Reverse mortgages were once anathema to savvy financial planning. These loans—which let homeowners over age 62 pull equity out of their homes while still living in them—were viewed as a costly last resort for covering retirement shortfalls.
That thinking has changed as older owners find themselves sitting on record levels of home equity, while at the same time grappling with how to maximize retirement income. Though the upfront costs of reverse mortgages can be steep—we’ll get to that in a minute—when used judiciously, they can be a valuable tool in retirement.
“One of the most intriguing benefits, I think, is spending coordination with your portfolio,” says Neil Krishnaswamy, a financial planner and enrolled agent with Exencial Wealth Advisors in Frisco, Texas. Borrowers can effectively use a reverse mortgage as a line of credit that they access when needed: They only pay interest on what they use, and the proceeds aren’t taxed.
In the event of a major market decline, for example, borrowers can access this equity in lieu of tapping their portfolios in a down market. “One of the biggest risks in retirement is that markets may not cooperate,” Krishnaswamy says. “If you have the option to access cash for spending in a tax-efficient manner, you can mitigate some of that risk.”
Some other uses: Homeowners who still have mortgages can use the proceeds of a reverse mortgage to pay off those loans and improve their cash flow, Krishnaswamy says. Depending on your age and health, a reverse mortgage may also be a less expensive insurance policy against long-term healthcare needs—and it might be the difference between claiming Social Security early or holding off for a higher payout.
The catch, of course, is that you or your heirs will need to pay back the loan when you sell the house or when you and your spouse both pass away. Interest, which recently hovered around 5%, accrues on any equity you access. Then there are the fees, which, although though rolled into the balance of the reverse mortgage, can be the biggest sticking point.
The basics of reverse mortgages
Most borrowers will want to focus on reverse mortgages offered by lenders approved by the Federal Housing Authority as part of the Home Equity Conversion Mortgage (HECM) program. To qualify, you need to be at least 62, have paid off your mortgage or built up adequate home equity, and still be living in the house. There are other stipulations, including that you sit through a counseling session, go through a credit application, and continue to pay taxes, insurance, homeowner dues, and maintenance.
How much you can borrow will depend on the value of your home, interest rates, your age, or, if you’re married to someone younger, the age of your spouse, among other variables. The maximum claim amount allowed under HECM is currently $726,525.
Borrowers with a fixed-rate loan can typically take the proceeds as a lump sum. Those who go with an adjustable-rate loan can opt for regular monthly payments or a line of credit. Whether or not you choose to tap into the funds right away—as opposed to keeping your reverse mortgage as a contingency plan—there are fees.
Origination fees are the most significant up-front costs. Under HECM, a lender can charge up to 2% of the first $200,000 of the home’s value or $2,500, whichever is greater, plus 1% of any amount above $200,000. HECM caps total origination fees at $6,000.
Borrowers also need to pay FHA mortgage insurance premiums equal to 2% of the maximum claim amount, plus 0.5% of the outstanding balance annually. In the event a lender cannot pay out the reverse mortgage proceeds, insurance kicks in. If the value of the property falls below the outstanding loan balance, borrowers or their heirs don’t need to make up the difference.
In addition to these big fees, reverse mortgage borrowers also pay monthly servicing fees, which are capped at $35, plus many of the same upfront costs associated with getting a traditional mortgage. Those include appraisal fees, credit report fees, escrow fees, document preparation, and more.
All told, for loan of up to $200,000, for instance, a borrower could pay as much as $10,000 in upfront fees—which are typically rolled into the loan balance—plus ongoing mortgage insurance premiums and service fees of about $1,400 a year.
How to know if a reverse mortgage is right for you
Still, like all things financial, it’s a balancing act. For homeowners who have the equity and want to stay in their house, there are worse things than tapping into home equity—as long as it’s part of an overall plan and not simply a license to spend.
As with refinancing a traditional loan, you’ll want to think through the timing of your decision. If you have plans to sell your home in the next few years, it likely isn’t worth paying the upfront fees for a reverse mortgage.
“I’ve come full circle on reverse mortgages,” says Steve Vernon, a consulting research scholar at the Stanford Center on Longevity, and author of “Retirement Game-Changers.” He added that he has even recommended it as an option for his friends in the San Francisco Bay Area, where average single-family home prices sit just under $1 million. “The costs of the loans are high,” he says, “but if you love your house and don’t have other resources, it’s something to consider.”