We have previously expressed reservations about the reverse mortgage (“RM”), and while we still would urge caution, it may be a good thing for certain retirees.
The primary appeal of the RM is that an elderly couple (they must be at least 62 years old) who need to borrow a substantial sum and who enter into a RM transaction will never lose their home to a mortgage foreclosure so long as they pay all real estate taxes, maintain adequate insurance on the property, and keep the home in good repair. (Incidentally, it need not be a couple; any person who is at least 62 and owns the residence he or she lives in could qualify.)
It is common for an elderly couple to own their residence free and clear of all encumbrances or at most subject to a very small mortgage. With inflation, homes bought for $30,000 in the mid-60’s can now be worth ten times that amount, so that there may be substantial equity in the property. The income from the couple’s retirement funds (including IRA’s and 401K plans) together with Social Security may be insufficient to pay their bills, and the RM affords them an opportunity to borrow a substantial portion of the equity in their home and still live there for the rest of their lives. And perhaps most important of all, the borrowers need make no repayments of principal or interest on the mortgage loan as long as at least one of them resides in the house, or until they both die.
For purpose of illustration, assume a couple own a home with a value of $250,000 with no mortgage encumbrance. The maximum amount that can be borrowed will vary with the age of the borrowers and other factors, but let us assume they would like to create a line-of-credit of $100,000. To complete the loan application, they must pay counseling and appraisal fees of perhaps $450. Although there will be other fees, this is the only amount which they would have to pay out-of-pocket. Assuming they qualify and the home appraisal is sufficient, they then complete the transaction; at this time there are fees that vary depending on the appraised value and other factors; in this case the fees would total about $7,000 which is somewhat “painless” since it is deducted from and reduces the available credit line, which in our illustration would then be $93,000.
Having closed on the RM, the borrowers may now draw down the loan as they like; they may take it all at once, in monthly installments, or in irregular amounts at such time as their needs require.
As the loan is drawn down, interest accrues at a fairly modest rate (it is currently 3.5% per annum) on the amount drawn down; like the principal though it does not have to be paid until the mortgage is satisfied. As it accrues, the interest is added to the principal loan balance, but it does not reduce the available credit which is established when the loan is made. In fact, there is a kind of “credit” which accrues (currently at the rate of about 4.2% per annum) on the portion of the authorized loan which has not been drawn down; this “credit” increases the amount of funds available to borrow. (It is not really a credit because if it is borrowed; it must be paid back ultimately.)
As I have outlined the fees above, you can see they are substantial, generally higher than those of a conventional mortgage. And in addition to the monthly interest there is a servicing fee of $35 per month. Again though, the borrowers do not pay the fee out-of-pocket as it is added to the principal debt and does not affect the amount of the available credit that can be drawn down.
When the latter to die of the borrowers or if both of borrowers move from the home permanently, the mortgage loan will be due and must be repaid from the borrowers’ estates or from the sale of the home. That includes all of the various fees and interest. If the owners would like to sell their home or just want to pay off the mortgage, they may do so at any time.
Let’s summarize: You have a home with substantial equity; your monthly income is insufficient to pay all of your bills; and you want to live in your home for the remainder of your life. The RM may be just what you need; but remember, though the interest rate on the loan is modest, the fees to obtain it are high. So, the borrowers’ heirs’ inheritance will be reduced by the amount drawn down by them; instead of inheriting a house in the illustration above worth $250,000, they’ll inherit one worth $250,000 less the amount actually borrowed (including all of the fees). Perhaps the single most desirable feature of the RM is that it is not a personal obligation; and if the value of the home shrinks (welcome to 2009) to a point that is less than the amount of the loan balance, neither the borrowers nor the estates of the borrowers are responsible for the difference beyond the value of the home.
The point we wish to make here is that, while the RM is not for all elderly couples, under the right set of circumstances it may be worthy of consideration.
It is an intriguing concept, though the rules are complex. If you would like to know more, please call us.
— Ken Butera