage a good solution?

As an absolute last resort if you are completely desperate.  The high closing costs mean you will lose out on large chunks of equity so you are better off selling and moving into a smaller house or apartment if possible.  There are also various government programs for seniors that want to keep their houses (aside from SS, there are property credits, etc).

Comments RSS