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Understanding reverse mortgages: What are the benefits and risks?

by Alliance America
October 24, 2023


As Americans live longer, healthier lives, longevity has become a key factor in financial planning. The concept of a reverse mortgage has become increasingly popular as more retirees look for ways to supplement their income and maintain their quality of life in retirement.

A reverse mortgage is a type of loan that allows homeowners to borrow against the equity in their home without having to make monthly mortgage payments. The loan is repaid when the borrower dies, sells the home or permanently moves out of the home.

For many retirees, a reverse mortgage can be a flexible and affordable way to get extra income in retirement. However, there are some important things to consider before taking out a reverse mortgage, including the costs and risks.

In this article, we'll take a closer look at reverse mortgages: what they are, how they work and the benefits and risks of taking out a reverse mortgage.

What types of reverse mortgages are available?

There are three different types of reverse mortgages available, and each one has its own set of rules and requirements.

The most common type of reverse mortgage is the home equity conversion mortgage (HECM). This type of loan is insured by the Federal Housing Administration (FHA) and is available to homeowners who are 62 years of age or older. To qualify for an HECM, the borrower must own their home outright or have a low mortgage balance that can be paid off with the loan proceeds. The loan amount is based on the value of the home, the age of the borrower and the interest rate. The borrower can choose to receive the loan proceeds in a lump sum, as a line of credit or in monthly installments.

Another type of reverse mortgage is the single-purpose reverse mortgage. This type of loan is offered by some state and local housing finance agencies and is typically used to pay for home improvements, property taxes or medical expenses. The rules and requirements for this type of loan vary by lender, so it’s important to do your research before you apply.

The third type of reverse mortgage is the proprietary reverse mortgage. This type of loan is offered by private lenders and is not insured by the government. Proprietary reverse mortgages are typically only available to homeowners with high-value homes. The loan amount is based on the value of the home, and the borrower can choose to receive the funds in a lump sum, as a line of credit or in monthly installments.

Reverse mortgages can be a great way to tap into the equity in your home, but it’s important to understand all of your options before you apply. You should also make sure that you are comfortable with the terms of the loan and that you will be able to make the required payments. If you have any questions, be sure to ask your lender or financial professional.

What are the benefits of reverse mortgages?

There are several key benefits of reverse mortgages, including:

  • No monthly mortgage payments are required. Although you’ll still be responsible for paying taxes, insurance and any homeowners association fees, you won’t have to make a monthly mortgage payment. This can free up a significant amount of money each month, which can be used to cover living expenses, medical bills or other necessary expenses.

  • The loan doesn’t have to be repaid until the borrower moves, sells the house or dies. With a traditional mortgage, the loan must be repaid in full if the borrower sells the house or passes away. With a reverse mortgage, the loan doesn’t have to be repaid as long as the borrower continues to live in the home. This can give seniors the peace of mind of knowing that they won’t have to worry about repaying the loan as long as they remain in their home.

  • The loan can be used for any purpose. There are no restrictions on how the loan proceeds can be used. Recipients can use the money to cover living expenses, make home repairs or improvements, pay for medical care or anything else they need or want.

  • Reverse mortgages can help people at or near retirement age stay in their homes. One of the main goals of a reverse mortgage is to help people stay in their homes for as long as possible. By providing extra money each month, reverse mortgages can help people live comfortably without having to worry about making ends meet.

What are the risks of reverse mortgages?

While there are several potential benefits to reverse mortgages, there are also some risks to be aware of, including:

  • You could end up owing more than your home is worth. If the value of your home decreases, you could end up owing more on the loan than your home is worth. This could put your heirs at risk of having to sell the home to repay the loan.

  • Reverse mortgages can be expensive. There are a number of fees associated with reverse mortgages, including origination fees, closing costs and servicing fees. These fees can add up and reduce the amount of money you have available to use.

  • You could lose your home if you don’t maintain it. You’re still responsible for paying property taxes, insurance and making any necessary repairs or improvements to your home. If you don’t keep up with these payments or make the needed repairs, you could lose your home.

  • Reverse mortgages aren’t right for everyone. Reverse mortgages can be a good option for some people, but they’re not right for everyone. It’s important to talk to a financial professional to see if a reverse mortgage is right for you before you apply for one.

  • The borrower may not be able to stay in their home for the entire term of the loan. If the borrower needs to move or sell their home before the loan is paid off, they may have to repay the loan in a lump sum. This could be a problem if the borrower is on a fixed income.

