Alternatives to a Reverse Mortgage
Feeling house rich and cash poor as you enter your retirement years? Last year, more than 50,000 retirees used a reverse mortgage to enhance their cash flow during retirement according to the National Reverse Mortgage Lenders Association. But the popularity of the reverse mortgage doesn’t mean it’s the right choice for every retiree. Depending on your retirement goals and your personal circumstances, you may want to consider alternatives before opting for a reverse mortgage.
We’ll explain who makes a good candidate for a reverse mortgage and what other options people nearing or in retirement should consider.
Are you a good candidate for a reverse mortgage?
Reverse mortgages are complicated financial products because you borrow money by drawing on the equity you’ve built in your home, but you aren’t expected to make payments on the loan. This means the loan balance grows while you or your spouse use the home as your primary residence. Keep in mind you must continue to pay taxes and insurance.
Once all co-borrowers (usually spouses) die or move out of the home, the loan must be paid off. In general, heirs pay off the reverse mortgage by selling the house. A reverse mortgage is a flexible tool because it can be set up for purchases, providing a lump-sum cash payout or providing a monthly income. When does a reverse mortgage make the most sense? Here are four instances:
Reverse mortgage for purchase: Retirees who plan to downsize, and can afford a large down payment on a house can pay for the rest of it using a reverse mortgage. This method of buying frees up cash from the previous home, and it gives retirees the benefit of living in the home without a payment. Over time using a reverse mortgage for purchase will probably drive a retiree’s home equity close to zero, so this is only a good method for people who do not want to leave a house to their heirs.
Provide portfolio security: Aspiring retirees who have a lot of home equity and a relatively small retirement nest egg may want to use a reverse mortgage line of credit to help strengthen their portfolio during their retirement years. For example, retirees can draw on their home equity when the markets take a downturn during their retirement years. This strategy can lead to a greater probability of having a nest egg survive a full 30-year retirement and lead to greater available income during retirement, according to a study by Neuwirth, Sacks and Sacks that was published in the Journal of Financial Planning. Retirees who want to use this strategy should consult with a HUD-approved reverse mortgage counselor and a fiduciary financial adviser to learn more.
Provide emergency income in retirement: Both the CFPB and AARP recommend retirees consider a variety of options before resorting to a reverse mortgage to make ends meet. When all other options are exhausted, a reverse mortgage acts as a last resort to access cash during retirement. Since a house tends to maintain its value, it can be helpful to wait before taking out a reverse mortgage when your other assets are depleted and you don’t have as much earning power.
Pay off existing debt in retirement: Many people aspire to retire debt-free, but that isn’t always a reality. If you need to get rid of debt payments to free up your budget in retirement, a reverse mortgage could be the tool to help you.
There are some risks that come with reverse mortgages. For instance, reverse mortgages have high upfront costs. If you choose to move soon after taking out a reverse mortgage, you would have paid several thousand dollars in financing fees without gaining much benefit. Additionally, reverse mortgages must be paid off as soon as you and your spouse move out or die. In most cases, borrowers or their heirs have to sell the home to pay off the loan. This means you can’t use the home as a rental property during your later retirement years, and the loan makes it more difficult to pass a family home onto your children.
If the risks of reverse mortgages don’t appeal to you or none of the above situations apply to you, consider one of these six alternatives to a reverse mortgage.
Home equity loan
A home equity loan is an installment loan that’s secured against the equity in your home. Equity is the value of your home less any amount that you owe on the home.
When you take out a home equity loan, you’ll get a cash payment from the bank. You can use the payment to make a large purchase (such as buying a car, paying for a child’s education or remodeling your house). Over several years, you’ll make monthly payments to repay the principal plus the interest.
Home equity loans are risky loans for retirees because defaulting on the loan can mean losing your home. However, savvy retirees may find good uses for home equity loans. Home equity loans make sense to use when you want to make large purchases without having to pay a higher marginal tax rate that may come with large distributions from retirement accounts.
For example, say you want to buy an RV and to do so you would need to withdraw $50,000 or more from your portfolio in one year. Withdrawing that much money in a single year could push you into a higher tax bracket if the money is in a 401(k) or traditional IRA account. Instead of suffering the tax consequences, you can borrow money at a low-interest rate using a home equity loan. Over time, the retiree can withdraw money from his or her portfolio to pay off the loan. That strategy can help retirees keep retirement income taxes low.
A home equity line of credit (HELOC) is like a credit card backed by your home. Your bank will set a credit limit based on the value of your home and your creditworthiness. When you need cash, you can draw from your HELOC up to your total credit limit. When you pay off the HELOC, you open up your line of credit again. This means you can borrow money (up to the credit limit) again.
It generally costs a few hundred dollars to set up a HELOC. The CFPB warns that the upfront costs of HELOC are expensive if you never actually need the credit. On the other hand, the upfront costs of a HELOC are much lower than the costs of establishing a reverse mortgage line of credit.
