The largest store of
wealth for most retirees resides in their home. At the same time, low rates on
savings and longer life expectancies have sent retirees scrambling for new
sources of income.
Enter the reverse
mortgage, which allows homeowners to convert their home equity into cash. Over
their 29-year history, reverse mortgages have earned a bad rep, thanks to
smarmy TV ads and fears that borrowers could easily lose their home to the
bank. And many financial advisers have given reverse mortgages the cold
shoulder, knocking them as high-priced, risky loans of last resort.
But the Federal
Housing Administration, which insures home equity conversion mortgages (or
HECMs), as reverse mortgages are formally known, has made rule changes that
have reduced the cost of these products and the risk to borrowers. Before the
changes took effect, as many as 10% of loans went into default because
borrowers could not keep up with homeowners insurance and property taxes. The
new rules require a financial assessment to ensure that borrowers have enough
money to pay ongoing costs. The amount of equity available immediately has
also been limited, but so has the up-front cost of mortgage insurance that
borrowers are required to pay.
Now financial advisers
are coming around to reverse mortgages, says Wade Pfau, the director of
retirement research at McLean Asset Management, in McLean, Va. Reverse
mortgages offer flexibility to help make other retirement resources last, he
says. You can continue living in your home or buy your next one without a
monthly mortgage payment (for more about an HECM for purchase, see Reverse Mortgages for New Home Buyers). You
could take monthly payments to supplement your income and defer taking Social
Security until age 70, when you'll qualify for the maximum payout, or
substitute those payments for an annuity.
One of the biggest
risks in retirement is that a market downturn could force you to sell
investments at a loss to maintain income. With an HECM line of credit, you
could make withdrawals when the market is down and, when your portfolio has
regained value, sell investments to replenish the line (see 7 Moves for Retirees to Survive a Stock-Market Swoon).
The basics. A reverse mortgage lets you convert your
home's equity into a lump sum or a line of credit. You don't make principal and
interest payments to repay the loan; withdrawals accumulate and interest on
them accrues until the loan is due -- usually after you or your heirs sell the
home.
To be eligible for an
HECM, borrowers must be at least 62 years old. The maximum payout, or principal
limit, for which you'll qualify depends on your age (or that of a younger
co-borrower or a nonborrowing spouse), the current interest rate, and the
appraised value of your home, up to a maximum of $625,500. (Some lenders offer
larger, "jumbo" reverse mortgages.) The older you are, the lower the
interest rate and the higher your home's value, the greater the initial maximum
payout.
You can withdraw up to
60% of your principal limit in the first year, unless you need more to pay off
a mortgage or make repairs required by the lender. At closing, you'll pay an
initial mortgage insurance premium equal to 0.5% of the appraised value of the
home if you take 60% or less in the first year, or a 2.5% premium if you take
more than 60%.
Interest charges and
annual mortgage premiums (at a rate of 1.25% of the amount you borrow) will
accrue on any outstanding balance—though no principal or interest payments are
due until the home is sold. The interest rate on lump-sum payouts is fixed -- a
typical rate is 5%. Monthly payouts or draws from a line of credit will have
variable rates (recently ranging from 3.1% to 4.1%).
You must also pay a
lender's origination fee and fees for third-party services (such as an
appraisal or inspection), plus closing costs, which can run $1,000 to $2,500 or
more. You can pay up-front costs out of pocket or from the loan proceeds.
Lump sum or line of
credit? You can take the money
up front in a single payment and lock in a fixed rate, but if you do, that's
all you get. Some borrowers choose this option to, say, eliminate debt or buy
their next home, and it preserves a chunk of home equity for heirs. Or you can
take a series of monthly payments or a line of credit, or some combination.
A line of credit
offers the most flexibility, allowing you to tap 100% of your principal limit
within the first two years. And right now, interest rates remain historically
low; the lower your rate, the more you can borrow.
Pfau recommends that
you take a reverse mortgage with a stand-by line of credit as soon as you're
eligible, even if you don't need the money right away. That's because the
amount of credit available to you will grow over time, and you can take
advantage of the higher credit line if you need money later to, say, pay
long-term-care bills or wait out another market downturn.
This is where reverse
mortgages get counterintuitive. Your untapped credit line increases as though
interest and mortgage insurance premiums were being applied to the balance,
even though you don't pay interest or insurance on money you don't tap. Plus,
if the variable interest rate increases over time, so does the rate of growth
of your available credit.
For example, say that
you had $400,000 in equity in a $500,000 home and you qualified for an initial
credit line of $165,014 at 4.1% interest. Over 10 years, if you took no
withdrawals and the interest rate never rose, your available credit would grow
to $279,938. If you plan to preserve your available credit for as long as
possible to maximize its growth -- rather than tap your equity immediately --
look for the highest interest rate you can get for the lowest up-front cost.
Your end of the
bargain. Although you'll no
longer make a monthly mortgage payment, you must maintain your home and pay
property taxes, hazard insurance premiums and homeowners association or condo
dues, or you'll risk defaulting on the loan. If the lender determines that you
can't handle those costs, it will set aside funds from your payout in an escrow
account and pay those bills.
The money you receive
will be tax-free. It won't affect what you pay for Medicare, how your Social
Security benefits are taxed or your eligibility for Medicaid. You or your heirs
can deduct interest on the first $100,000 of indebtedness when the loan is
repaid.
The loan -- the sum of
payouts and accrued costs -- comes due and payable when the last surviving
borrower sells the home, leaves for more than 12 months due to illness, or
dies. Lenders must allow a nonborrowing spouse or committed partner to stay
after the borrower dies.
You'll never owe more
than the value of your home when you or your heirs sell it to repay the reverse
mortgage, and you can keep any leftover equity. If your heirs want to keep the
home, they can refinance the reverse mortgage, or they can pay the outstanding
debt or 95% of the home's appraised value, whichever is less.
Smart shopping strategies
It pays to talk with
at least a few lenders and compare their offers. You will also have to get
mandatory counseling from a HUD-certified housing counselor (to find one, call
800-569-4287 or search for "HUD Approved Housing Counseling Agencies"
online). You can do the session over the phone or in person; a session costs
$125 to $250.
Run what-if scenarios. Use the reverse mortgage calculator at
the Mortgage Professor website (www.mtgprofessor.com) to
try out a variety of loan terms. You'll also receive competitive offers from
participating lenders. You can use the offers as a basis of comparison if you
want to shop more.
To find other lenders
doing business in your state, visitwww.reversemortgage.org,
the website of the National Reverse Mortgage Lenders Association, and click on Find a Lender. Look for a loan officer who is a
"Certified Reverse Mortgage Professional."
Haggle over
origination fees. The
Federal Housing Administration says lenders can charge an origination fee equal
to the greater of $2,500 or 2% of your home's value (up to the first $200,000),
plus 1% of the amount over $200,000, to a cap of $6,000. But lenders aren't
required to charge the max, so if a lender says, "The government sets the
origination fee," keep negotiating.
