For homeowners 62 years and older, a reverse mortgage may seem like an excellent way to tap into home equity, generating much-needed retirement income. After all, the loan typically doesn't have to be repaid as long as the last surviving borrower lives in the home or until the home is sold.
Unlike conventional "forward" mortgages, where you make a monthly payment to the lender, a reverse mortgage lender issues you money that is generally not taxable and does not affect Social Security or Medicare benefits.
"For a person 62 years of age or older who wants to utilize his home to supplement cash flow and doesn't have to worry about budgeting to pay it back, it's a pretty interesting product," says Bob Walters, chief economist at Quicken Loans in Livonia, Mich.
But before rushing out to apply for a reverse mortgage, be aware that this type of loan has several downsides. Closing costs and fees can be steep, and if you are thinking about leaving your home in two to three years, this is not a financially prudent way to extract money from your home. In that case, a home equity loan is likely a cheaper option.
Reverse Mortgage Types
Homeowners can choose from three types of reverse mortgages:
Single-purpose reverse mortgages.
Proprietary reverse mortgages.
Home equity conversion mortgages, or HECMs.
Some state and local government entities and nonprofits offer single-purpose reverse mortgages. They are usually low-cost loans, but they are generally available only to people with low or moderate incomes. Also, they can only be used for specific purposes, such as home repairs, improvements or property taxes.
Proprietary mortgages are private loans backed by the companies that market them.
Federally insured home equity conversion mortgages, or HECMs, backed by the U.S. Department of Housing and Urban Development, or HUD, account for 90 percent of all reverse mortgages, according to the National Reverse Mortgage Lenders Association.
HECMs and proprietary mortgages normally have no income requirements and they can be used for any purpose. But they generally have high upfront costs and normally require the borrower to meet with an independent government-approved housing counselor before applying.
How Much Can You Borrow?
Generally, the more valuable your home, the less you owe on it, and the older you are, the more money you can extract from your home. Remember, the home must be your primary residence.
The amount you can borrow also depends on current interest rates, loan fees and the appraised value of the home or the Federal Housing Administration's mortgage limits for the area, whichever is less.
FHA does not limit the value of homes qualifying for an HECM reverse mortgage. An appraiser determines home values. However, the FHA does set limits on the amounts that can be borrowed. The loan limit is $417,000 effective Nov. 1, 2008.
The Housing and Economic Recovery Act of 2008, signed into law July 30, 2008, may increase the amount that can be borrowed under the HECM program. At this writing, FHA is still working out the details.
According to the Federal Trade Commission, HECMs generally provide larger loan advances than proprietary loans at a lower overall cost. But owners of homes with high appraised values and small or no mortgages may qualify for larger loan advances through a proprietary reverse mortgage, though the cost will likely be higher.
Borrowers today have a wide range of choices in reverse mortgage products. Some feature fixed interest rates.
But most reverse mortgage products come with variable interest rates pegged to such short-term indexes as the Constant Maturity Treasury index or the London Interbank Offered Rate, or LIBOR, plus a margin, according to David Cesario, executive vice president of sales and marketing at 1st Reverse Financial Services in Westmont, Ill.
"You may have a Treasury with a 150 to 175 basis point margin (a basis point is one one-hundredth of a percentage point). So you'll hear it sometimes as an HECM-175 which means the 175 is the margin over the index," Cesario says.
"There are also loans now like the HECM-100 LIBOR, so you'll have a 100 basis point margin over the LIBOR index."
For example, if the interest rate on the LIBOR were 3.5 percent and you had a HECM-100 LIBOR loan, the rate on the loan would be 4.5 percent. Keep in mind, though, that rates are low in the current environment, and may very well go up in the future.
Understand, too, that the interest is charged on the outstanding balance and accrues over time, increasing the loan amount. This is the magic of compounding interest at work in reverse -- meaning it favors the lender instead of you.
Insurance Premiums, Other Fees
FHA-backed reverse mortgages require lenders to collect insurance premiums.
Borrowers will pay 2 percent of the maximum loan amount upfront, plus a 0.5 percent annual premium that is accrued on a monthly basis and added to the outstanding balance.
Borrowers should also expect to pay for an appraisal, credit report, title insurance, legal fees and recording fees -- just as they would for any other mortgage.
Origination fees can also add up quickly and reduce the overall amount of money available to you at closing.
The new housing rescue law limits the fees for HECM reverse mortgages to 2 percent of a loan up to $200,000, plus 1 percent of any portion greater than $200,000. Origination fees are capped at $6,000, but in the future this cap will be indexed to inflation.
Nevertheless, on a $200,000 loan, that's $4,000 in origination fees in addition to other loan costs.
"Reverse mortgages traditionally have been very restrictive and pretty costly," says Paula de Vos, a Certified Financial Planner and president of Synergist Wealth Advisors in Carmel, Calif.
Borrowers should fully understand the loan documents before they sign because they are in fact legal documents that could affect your heirs, de Vos says.
"If you don't fully understand what is being proposed, seek the counsel of someone who does."