Is a Reverse Mortgage Right for You?

Is a Reverse Mortgage Right for You?

Nelson Smith |Jun 30, 2020

Reverse Mortgage Definition

Many folks run into an issue when they retire. They end up with a paid-off house with some retirement savings, and not many other financial assets. Sure, they’re eligible for Social Security and other retirement benefits, but that’s often not enough. This doesn’t translate into a whole lot of income.

The most common solution to this problem is to downsize to a smaller house, a move that frees up capital that can be put to work in stocks, bonds, CDs, or various other income-producing investments. And since you can sell your home without paying taxes on the proceeds, every dollar gained can be invested in your future.

But there are a few problems with that method. First, moving is a pain. Most people try to avoid it at all costs. It can also be expensive if you hire people to help you do it. Putting the cash into stocks isn’t guaranteed either. As we’ve seen over the last few months, stocks sometimes crash. Retirees might be better served to put their money in safer investments, but interest rates are incredibly low right now.

Some retirees are using a different way to extract income by utilizing reverse mortgages. Let’s take a closer look at this method and the reverse mortgage definition, and see if it might work for you.

What Exactly Is a Reverse Mortgage?

A reverse mortgage by definition works exactly how the name implies. If you pay money every month to the bank for a regular mortgage, you’ll receive money every month on a reverse mortgage. You can also opt for a one-time sum.

Before you start getting too excited, we should verify some details. A reverse mortgage isn’t free money. All that cash needs to be paid back at some point, which happens when the property is sold. The balance of the loan goes up every month depending on how much cash you get, and a borrower is charged interest each month on the cumulative balance.

A regular mortgage sees interest charges drop steadily as the loan is paid off. The opposite happens with a reverse mortgage. The amount of interest paid keeps going up as the balance owing goes up. When you’re investing, that’s a powerful thing. But it works against you when borrowing.

This compounding effect is why reverse mortgages are only offered to retirees with paid-off homes. The lender must ensure the amount paid back to the borrower won’t exceed the value of the house. Reverse mortgage lenders do this by capping the loan-to-value ratio at approximately 50% of the value of the house. So, if you have a $500,000 house, the maximum reverse mortgage balance you’ll qualify for is $250,000.

The loan is generally Federal Housing Agency insured and it’s a non-recourse loan. This means if you take out a reverse mortgage and the value of your home tanks, the bank can only sell the house to recoup its losses.

Who Should Take a Reverse Mortgage?

As I previously mentioned, the product simply isn’t offered to younger people. You must be 62 or older to get a reverse mortgage. The loan must also be secured against your principal residence; investment or vacation properties do not apply.

A reverse mortgage is well-suited for people who don’t have a lot of investment knowledge. Borrowing against your house is a lot simpler than trying to manage an investment portfolio, although the latter can always be outsourced to a fund manager or financial advisor.

A reverse mortgage can be a smart part of a retirement strategy. One way to do it might be to exhaust your savings when you first retire, leaving the reverse mortgage as an option in your 70s or 80s. This minimizes interest charges, ensuring more cash in your pocket when it comes time to sell.

Pros and Cons of a Reverse Mortgage

Reverse mortgages are gaining popularity with retirees because they’re easy. Unlike other methods of extracting home equity, getting a reverse mortgage is a simple process. You’re just borrowing against property you already own versus getting a brand-new house.

Another plus for a reverse mortgage is you’re able to productively use your home equity. After years of paying off your home, it finally returns the favor and starts paying you.

The biggest con is the amount of interest charged, of course. Reverse mortgage rates are often 2 to 3% higher than conventional mortgage rates. That can really add up over time, especially if you end up staying in your home for a couple of decades – or longer.

Say you take $500 per month from your home and get charged 5% annually for the privilege. You consistently get paid that much for 15 years and then go to sell your home. You’ll be stuck paying back nearly $136,000 to the bank.
Many retirees want to leave an inheritance for their kids or grandkids. A reverse mortgage will impact their ability to do so. This is something you can recognize and plan around, but it must still be considered when looking at your total financial picture.

Another disadvantage is you may run out of allowed home equity before you’re ready to leave your home. In this situation, the bank is in control of your retirement, not you.

How to Apply

Before applying for a reverse mortgage, you must first own your house. Exceptions apply for folks who have almost paid off their home, provided part of the reverse mortgage is used to pay off the existing loan.

You’ll also have to speak to an approved councilor before being allowed to apply. This person will guide you through the process and explain how everything works.

The next step is to apply for the loan. Note that this isn’t as easy as going down to your local bank branch. Reverse mortgage lenders tend to specialize in their unique loan. Certain mortgage brokers will be permitted to do reverse mortgages as well.

After this, the steps are the same as applying for most any loan. You’ll need to submit paperwork, verify certain financial information and so on.

Reverse Mortgage Definition: The Bottom Line

Like any financial product, reverse mortgages have pros and cons.

Ultimately, it’s up to you whether you decide to get one.

This special category of mortgage lending has experienced steady growth over the last decade or so as more Americans see the benefits. Many folks will happily pay interest if it means not selling their home.

But just remember one thing: compound interest is wonderful when you’re investing. It’s not very nice when it’s working against you. Reverse mortgage balances have a habit of ballooning much higher than the homeowner ever imagined.

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Katie Macomb | June 30, 2020

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