As you approach retirement, the realization that your estate’s assets have limitations set in. Many retirees are living in homes they own with little or no debt, and the question is: is there a means of living in the residence through the golden years while taking advantage of the equity that has built through the years?
For many an outright sale is not desired because they have many years of toil invested in their residences, and now that the home is debt-free, they want to live out their days in the home, even though they may need the equity in the property to pay their bills.
A conventional mortgage may solve the problem of immediate cash or even the need of a nestegg; but conventional mortgages secure loans which must be repaid somehow. Generally it means making a monthly payment under an amortization schedule; and if the funds to make these payments are not available for any reason, the owners can face foreclosure, loss of the residence, and even the possibility of the bank’s pursuing them for the balance due on the loan if the mortgage foreclosure sale fails to generate sufficient funds to satisfy the loan fully. With property values falling steeply over the past five years, this is not a rare scenario. The consequences could be catastrophic.
Enter the reverse mortgage. It is a more recent concept, and it has many attractive features. It also has a major drawback: it is a very expensive way to borrow money.
First the advantages. When owners enter into a reverse mortgage loan which is insured by the Federal Housing Administration (the “FHA”), a sum of money is made available to be drawn down (a) in a lump sum, (b) as needed as a line of credit, or (c) in a fixed monthly amount for the rest of their lives at the option of the borrowers. The most attractive feature is that they cannot be required to pay off the mortgage until they sell the property, stop living there, or die. The FHA insures the borrowers that the lender will be able to perform (i.e., make the payments to you as they are due). We all know banks can fail in this age.
Those who choose to have fixed monthly payments for the rest of their lives are gambling on their mortality to some extent. The monthly amount they are to be paid is based on an actuary table, and if they live for many more years than the table predicts and ultimately borrow more than the property is worth, the borrowers (or their estates) are spared repayment beyond the value of the property.
As stated above, another advantage is that there is no fear of a mortgage foreclosure ever, so long as the borrowers (a) continue to own and reside in the residence, (b) pay their real estate taxes in a timely manner, and (c) maintain property insurance; the loan would be due and payable upon the failure of any of these events. Also, when applying for a reverse mortgage the borrowers need not have any income; the only thing the lender will base the loan on is the value of the residence.
Another feature (I hesitate to say “advantage”) is that no fees are paid at the outset; they are all calculated and deducted from the payments which are to be made to the borrowers.
At the death of the last of the owners to die, the loan must be satisfied, but again an advantage: if the proceeds from the sale of the residence are insufficient to satisfy the loan fully, the lender is unable to proceed against the estate of the borrowers. There can be no personal liability beyond the value of the residence. Of course that is not the case with conventional mortgages; until the debt is paid in full, there is personal liability beyond the value of the mortgaged property.
An obvious advantage of the reverse mortgage (as opposed to selling the home and living in a rental apartment) is that the owners may preserve for their families the family homstead, to the extent that there is equity in the value beyond the mortgage debt on their deaths. Yet another advantage of this is that the heirs would be entitled to receive the property with a stepped-up basis for capital gains purposes which can result in a significant tax savings.
There is a limitation on the amount you may borrow. The most that can be borrowed is based on a percentage of the appraisal, and somewhat paradoxically the older a borrower is, the greater is the percentage which can be borrowed (somewhat morbidly, the older a person, the fewer the months of payments, causing the amount of each payment to be increased). In the five-county Philadelphia region, the most a home may be appraised for reverse mortgage purposes is $292,000, even though its actual value may be much more than that; based on that appraisal, the most that can be borrowed will generally fall between 50% and 75% of the appraisal ($145,000 to $220,000; they use the age of the younger owner to make the determination, which reduces amount available to be borrowed).
Now about the cost of all of this. Although the borrower pays no fees out-of-pocket when the mortgage is obtained, there are substantial expenses, which are generally much greater than those incurred in a conventional mortgage loan; these costs are deducted from the borrowed amount, reducing the funds available. The fees are based not on the amount borrowed (as they are with conventional mortgages) but on the appraised value. Assuming a maximum appraisal of $292,000, the costs of a loan (regardless of the amount, but in no event more than $220,000 would be available on that appraisal) will approximate $15,000 (or 7.5% if the loan is $200,000). The costs on a conventional mortgage of $200,000 would range between $4,000 and $6,000 (2% to 3%).
Interest rates on reverse mortgages are generally very low compared to conventional mortgage rates. They are equal to the sum of the rate on US Treasury bonds plus 1.5%; at this writing that would be a very attractive 3.64%. But where they giveth, they also taketh away; since no payments are being made until the loan is satisfied, the borrowers may not claim the interest deduction on their federal income tax returns as they could with a conventional mortgage. The interest deduction would be available at the time the loan is satisfied; but if the loan is not repaid until death, the deduction is all but meaningless to the borrowers.
Conclusion: The reverse mortgage has many attractive qualities for an elderly couple in need of the use of the equity in their residence, and some that are not so attractive. It is somewhat “painless” at the time the loan is made since most fees are deferred, and it does put the equity in your residence to work; however , while interest rates are attractive, the cost of the loan is very high. It may present a solution to your cash requirements, but it is best done only after careful scrutiny.
— Ken Butera