Is a Reverse Mortgage a Bad Idea?
A reverse mortgage allows senior homeowners to tap into the equity they’ve built up in their homes to provide additional income, fund home repairs and maintenance, or cover other expenses. The appeal of a reverse mortgage is that it generally doesn’t have to be repaid until the borrower passes away, sells the home or moves out. But reverse mortgages are not without their risks. They can be an expensive way to borrow, and when predatory lenders take advantage of borrowers who might not understand what they’re getting into, borrowers could end up losing their homes.
Certain protections have been put into place to help ensure reverse mortgage borrowers understand those risks before they take them on, but many potential borrowers and their families may still wonder, is a reverse mortgage a bad idea?
Are reverse mortgages becoming safer?
The majority of reverse mortgages are Home Equity Conversion Mortgages (HECMs) that are insured by the Federal Housing Administration (FHA). Over the years, many changes have been made to HECMs, aimed at protecting consumers. Let’s take a look at some of those changes.
At one time, all HECMs were structured as open-ended loans with adjustable interest rates — an open-ended loan is similar to a line of credit, where the borrower can access additional funds after the closing date, up to a pre-determined limit. Having an adjustable interest rate meant in times of rising interest rates, more interest would be added to the loan balance each month.
In 2008, the FHA began allowing lenders to structure HECMs as closed-end loans, meaning they were for a fixed amount. Additional principal amounts couldn’t be borrowed after the loan closing without taking out another loan.
On the plus side, with a fixed-rate loan, borrowers know the rate of interest they’ll be charged over the life of the loan and rising interest rates won’t impact their reverse mortgage balance. According to a 2012 report from the Consumer Financial Protection Bureau, fixed-rate, closed-end HECMs comprised about 70 percent of all new HECM loans. The number of HECMs has fluctuated since the program began in 1990, according to the National Reverse Mortgage Lenders Association, falling to 42,284 so far this fiscal year, which ends Sept. 30. The program peaked at 114,692 loans in 2009.
The way borrowers use their reverse mortgage proceeds has also changed. Reverse mortgages were initially intended to allow borrowers to turn their home equity into a stream of income to help cover everyday expenses or a line of credit to cover expenses like home repairs and medical expenses. Instead of tapping their home equity on an as-needed basis, potentially borrowing less and thereby facing less interest and fees over the life of the loan, the CFPB reported in 2012 that borrowers were increasingly taking the upfront lump sum to refinance an existing mortgage or other debt in early retirement or even before reaching retirement.
A 2016 survey conducted by researchers at Ohio State University found that while gaining extra income to help cover everyday expenses is still the most common (41 percent) reason borrowers seek out reverse mortgages, 38 percent of borrowers planned to use their reverse mortgage proceeds to pay off mortgage debt and 25 percent intended to use it to pay off non-mortgage debt.
Read more about smart and safe ways to use a reverse mortgage, including what you need to know about the different disbursement methods, here.
Mandatory pre-loan counseling
Reverse mortgages are designed for seniors who may be living on a fixed income. For many seniors, their home’s equity is their largest asset. To ensure that these seniors understand the risks and requirements of a reverse mortgage, all HECMs require potential borrowers to meet with a HUD-approved housing counselor prior to obtaining for a reverse mortgage.
The counselor will review the borrower’s financial needs, reasons for seeking a reverse mortgage, help them understand the potential consequences, and discuss alternatives.
Mandatory financial assessment
Reverse mortgage borrowers are required to stay current on their property taxes, insurance and home maintenance as a condition of the loan. If a borrower is unable to keep up with those payments, they could face foreclosure.
To prevent such scenarios, all HECMs now require lenders to conduct a financial assessment for borrowers to ensure they have the means to pay those ongoing costs over the life of the loan. If the results of the financial assessment indicate that the borrower may have trouble keeping up with those payments, the lender must set aside a certain amount of loan proceeds to pay for those expenses.
