Is a Reverse Mortgage Right for You?

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

If you're age 62 or older and looking for a way to cash out some of the built-up equity in your home, a reverse mortgage could be the solution. But don't jump without weighing the pros and cons of this relatively new product, as well as the alternatives. For some cash-strapped homeowners, there might be better options.

Reverse mortgage basics

With a reverse mortgage, homeowners age 62 or older can access their home's equity without taking out a loan they need to repay, at least as long as the house remains their primary residence.

Cash from reverse mortgages can come in several forms:

• A lump sum
• A certain number of monthly payments
• A standby line of credit or a combination of the above

At first blush, a reverse mortgage appears to turn the tables on the lender, since the bank pays the homeowner. However, a reverse mortgage means you're borrowing against the value of your house. And you still have to insure and maintain the property, and pay real estate taxes.

Answer these questions to help you decide if a reverse mortgage is for you:

1. Are you (and all the homeowners) at least 62 years old?
2. Do you own your home?
3. Do you live in that home?
4. How much equity do you have in your home?
5. What other sources of income do you have in retirement?
   
   • Social Security
   • Work
   • Retirement savings
   • Other aid programs
6. Have you considered the alternatives?

When you sell your home or leave it for other reasons (such as if you rent it out or pass away), the loan balance is due. You or your estate must repay the amount borrowed, plus any accrued interest and other costs. Commonly, the loan is paid off by selling the house. If there's any money left over (for example, if your home appreciates faster than the cost of the reverse mortgage), you or your estate will keep the difference. In no case will you owe more than the home's value, even if it's worth less than the debt you've accumulated.

Properties that qualify for reverse mortgages include single-family homes and two- to four-unit dwellings. If you live in a condominium or planned-unit development, you might also be able to get a reverse mortgage if your property is approved by the Federal Housing Administration (FHA).

The pluses

The positive attributes of a reverse mortgage include:

• You can get cash immediately.
• Payments to you are free from income tax.
• You don't have to repay the loan until the house is no longer your primary residence—if you move or pass away.
• There's no default risk. Your legal obligation to pay back the loan is limited by your home value at the time the loan is repaid, even if you've borrowed more than that amount.

At this point, you might be tempted to "lend" your house to the bank and have it pay you.

But, as with most financial strategies, there are some caveats to consider:

• Rising debt. Even though you (or your estate) don't have to repay the reverse mortgage loan until you move or pass away, you are still incurring debt. What's more, since you're taking money out of your home and not paying it back, the level of debt increases with each passing month (as does your interest expense). If your home's value appreciates fast enough, that appreciation could offset your borrowing costs and interest charges. But that's a big "if," and it depends on regional factors and the long-term health of the economy.
• High closing costs and loan origination fees. The up-front costs can amount to as much as 10% or more of the loan limit—the equivalent of paying 10 "points" on a conventional mortgage loan. When you consider these costs, keep in mind that if you move from the home to live elsewhere (for any reason), you will need to repay the loan immediately.
• Cash payout less than the full home value. You won't be able to tap the full value of your home with a reverse mortgage. There's also a cap, though it was raised significantly in 2009. Through 2010, the lending limit for federally insured Home Equity Conversion Mortgages (HECMs) is derived from the lower of the appraised value or the FHA HECM mortgage limit of $625,500.
• Less protection from creditors. It's typically much harder for creditors to get at your home than it might be for them to go after cash that's sitting in your bank account.
• Reduced benefits or disqualification from some assistance programs. Proceeds from a reverse mortgage won't affect your eligibility for Social Security or Medicare, but might disqualify you from receiving benefits from some state-administered programs such as Medicaid or food stamps.
• Potential family strife. Your relatives might be a little upset to find out someday that the bank owns a substantial portion (or all) of a home they expected to inherit. It's a good idea to talk to your heirs if you plan to take out a reverse mortgage, at least so there are no surprises down the road. Having said that, if a reverse mortgage is your only option, you probably shouldn't worry too much about what the kids might think.