  • Reverse mortgages typically have higher interest rates than traditional mortgages. This means that the borrower will end up paying more in interest over the life of the loan.

Some issues to consider before opting for a reverse mortgage

As people age, they often face the challenge of how to pay for expenses such as health care, home repairs and day-to-day living costs. For many, their home is their biggest asset, and they may consider a reverse mortgage as a way to get the cash they need. Before taking out a reverse mortgage, there are a few issues to consider.

How long do you plan to stay in your home? A reverse mortgage is a loan that must be repaid with interest. The loan balance grows over time and is due when the borrower dies, sells the home or moves out of the home for 12 months or more. If you plan to stay in your home for the rest of your life, you may want to consider a different type of loan that does not need to be repaid.

How will a reverse mortgage affect your estate and heirs? A reverse mortgage will reduce the value of your estate because the loan balance will need to be paid from the proceeds of the sale of your home. Your beneficiaries may not have enough money to pay off the loan and keep the home, so they may need to sell the home.

What are the costs associated with a reverse mortgage? There are several costs associated with a reverse mortgage, including an origination fee, closing costs and ongoing fees for servicing the loan. You will also be responsible for paying property taxes and homeowners insurance. Be sure to ask about all of the costs so there are no surprises.

Calculating the total cost of a reverse mortgage

The exact amount of cash you can get from a reverse mortgage depends on several factors, including your home’s value, the interest rate and the loan program.

To calculate the total cost of a reverse mortgage, you’ll need to take into account the interest rate, origination fees and closing costs. The interest rate on a reverse mortgage is generally higher than the rate on a traditional mortgage. This is because the loan is not repaid until the borrower dies or sells the home. The origination fee is a one-time charge paid at closing to cover the lender’s costs. Closing costs can include things like appraisal fees, title insurance and loan origination fees.

Assuming a 5% interest rate, after five years a reverse mortgage of $100,000 with $2,000 in origination and closing costs would have a total cost of $30,336. This amount shows how compounding interest can make the outstanding balance of a reverse mortgage rapidly grow over time. If you take out a reverse mortgage and don’t make any payments, the interest accrues and is added to the loan balance. This can quickly add up, so it’s important to keep this in mind when considering a reverse mortgage.

Why do reverse mortgages get a bad rap?

Reverse mortgages often get a bad rap for several reasons. These reasons include:

  • High fees and costs. Reverse mortgages tend to come with higher upfront costs than other loan types. Origination fees, mortgage insurance premiums and closing costs can add up, making them more expensive initially than other financial products.

  • Complexity. The terms and conditions of reverse mortgages can be confusing for many borrowers. Misunderstanding the terms can lead to unexpected outcomes and financial strain.

  • Potential for scams. Due to their complexity and the age group they target (older homeowners), reverse mortgages have been associated with scams and predatory lending practices. Some unscrupulous lenders or third-party companies might mislead borrowers about the terms or sell additional, unnecessary financial products alongside the reverse mortgage.

  • Decreasing home equity. A reverse mortgage is essentially borrowing against the equity of one's home. Over time, as the loan amount increases (due to accruing interest), home equity decreases. This can be problematic if the homeowner wants to leave the property as an inheritance.

  • Risk of foreclosure. If a borrower fails to meet the obligations of the reverse mortgage, such as paying property taxes, homeowner's insurance or maintaining the home, they might face foreclosure.

  • Impact on public assistance. The funds from a reverse mortgage can affect one’s eligibility for certain needs-based public assistance programs. For instance, obtaining a lump sum from a reverse mortgage could disqualify someone from receiving Medicaid.

  • Not a long-term solution. While a reverse mortgage can provide short-term financial relief, it's not always a viable long-term solution. If a homeowner outlives the loan proceeds or needs to move out (for example, to enter assisted living), they might find themselves without a source of funds or even a home.

  • Potential impact on spouse. If one partner takes out a reverse mortgage and then passes away, the surviving spouse (if not on the loan) might have to repay the loan or face eviction if they can't afford to do so.

  • Misconceptions and bad press. Stories about seniors losing their homes or facing unexpected loan terms have made headlines, contributing to the overall negative perception of reverse mortgages.

However, when used correctly and for the right reasons, reverse mortgages can provide valuable financial flexibility for seniors. It's essential for anyone considering a reverse mortgage to consult with financial professionals, understand the terms fully and shop around for the best deal.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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