A 2017 analysis by the financial services firm New View Advisors LLC found that the tax and insurance default rate on HECMs dropped from 1.17% prior to the financial assessment rules to 0.39% after the set-aside requirement was put in place.
However, these set-asides are not foolproof. The amount of the set-aside is based on the life expectancy of the youngest borrower. If the borrower enjoys a longer life than predicted by the expectancy tables, the set-aside may not be enough to cover the obligations and the borrower could face foreclosure.
Limits on costs and fees
Any mortgage involves paying fees. With a reverse mortgage, certain fees are limited by law.
An origination fee covers the lender’s costs associated with underwriting the loan. HECM lenders may charge $2,500 or 2% of the first $200,000 of the home’s value, whichever is greater, plus 1% of the amount over $200,000. Origination fees are capped at $6,000.
The FHA insures HECMs. This means if the balance of the loan becomes greater than the value of the home, the FHA will pay the difference to the lender, rather than the borrowers and heirs. To ensure that the government has the funds to make this guarantee, all HECMs require borrowers to pay a mortgage insurance premium (MIP). Lenders charge an upfront MIP of 2% of the home’s appraised value or the FHA lending limit (currently $679,650), whichever is less. The upfront MIP typically comes out of the loan proceeds. Lenders also charge MIP on an annual basis at a rate of 0.5% of the outstanding loan balance. The annual MIP is added to the borrower’s balance over the life of the loan.
Despite these caps, reverse mortgages are expensive. Vincent Averaimo, an attorney with Milford Law in Milford, Conn., said borrowers can expect to pay anywhere from $10,000 to $15,000 in upfront costs for a reverse mortgage and interest rates are typically significantly higher than what you’d find in the market. “Because of this,” he said, “the debt increases at a quicker pace, eating into more of the equity and ultimately reducing the overall draw amount that a borrower may be allotted by the reverse mortgage lender.”
The Truth-in-Lending Act (TILA) requires that borrowers receive written disclosures about the important terms of any loan or credit agreement before they are legally bound to pay the loan. The required disclosures include things like APR, finance charges, the total amount financed and penalties.
All reverse mortgage borrowers receive multiple disclosures, including a Total Annual Loan Costs (TALC) disclosure and a Good Faith Estimate of the various fees being charged. These disclosures are designed to ensure borrowers understand the costs and terms of the loan.
Reverse mortgage risks to consider
The largest risk of a reverse mortgage may be that many senior borrowers simply don’t understand what they’re getting into. Although the housing counseling and financial assessment requirements are designed to help potential borrowers understand the potential risks and requirements of a reverse mortgage, reverse mortgages are complex products.
As Jack Guttentag, a professor emeritus at the University of Pennsylvania’s Wharton School, pointed out in a recent research article, “HECMs are far more complicated and difficult to understand than the mortgages [seniors] had used to buy their houses … complexity makes seniors exceptionally easy to hoodwink, and it also makes them wary and suspicious.”
Guttentag pointed out that many of the measures taken to protect seniors have not had the desired effect.
- Mandatory counseling. Counseling is delivered with the assumption that if a senior is looking into a reverse mortgage when they’d be better off without one, housing counseling will help them realize this and they’ll withdraw their application. “In fact, very few seniors opt out of the process as a result of counseling,” Guttentag wrote.
- Mandatory disclosures. Guttentag suggested the federal government has failed at wording disclosures so borrowers can understand them and ensuring disclosures are provided to borrowers at times when they would be useful. According to Guttentag, the main decision facing borrowers is which of the several types of available reverse mortgages would best meet their needs. However, the TALC fails to assist borrowers with this decision because lenders are not required to compute a TALC for each major reverse mortgage option. “Borrowers receive only one TALC, on the option they have already selected,” Guttentag wrote. “The only ones who benefit from TALC are regulators, who can indulge the illusion that seniors are receiving the information they need, and the firms who license the software that lenders need to calculate it.”
Where to find more information
“If a borrower does their homework and uses all resources available to determine whether or not a reverse mortgage is good for their specific needs, a reverse mortgage can be a safe, helpful product that can allow seniors to maintain their independence and stay safe in their home,” Averaimo said. Here are a few ways to do that.