If you withdraw money using your HELOC, interest will accrue on the amount you’ve borrowed. Each month, you’ll pay at least the amount of interest you owe. You may be required to pay back some of the principal amount you owe, too. A HELOC usually has a draw period in which you can borrow money and a repayment period. The draw period often lasts a decade or more, and repayment can last up to 20 years. The Federal Trade Commission (FTC) warns borrowers to be careful to understand the details of the draw period and to watch out for balloon payments.
A HELOC is riskier than a reverse mortgage since your house is on the line if you default. On top of that, you must make monthly payments on the HELOC, which could pinch cash flow for retirees on a fixed income. However, the low costs of setting up a HELOC may make it a good choice for you.
Many people want to pay off their home before they retire, but that isn’t always a realistic option. If you want to stay in your home but you still owe money on the mortgage, a reverse mortgage isn’t always the best way to cut your payment. People nearing retirement may also want to consider refinancing to a traditional 30-year mortgage. Refinancing a home loan will spread your loan balance over a longer time, which may lower your monthly payments. People who refinance before retirement will make smaller monthly payments, but they will continue to build home equity throughout their retirement. If passing on your house is important to you, a traditional refinance could help you stay in your house and still afford the monthly payments.
Many people love the house where they raised a family and spent their working years. However, a big, empty house might not be a great choice for some people during retirement. If you don’t want to maintain a large house, or you want to move to an area with a lower cost of living, downsizing could be a great move for you.
If you downsize, you can use the equity from the sale of your current home to buy a less expensive home in cash. Not only does this leave you with a paid-off house, it may also leave you with cash leftover to pay off debt, invest or hold as emergency savings.
Retirees who downsize can enjoy a house with no payments and cushion their nest egg without having to deal with the hassle and costs of a reverse mortgage.
Even if you owe money on your current mortgage, you may benefit from downsizing during retirement. Selling your larger home will allow you to put a substantial down payment on a new home. This gives you the benefit of small monthly mortgage payments that won’t strain your budget during retirement.
Of course, downsizing has its drawbacks. Not only will you have to endure the stress of moving, you’ll pay a high price to sell and buy a new home. A proprietary study by Zillow and Thumbtack showed that home sellers spent an average of $15,000 to sell their home in 2017. If the sale of your home doesn’t allow you to buy the next place in cash, you’ll have to pay closing costs on a mortgage, too.
Boosting retirement income
A reverse mortgage can help you cut your housing expense to zero, provide cash in a pinch or offer a monthly income. It can be a great tool, but many retirees can boost their retirement income through other means. The American Psychological Association recommends that early retirees consider getting a part-time job because it can make it easier to transition from full-time work, and the pay could reduce your need to rely on retirement savings or debt.
If part-time work isn’t realistic, you may still be able to increase your income. For example, renting a room of your house to a family member can also provide a steady stream of income.
Waiting for a reverse mortgage
If you don’t think you’ll stay in your current home for too much longer, a reverse mortgage isn’t likely a good fit right now. The upfront costs are too high if you plan to move in a few years. That doesn’t mean a reverse mortgage will never make sense for you. Whenever your income, expenses or housing needs change during retirement, you may want to reconsider a reverse mortgage. It could be the tool you need to bolster your cash flow or to help you buy your retirement home.
Compare your options
When you’re making your retirement budget, you’ll want to consider all your options. Use this chart to compare and contrast the monthly payments, the upfront costs and the pros and cons of each debt product. In addition to the pros and cons, you’ll want to consider whether you expect to remain in your house throughout retirement. Reverse mortgages, refinances and downsizing all come with hefty upfront costs. If you don’t plan to stay in your house long enough to recoup the costs, you could be wasting your money.
|Alternatives to a Reverse Mortgage Comparison|
|Reverse Mortgage||Home Equity Loan||HELOC||Refinance||Downsize|
|Monthly Payment||$0||Highest payment
(Principal plus interest).
(May be interested only during draw period).
if you haven’t borrowed money.
|Low fixed payments||$0 or low fixed payments|
|Upfront costs and fees||High
(2% upfront mortgage insurance, plus origination and lender fees can cost around $7,500)
(Origination fees plus closing costs, which cost more than a HELOC in most cases).
(Appraisal, application, points and closing fees.
|Moderate to high
(Origination fees and closing fees cost between $2,000-$,5000).
(On average, home sellers paid $14,000 in selling costs in 2017. If you need to take out a mortgage, you’ll also need to pay origination and closing fees).
|Pros||No foreclosure risk.
No monthly payments.
Flexible options for receiving payment.
Heirs will not inherit debt.
|Low interest rate (fixed).
Low origination fees.
Paid off over time.
|Low interest rate.
Low origination fees.
Only pay interest if you borrow.
|Lower monthly payments.
Continue to build equity.
Eligible for a reverse mortgage later.
|House may be a better fit.
No or low monthly payments.
Become debt free.
|Cons||High upfront costs.
Lose home equity over time.
Interest not tax-deductible until you pay the loan.
Requires monthly payments.
|Variable interest rate.
|May not live in house long enough to justify high upfront refinancing fees.
Interest is tax-deductible (if itemizing taxes applies to you, and you aren’t taking cash out).
|Hefty upfront selling and buying fees.
Have to sell family home.