Reverse Mortgages Aren’t Just for People Who Are Out of Money
They let homeowners tap into their home equity and not repay the loan until the house is sold.
By Peter Coy.
Reverse mortgages are surprisingly unpopular considering that they let you spend the wealth locked up in your home without having to sell, protect you from a decline in the home’s value, and even (if you so choose) pay you monthly checks for as long as you live, like Social Security. Fewer than 1% of eligible homeowners have a reverse mortgage, according to a Brookings Institution report.
The word “reverse,” which conjures images of retreat and defeat, might be the problem. Or maybe it’s “mortgage,” which is no one’s favorite financial product. There seems to be an impression that taking out a reverse mortgage is an act of desperation by people who have no choice but to crack open and spend their nest egg of housing wealth.
That’s unfortunate because a reverse mortgage can be a smart choice for a wide range of people aged 62 and older, including ones who are far from desperate. Many people who are well set for retirement have most of their wealth tied up in tax-advantaged savings plans such as 401(k)s. Extracting some money from the house they live in without having to sell it can be a good way to raise cash for big expenses—say, to help pay for at-home health care or their grandchildren’s education.
A reverse mortgage is like a regular mortgage loan except those payments of principal and interest are optional. The interest, plus any money taken out, gets added to the balance owed. The loan comes due when the borrower moves out or dies. At that point, the borrower—or heirs if the borrower has passed away—can keep the home by paying off the loan, sell the home to pay off the debt, or, if there’s no equity left, turn over the keys to the bank. The loan is non-recourse, so the borrower never owes more than what the house is worth.
The borrower can take money out in a lump sum, as a line of credit, or in a series of monthly payments. The lump sum could be useful for someone who needs a lot of money all at once. The line of credit is the most flexible. The monthly payments provide longevity insurance, because they continue as long as you live in the home, even if the sum paid out ends up far exceeding the value of the home. (Lenders carry Federal Housing Authority insurance against that eventuality.)
However a borrower extracts money from the house, the payments aren’t taxable because the Internal Revenue Service regards them as a loan, not income.
Where taxes become an issue is at the time of the sale. The seller owes a capital gains tax on the difference between the sales price and the purchase price. The tax is owed to the IRS even if the borrower has to surrender most or all of the sales price to the bank to settle the loan. That’s true of any home sale, of course, but it tends to sneak up on reverse mortgage borrowers who haven’t planned well. One nice feature for heirs: If the borrower dies without ever leaving the home, there’s no capital gain tax due on the sale.
One recent convert is Laurence Kotlikoff, an economics professor at Boston University who’s an expert on retirement planning. He was featured in a March 26 webinar sponsored by a reverse mortgage advocate, Tom Dickson, founder of the Financial Experts Network, which puts on webinars for financial planners. The webinar’s title: “Highly respected economist changes his view of reverse mortgages.”
Kotlikoff told the audience that one feature he came to appreciate is the built-in protection against the decline in a home’s value. The maximum amount that can be borrowed under a reverse mortgage rises every year at a pace that’s specified in the loan document. It’s not limited by the house’s actual market value, which might fall. “This is really great insurance against a decline in house value,” he told the audience.
Another fan of reverse mortgages is Wade Pfau, a professor of retirement income at the American College of Financial Services. On his blog, Pfau says people should consider taking out a reverse mortgage when they’re relatively young (62 is the minimum age for FHA-insured loans). For one thing, he writes, the freed-up money “reduces strain on the investment portfolio, which helps manage the risk of having to sell assets at a loss after market downturns.” For another, the amount you’re eligible to borrow goes up annually, so the earlier you start, the higher the ceiling can get. “Reverse mortgages have transitioned from a last resort to a retirement income tool that can be incorporated as part of an overall efficient retirement income plan,” Pfau writes.
An occasional misunderstanding about reverse mortgages is that taking one out involves turning over the keys to the bank. In fact, the borrower retains title and can pay off the mortgage at any time if he or she chooses. When people do lose title to their homes it can be because of non-payment of property taxes. But that’s not unique to reverse mortgages.
One hurdle for many potential customers is the high origination fees. In the webinar, Dickson gave an example of a 62-year-old with a house valued at $400,000 who is qualified to take out $205,000. The initial fees could amount to more than $13,000, reducing the proceeds to $192,000. Because of those origination fees, it doesn’t make sense to take out a reverse mortgage unless you plan to stay in a house for three to five years or more, Dickson says in an interview. (The longer the better.)
Two other caveats about reverse mortgages. One is that it pays to shop around because costs vary widely. Another is that the wealth you have in home equity shouldn’t be spent carelessly. As Pfau puts it, “if this liquidity creates the temptation to use the proceeds in an unwise manner, then you may be better off avoiding it.”