Pros and cons of reverse mortgages

Homeowners with equity in their homes often seek to tap their equity to improve their finances. However, most mortgage programs require monthly payments in exchange for providing extra cash. Senior homeowners have access to reverse mortgages, which can provide them with the money they need while eliminating all monthly mortgage payments.

While these mortgages offer the cash you need, they can be tricky for some borrowers. It is important to carefully explore all aspects of these loans before applying for one. Learn what a reverse mortgage is, how they work and the pros and cons of this mortgage option.

Key insights

• Reverse mortgages are usually limited to homeowners who are at least 62 years old.
• Different types of reverse mortgages meet the financial needs of various borrowers.
• The loan funds are tax-free and do not affect Social Security or Medicare.
• The loan is repayable when the borrower dies or moves out of the home.

What is a reverse mortgage and how does it work?

A reverse mortgage is a type of loan that allows eligible seniors to tap into their home equity without the obligation of monthly payments. Traditional mortgages pay down the balance over the life of the loan, but the balance of a reverse mortgage grows over time as interest charges increase the amount owed. There are multiple types of reverse mortgages; borrowers can receive a stream of payments, a lump sum or a line of credit.

To qualify for a reverse mortgage, you must be at least 62 years old and have equity in your home. In general, the older you are, the higher the maximum loan amount can be. The lender reviews your finances to ensure that you can handle ongoing expenses of the home, like property taxes and insurance. Additionally, borrowers must undergo financial counseling with an approved counselor (for a federally insured Home Equity Conversion Mortgage).

Unlike on a traditional mortgage, the balance on a reverse mortgage grows over time.

Although there are no loan payments required, lenders still perform a financial assessment of the borrower before approving the loan. Borrowers maintain ownership of their homes and are still responsible for the ongoing costs of homeownership, including property taxes, insurance, utilities, repairs and maintenance.

Casey Fleming, a mortgage advisor and the author of "The Loan Guide: How to Get the Best Possible Mortgage," advises borrowers that "a reverse mortgage is a lifetime loan, meaning that as long as you live in the property, maintain it and pay your taxes and insurance, it cannot be called or terminated. However, if you move out for more than 12 months, the loan is now due and payable. You have six to 12 months after it's called to come up with a plan to pay it off."

The borrower can live in their home for as long as they like. However, the reverse mortgage must be repaid if the borrower moves out, sells the home or dies. Borrowers or their heirs can pay off the loan with cash or a new mortgage to retain ownership of the home.

Pros of a reverse mortgage

Reverse mortgages offer a financial cushion to elderly homeowners who want to continue living in the same homes. The advantages of using this mortgage option over more traditional home loans include:

• Borrowers can choose how to access their equity. Reverse mortgages can be a stream of income, a lump sum or a line of credit. Many options fit the different needs of borrowers.
• The money is tax-free. You do not owe any taxes on the money that you receive from your reverse mortgage loan. However, you may still owe capital gains taxes when the home is sold after you move out.
• Income won’t affect Social Security or Medicare payments. A reverse mortgage does not affect Social Security and Medicare benefits since reverse mortgage distributions are nontaxable payments.
• There are no monthly mortgage payments. With a reverse mortgage, you do not need to make any payments to your new lender for as long as you remain in the home.
• You can live in your house for the rest of your life. Many seniors worry about leaving their homes before they're ready. Reverse mortgages provide access to your home equity without you having to move or make additional monthly payments.
• Cancel without penalty. Borrowers have at least three business days to cancel a reverse mortgage for any reason without incurring a penalty. If you've decided that this loan isn't good for you or an advisor recommends against it, you can cancel it in writing.

Cons of a reverse mortgage

A reverse mortgage can seem like a miracle cure for your finances, but there are drawbacks to these loans. Some borrowers sign up for a reverse mortgage without understanding how it differs from a traditional mortgage.

• You cannot tap into the full value of your equity. Your age, current interest rates and your home's appraised value determine the maximum loan you can get. Additionally, there is a maximum reverse mortgage amount of $970,800 on government-backed loans. As a general rule, the older you are, the more you can withdraw through a reverse mortgage.
• Reverse mortgage fees are substantial. With the most common type of reverse mortgage, a government-backed Home Equity Conversion Mortgage, or HECM, you'll pay up to $6,000 in origination fees plus an FHA mortgage insurance premium, third-party charges and servicing fees.
• The loan balance increases each month instead of decreasing like in a traditional mortgage. The interest that accrues on your loan each month adds to your mortgage balance. This means that you'll owe more on your home in the future than you owe today.
• The borrower pays taxes and insurance. While a reverse mortgage eliminates your mortgage payments, borrowers are still responsible for paying property taxes and insurance payments yearly. Homeowners must also pay for utilities, repairs, maintenance and other costs of the home.
• Interest rates may change on your loan. Most reverse mortgages have a variable interest rate, which can impact the amount of interest charged each month. Additionally, reverse mortgage interest is not tax-deductible until you make payments or pay off the loan.
• The debt might exceed the home’s value eventually. With your mortgage balance increasing each month, it is possible that your loan may exceed your home's value as it fluctuates in value through the normal housing cycle.
• The loan must be repaid if you move out. Borrowers must repay a reverse mortgage when they move out of the home. This is true even if the borrower moves into an assisted living or hospice care facility.
• Your spouse or partner may be affected. If your spouse or partner is not a signer on the loan, they may have to sell the property to repay the loan if you move out or pass away. Some lenders allow them to continue living in the home as long as they care for the property, but the reverse mortgage stream of income stops.
• It impacts estate planning. The payments received, the interest charged and loan costs reduce the value of the estate that you pass on to your heirs.
• Your heirs could be stuck with a steep bill. If your reverse mortgage balance is higher than your home's value, your heirs may be responsible for up to 95% of the home's appraised value when it sells. Mortgage insurance covers the remaining loan balance.

Fleming, the mortgage advisor, noted that "a reverse mortgage is always nonrecourse, meaning that if you are ever 'underwater' (you owe more than the value of the home) the lender cannot call the loan, nor if you pass away or decide to sell can they come after you (or the estate) for a deficiency judgment."

Alternatives to reverse mortgages

Because of the risks associated with a reverse mortgage, you might want to consider one of these alternatives first:

• Getting a home equity line of credit (HELOC) or home equity loan: Borrow against your home equity with a second mortgage. HELOCs and home equity loans require monthly payments, and you'll also need to keep making your primary mortgage payments.
• Downsizing: Sell your current home and move into one at a lower cost. Homeowners with a lot of equity may be able to buy their new home without needing a mortgage.
• Selling your house: You can sell your home and move in with your family or rent another place to live.
• Taking on a roommate: Rent out a portion of your home to a roommate to generate income.
• Moving in with family and renting out your home: Earn income by moving in with family or friends and renting out your home.

Bottom line

A reverse mortgage can provide a financial lifeline for seniors with equity in their homes. This type of loan offers access to home equity without requiring the homeowner to sell the property or make monthly payments.

While these home loans can be a financial blessing, they can also be a curse in the wrong situations. Seniors must understand that the loan balance increases each month, and there are important ramifications for estate planning. Seek advice from a financial counselor or debt-management organization before signing on the dotted line.