(MoneyWatch) "Why do I need to save? I'll just tap the equity in my house when I retire," said a former client at the end of 2006. He and his wife were in their late 50's and I was recommending that they increase their retirement contributions.
During the real estate boom, I encountered a lot of people who thought they would use their home equity to fund everything from big splurges, to college tuition, to retirement. When the bubble burst, many were forced to spend savings and cash-in investments and now face retirement with home equity that is on average 30 percent lower than it was at the peak. For some of these near or current retirees, the allure of a reverse mortgage is calling.
A reverse mortgage is a home loan that allows homeowners 62 and older to convert a portion of the equity in their homes into cash, as long as the home remains their primary residence. Most reverse mortgages are offered through the Department of Housing and Urban Development and are guaranteed by the Federal Housing Administration (FHA) through a program called Home Equity Conversion Mortgages (HECM). (FHA provides on line counselors as well as valuable information here or by phone at (800) 569-4287.)
Unlike a traditional mortgage, there's no lengthy underwriting process and you don't make monthly principal and interest payments. You are required to continue to pay real estate taxes, utilities, and hazard and flood insurance premiums. The amount you can borrow depends on several factors, including: the age of the youngest borrower, the current interest rate, the appraised value of your home and whether the rate is fixed or adjustable. The more valuable your home is, the older you are, and the lower the interest rate, the more you can borrow.
If the home is sold or no longer used as a primary residence, or the borrower dies, then the loan, the accumulated interest, and other HECM finance charges must be repaid. All proceeds beyond the amount owed belong to your spouse or estate. If the house sells for less than the money owed, the FHA takes the loss - no debt is passed along to the estate or heirs.
In essence, a reverse mortgage can help retirees convert an illiquid asset - a house - into a liquid one that can help supplement retirement income. Sounds too good to be true, right? For some, it is. One big downside of a reverse mortgage is that younger retirees who use them may run out of money and options at too young an age. These folks may have been better off selling their homes and using the equity to purchase another home or renting. Additionally, it may make sense to spend other assets before extracting home equity via a reverse mortgage.
Another consideration regarding reverse mortgages is the cost. FHA charges a single up-front mortgage premium equal to 2 percent of the home's appraised value or $625,500, whichever is less. The borrower is also charged a 1.25 percent annual premium on the entire loan balance. In addition, the borrower is charged a monthly servicing fee of up to $35. Add it all up and it's clear that a reverse mortgage isn't a good choice if the borrower will move out of the home in three years or less, because of the high up-front costs. It's also important to remember that reverse mortgage payouts also can impact a borrower's eligibility for means-tested benefits programs, like Supplemental Security Income (SSI) and/or Medicaid.
Consumer Union issued a warning on reverse mortgages, which noted "deep concerns about the suitability of the products for some borrowers" and "the aggressive marketing and misleading advertising of reverse mortgages to seniors." Celebrities like James Garner, Robert Wagner, Fred Thompson and Henry Winkler have all been paid to tout the benefits of reverse mortgages.
You may be wondering, "What does the Fonz know about reverse mortgages?" The answer is not much, which is why I strongly recommend that if you are serious about a reverse mortgage consult a registered investment advisor or an attorney, who can help determine if it is in your best interest.
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