The alternatives

In an ideal world, your home should not be the centerpiece of your retirement plan. Sure, it has cash value, but it's also the roof over your head. And it's generally a good idea to avoid taking on unnecessary debt, especially in retirement, when income sources can be largely fixed.

Even when borrowing makes sense, the typically high up-front costs mean that reverse mortgages should generally be viewed as a financial tool of last resort.

Consider the alternatives:

• Work part-time. It can generate spending money, and also give you a sense of purpose and provide opportunities for social interaction. Of course, this presumes both you and the job market for seniors remain healthy.
• Spend less. Reassess your retirement spending needs. Create a budget and find ways to trim your spending. Ask yourself: Are there things you're still paying for in retirement that you really don't need?
• Downsize. It's possible to eat your home equity cake and have it, too. By downsizing, you could sell your current house, buy a smaller place and pocket the leftover cash. If you're thinking about downsizing, take into account that you'll likely incur real estate commissions and moving costs, and consider changes to your property taxes and other ongoing expenses. If your home has appreciated since you bought it, you might also have to contend with capital gains taxes. But keep in mind that, if you've lived in your home for at least two of the past five years, you're eligible for a capital gains tax exclusion of up to $250,000 of gains if you are a single tax filer ($500,000 for a married couple filing jointly).
• Sell and move in with your kids. This strategy will allow you to keep the bulk of your cash after selling. But everyone concerned should be prepared for an extended-family environment.
• Make your kids your banker. How about selling the house to your kids and renting it back from them at the current market price? The downside to this alternative is that you need to be careful about doing business with loved ones, which can sometimes lead to family discord. Consult with a financial professional to ensure that all parties are protected and you don't run afoul of IRS gifting and income tax rules.
• Take out a home equity line of credit (HELOC) or another mortgage. If you can't move, and if going into debt is your only option, consider opening a home equity line of credit. You'll have to repay the loan, but this is usually inexpensive compared to the up-front costs of a reverse mortgage.

Reverse mortgages vs. the alternatives

There are many alternatives to a reverse mortgage. In the hypothetical example below, we compared a reverse mortgage to two strategies that tap home equity and then use an immediate annuity to provide a monthly income stream:

• Taking out a home equity line of credit and buying a single premium immediate annuity (SPIA).
• Downsizing to a smaller home and buying an SPIA. If the home has an average appreciation rate of 2.5% over 20 years, downsizing and using the cash to purchase an annuity would provide the best solution, given our assumptions.¹

But under what circumstances would taking out a HELOC or entering into a reverse mortgage be better? If you expected a much higher appreciation rate for your home—say, 5% on average—then the HELOC strategy would win (which makes sense, since you are using greater leverage on a highly appreciating asset). Coming in second would be the reverse mortgage strategy, with the downsizing finishing last.

On the other hand, a flat or negative real estate market over the same time period would favor the reverse mortgage strategy.

Compare the alternatives

Although reverse mortgages can allow you to tap the equity in your home, they may not be the best solution for your cash needs. For help deciding which option is right for you, consult your financial or tax advisor.

1. Table assumptions: Home's cost basis is $250,000; home's full market value is $500,000 and home is fully paid for; reverse mortgage rate is 6.25%; reverse mortgage loan up-front costs are 9.5%; home equity line of credit (HELOC) rate is 5.6%; home appreciation is 2.5%; real estate commission is 6%; inflation is 2%; single premium immediate annuity (SPIA) for female age 70, single life, as of December 1, 2009 = $1,740 (male age 70 = $1,890); net monthly cash flow ignores taxes; reverse mortgage income is not taxable; SPIA income is partially taxable; HELOC interest expense is deductible. Net present values are discounted at the assumed inflation rate. This is a hypothetical example for illustrative purposes only and not intended to represent results you should expect for your particular situation. Actual terms and rates will vary.