Tap into NRMLA resources
The National Reverse Mortgage Lenders Association (NRMLA), maintains ReverseMortgage.org, a site dedicated to educating consumers. Its resources can help educate potential borrowers and find reverse mortgage lenders that are licensed in your state and have signed the NRMLA’s Code of Conduct and Professional Responsibility.
Talk to a housing counselor
The Department of Housing and Urban Development certifies counselors around the country to provide homeowners with impartial education about reverse mortgages. Counseling can be done over the phone or in person. Look for a HUD-approved housing counselor in your area to answer questions and help you decide if a reverse mortgage is right for you. You can also call HUD’s housing counselor referral line at (800) 569-4287.
Check out CFPB resources
The CFPB published a Considering a Reverse Mortgage Guide and a Reverse Mortgage Decision Guide to help borrowers understand reverse mortgages. The agency also has a two-minute video designed to give homeowners and their families an overview of these loans.
Alternatives to a reverse mortgage
While reverse mortgages can provide seniors with an opportunity to access their home’s equity while staying in their homes, they are not right in every situation. Here are some alternatives you might consider and discuss with your housing counselor, family and financial adviser.
Traditional home equity loan or line of credit
If most of a borrower’s wealth is tied up in home equity and the borrower needs fund to cover home repairs or maintenance, a traditional home equity loan (HEL) or home equity line of credit (HELOC) might be a viable alternative to a reverse mortgage.
Reverse mortgages are generally easier to qualify for than HELs or HELOCs. This is because HELs and HELOCs require adequate income and credit scores, while reverse mortgages typically base approval on the value of the home and the borrower’s ability to continue paying property taxes and insurance.
Reverse mortgages do not require monthly mortgage payments, but they come at a higher cost than a HEL or HELOC.
Refinancing your traditional mortgage
If a borrower has an existing mortgage on the home and is having trouble making the monthly mortgage payments, refinancing into another traditional mortgage may be a better move than taking on a reverse mortgage.
Refinancing to a lower interest rate or a longer term may lower the monthly payments enough to allow some wiggle room in the borrower’s monthly budget.
Sell the home and downsize
Many borrowers seek a reverse mortgage because they want to stay in their homes. But if a borrower has more home than they need, just keeping up with real estate taxes, insurance and repairs and maintenance can be a struggle.
Making those payments is a requirement of any reverse mortgage. So while a reverse mortgage might help a borrower stay in the home longer, they could wind up losing the home down the road if they cannot pay property taxes, homeowners insurance and the cost of maintaining the home. In that case, the borrower might be better off downsizing into a smaller, more affordable home now rather than facing foreclosure later.
Applying for federal, state or local assistance programs
The federal government and some state and local governments have programs designed to help seniors who are struggling to stay afloat financially. Unfortunately, many eligible seniors do not apply for these programs simply because they’re not aware of them.
The National Council on Aging maintains BenefitsCheckUp.org, a web-based service designed to match benefits programs to seniors with limited income and resources. Simply enter your zip code and provide a few details (such as age, gender, marital status and monthly income) to find out what benefits might be available in your area. Programs include help with health care and prescription drug costs, income assistance, food and nutrition, housing and utilities, employment, education and more.
The Administration on Aging, part of the U.S. Department of Health & Human Services, has an Eldercare Locator to help seniors and their family members find local agencies that can help with home and community-based services like transportation, meals, home care, and caregiver support.
Seniors who have trouble covering their basic living expenses can use these resources to find programs that may help them cover those expenses without draining their home equity.
The bottom line
A reverse mortgage can be a good tool for some senior homeowners, but it’s not always the best option. In fact, if borrowers enter into a reverse mortgage for the wrong reasons or without understanding the potential consequences, they can do more harm than good. Before you commit to a reverse mortgage, consider your alternatives and gather as much information as you can on the options available. That’s the best way to ensure you hold on to your home and enjoy a happy retirement.