Reverse mortgages offer many benefits and also have drawbacks. It's wise to consider reverse mortgage pros and cons before applying. Reverse mortgages are oddball mortgage products -- not well-understood by the general population. One reason for this is that they haven'y been in the mainstream that long, and the other is that they're only available to homeowners 62 or over. In general, a reverse mortgage provides homeowners a way of drawing against their home equity to provide supplemental income. This can be a good solution for cash-poor elder homeowners who own their homes outright or at least have a lot of home equity. About 90 percent of all reverse mortgages sold are backed by the Federal Housing Administration or FHA. FHA reverse mortgages are known as Home Equity Conversion Mortgages, or HECMs. The FHA reimburses mortgage lenders for losses related to failed reverse mortgages and has developed guidelines applicable to HECM loans.
Pros: The Benefits of Reverse Mortgages
Here a few examples of how reverse mortgage loans can work for eligible homeowners:
- Qualifying is easy. Reverse mortgage borrowers don't have to make payments, so credit ratings are less important. Reverse mortgages are the only home loan products that don't assess higher interest rates and fees for people with bad credit. Another plus is that there are no monthly payments and lenders don't need to review borrower income as a condition of loan approval. However, lenders do conduct a "financial assessment" to make sure the homeowners are capable of paying their home-related expenses like property taxes, insurance premiums, HOA dues and home maintenance. If it appears an applicants can't be counted on to take care of those obligations, some loan proceeds are held back and used by the lender to cover these expenses.
- Reverse mortgage proceeds are not taxed as income. Funds withdrawn with a reverse mortgage don't incur income taxes. Here's an example of how this advantage works. Let's say that a homeowner takes on a part-time job for extra money, and her tax bracket is 25 percent. She would have to earn approximately $1,250 to increase her spending money by $1,000. A $1,000 withdrawal from a reverse mortgage actually puts $1000 in the homeowner's pocket.
- Homeowners retain their home equity. Some people think that taking out a reverse mortgage means they no longer own their home. That's not true. In fact, when reverse mortgage borrowers sell their homes, any extra funds remaining after the reverse mortgage is paid off belongs to the borrowers. In cases involving reverse mortgage borrowers who have passed on, any funds remaining after the reverse mortgage is paid off are typically distributed to heirs. Heirs can also choose to pay off the reverse mortgage instead of selling the property.
- Reverse mortgages can help homeowners avoid foreclosure. Those with home equity but insufficient income can retire their existing home loans with reverse mortgages, and never make another mortgage payment.
- Borrowers can't outlive a reverse mortgage. Borrowers who choose to receive monthly payments for life (this is called the "tenure" option) cannot outlive their reverse mortgages. If a reverse mortgage loan's balance owed exceeds the mortgaged home's value when the last borrower leaves, neither the borrowers nor their heirs are responsible for repaying the difference.
- Reverse mortgage proceeds can be used for any purpose. Whether borrowers want to increase their income, withdraw a lump sum for a big-ticket purchase, or use reverse mortgage funds to start a second career, it's their choice. Reverse mortgages can also be used to purchase a home without mortgage payments.
- Reverse mortgages can be great sources of backup funds. By setting up a reverse mortgage line of credit, borrowers only pay interest and annual mortgage insurance on amounts they use. The line grows over time as their home appreciates.
Cons: Tradeoffs of Reverse Mortgages
- There are occupancy requirements. Reverse mortgage borrowers are required to live in the mortgaged home. Seniors emerging from stints in hospitals or nursing homes (generally longer than 12 months) have faced foreclosure due to strict owner occupancy requirements for reverse mortgages. Homeowners planning extended absences from home are encouraged to discuss their plans with reverse mortgage lenders or a real estate attorney before applying for a reverse mortgage.
- Maintenance and taxes are still required. Reverse mortgages require that homeowners pay property taxes, hazard insurance and maintain their homes. If a home's value is compromised by poor maintenance or failure to pay property taxes and hazard insurance premiums, the mortgage lender may foreclose.
- Reverse mortgages can be expensive. Reverse mortgages are not the ideal answer for homeowners needing a few thousand dollars to repair a porch (unless the applicant's income is low enough to qualify for a special-purpose loan). While fees for FHA-insured HECMs are limited by the federal government, the required mortgage insurance isn't cheap -- traditional home equity loans are much less expensive for those who have the income to qualify.
- Reverse mortgage borrowers can lose eligibility for Medicaid or Supplemental Security. Reverse mortgage proceeds taken as a lump sum and not spent immediately could cause homeowners to lose eligibility for needs-based programs subject to maximum income limitations. In most cases, a single person is only allowed to have $2,000 in cash to be eligible for Medicaid.
- Heirs may worry about their inheritance. Homeowners with heirs can run into family misunderstandings and complications with their wills and estates due to reverse mortgages. It's important to discuss plans for a reverse mortgage with family members, estate planners or legal counsel as appropriate.
Reverse mortgage pros and cons can be difficult to navigate. Applicants with FHA-backed reverse mortgages are required to complete reverse mortgage counseling with an FHA-approved counselor. Advocates like Consumers Union recommend that homeowners shop carefully for their best reverse mortgage deal and avoid signing anything that they don't understand.