Is the Reverse Mortgage your Panacea?

Is the Reverse Mortgage your Panacea?

You are 62 (or older); you live in a home which has no mortgage and has appreciated substantially (beyond your dreams in this market!); you have retired; and your income from your pension plans (IRA’s, 401(k)’s, and company pension) and social security benefits are steady but insufficient to permit you to enjoy a comfortable lifestyle. Most of all you are very happy living in the home you purchased many years ago and fear that the pressure of circumstances may force you to sell it.

What are your options?

The obvious first option is selling that most valuable asset, your home; but this may create problems larger than the one you are trying to solve. There is a possibility of capital gains tax on a sale, and you must consider the cost of the replacement residence (though you might rent). The greatest hurdles to the sale though are intangible: giving up a residence you love because it fits like an old shoe, the disruption and expense of the move, and adjustment to a new neighborhood.

A second option would be to seek a conventional mortgage. Although this would let you retain your home (for now), the problem is fairly obvious: your income is probably not great enough to support an application; where will you find the funds to repay the loan? Such a loan might put pressure on you to sell the property before you want to, albeit several years from now.

In lieu of those options, the “reverse mortgage” may be for you; however, proceed with caution. If your 62 (or more) years have taught you anything, mostly you know to beware of old goods in fancy new wrappings. To some extent the reverse mortgage may fall into that category, but it does have certain features which may distinguish it from other “solutions” and make it right for you.

There are three major advantages of reverse mortgage financing: (a) you are able to remain in your home indefinitely; (b) you avoid any issue of capital gains taxes since you have not sold your home; additionally, if you hold on to the property until your death, your heirs will receive a “stepped-up basis” which would eliminate or greatly reduce any capital gains tax when it is finally sold by them; and (c) most important of all, there are no mortgage repayments of principal or interest until you die, or upon sale if you later decide to move (though lenders are charging a service fee of approximately $35 per month until the loan is fully satisfied at your death or upon sale).

Such loans can be structured in a number of ways. You might create a mortgage and be paid the full amount of the loan immediately in a lump sum; you might choose to be paid a certain amount on a periodic basis, say monthly, until the loan is fully disbursed; you might have a combination of both (a partial payment now with smaller monthly payments); or you might create a line of credit where you draw against the principal only if and when you want to.

There are disadvantages to consider. Though the Federal Housing Administration (“FHA”) has a program in which it insures reverse mortgage loans made by private banks, and it seems to offer not only the best rates but also assures certain protections that may not be available with non-FHA-insured loans; however, these can be very expensive loans, even with the most reputable lenders. Typically, they will charge fees which will be in the range of 5% of the appraised value of your home, and depending on your age and other factors, the amount of the loan will probably not exceed 50% of the appraisal and could be substantially less. (In conventional loans bank closing fees are generally closer to 3% of the amount borrowed, a substantial difference.) Assuming a loan of $125,000 against an appraised value of $250,000, that would mean closing fees of $12,500, or one-tenth of the borrowed amount. And while the current interest rates which are tied to T-bill rates are below 5%, there is the aforesaid $35 service charge (in addition to interest). The interest rates are variable and are currently at historic lows, so you could expect them to rise.

Also, some lenders (only non-FHA lenders) will insist when it is time to satisfy the reverse mortgage loan that they be paid a percentage of the increase in the value of your home as it appreciates. We would strongly discourage a loan with this provision, even if it means paying a higher rate of interest or reduces the amount you may borrow.

Another (negative?) consideration: since unlike a conventional mortgage which is amortized and repaid little-by-little on a monthly basis until it is fully satisfied, by its definition the reverse mortgage is not repaid until your death (in most cases), and for your heirs that means the value of your residence property will be diminished by the balance due on the mortgage at death. While the size of the estate you leave behind may be a serious consideration, you must weigh it against your needs for the rest of your life.

An exceptionally attractive feature of the FHA-insured loan is that the estate of the decedent can never be assessed a deficit if, for example, the total of principal borrowed and interest accrued exceed the value of the house when it is sold on the borrower’s death. It is conceivable that a person could live 20 years beyond his or her projected mortality at the time of the loan, and the piled up interest when added to the principal might exceed the property’s value at death.

So, what to do? The reverse mortgage is an intriguing concept which is not wholly without its drawbacks but which may be the proper solution for your needs. Proceed cautiously and carefully familiarize yourself with all of the terms if you do determine it is best for you.

— Ken Butera