Reverse mortgages are being used by more and more retired homeowners to fill the gap between their income and their required expenses. For some homeowners, a reverse mortgage (RM) may be the best way to provide income or to pay off debts or expenses. However, senior homeowners have other alternatives available to them that may make more sense than a reverse mortgage, depending on their goals and financial situation.
The following alternatives may be preferable to a reverse mortgage in some cases:
- A “cash-out” refinance
- A charitable home remainder annuity
- Selling the home and either downsizing, renting or buying into a long-term care community
Considering a Reverse Mortgage
A reverse mortgage is a loan product that allows a homeowner to pull out a lump sum or stream of income from part of the equity in their home. The reverse mortgage lender receives neither principal nor interest payments during the life of the loan. If the homeowner passes away or vacates the home for over a year, then the house is sold, and the lender receives the principal plus the accrued interest from the proceeds of the sale. If the house sells for more than the reverse mortgage balance, the homeowner or their heirs receive the difference. If the homeowner dies and the house sells for less than the balance, the lender takes a loss.
Who Can Get a Reverse Mortgage?
Homeowners who are age 62 or older are eligible for a reverse mortgage. The homeowner doesn’t have to qualify based on income or credit like a traditional mortgage. However, the home must be in good condition and the homeowner must have paid off their existing mortgage loan, or at least have the loan balance paid down substantially. Most reverse mortgage loans allow for an initial draw that may be used to pay off the balance of the existing lien.
What Are the Advantages of a Reverse Mortgage?
The advantages of a reverse mortgage include:
- The homeowner doesn’t have to make payments on the loan.
- The income or lump sum they receive is not taxable.
- The homeowner can live in the house for the rest of his or her life, even if the loan principal and interest grow to be more than the value of the home.
- The lender cannot force the homeowner out of the home while they live there and comply with the terms of the RM.
- The homeowner can sell the home and pay off the reverse mortgage.
- After the homeowner passes away, the equity left over after paying off the reverse mortgage goes to their heirs.
What are the Disadvantages of a Reverse Mortgage?
Disadvantages of reverse mortgages may include:
- High up-front costs (as high as two percent of the loan amount).
- High ongoing costs, such as mortgage insurance and servicing fees.
- Risk of the interest rate increasing (reverse mortgage rates are always adjustable).
- Lump-sum proceeds may affect eligibility for Medicaid.
What Factors Should Be Considered Before Deciding on a Reverse Mortgage?
Before deciding to take out a reverse mortgage, homeowners should consider the following possibilities:
- Are other retirement income sources available to the homeowner?
- Would downsizing or taking a cash-out refinance make more sense?
- Is it the homeowner’s goal to bequeath the house or other assets to their heirs?
- Is the reverse mortgage lender reputable, and are the fees and interest rate reasonable?
- Would receiving a lump sum affect the homeowner’s eligibility for Medicaid or other need-based benefits?
Considering a Cash-Out Mortgage
A cash-out mortgage is a traditional mortgage, with payments due each month. The homeowner receives a lump-sum payment, which can be used to provide income and pay off debts or expenses. Cash-out mortgages are available with a variety of terms, such as fixed or variable interest rates, interest-only or negative amortization, and various lengths.
When Is a Cash-Out Mortgage a Better Choice Than a Reverse Mortgage?
If a homeowner can qualify for a traditional mortgage, he or she may be able to save substantial amounts of money that would otherwise be spent on interest, fees and costs by taking out a traditional mortgage. If interest rates are reasonably low and the homeowner chooses a fixed interest rate, he or she can eliminate the interest rate risk of the RM. This may substantially increase the amount of equity left over for heirs or for the homeowner if he or she must move to a nursing home or assisted living facility.
When Is a Cash-Out Mortgage not a Better Choice Than a Reverse Mortgage?
The primary disadvantage of the traditional mortgage is that payments are due each month. This may be a burden or a stressor for some homeowners. The homeowner must also decide how to manage the lump-sum payment so that it provides a steady stream of income. Proceeds from a traditional mortgage may affect eligibility for benefits such as Medicaid or other programs that have financial limitations.
Considering a Charitable Home Remainder Annuity
A charitable home remainder annuity is a contract made with a charitable organization, whereby a homeowner essentially wills their home to a charity in return for an annuity that lasts the homeowner’s lifetime. The homeowner retains a life interest in the home, so as long as he or she is alive, he or she can remain in the home. The homeowner also receives a tax deduction for the charitable gift, but heirs typically receive none of the home’s value at the homeowner’s death.
When is a Charitable Gift Annuity a Better Choice Than a Reverse Mortgage?
For a charitable annuity to make sense, the homeowner must have the primary objective of leaving a substantial amount of assets to a particular charity. If that is the case, the tax benefits of a charitable annuity will allow more assets to flow directly to the charity and less to the government. Depending on the homeowner’s age and prevailing interest rates, the homeowner may receive a favorable income stream based on the remainder value of the home. As an example, a charitable remainder annuity for a $500,000 house may generate $2,000 of income per month or more for life. Furthermore, the charitable tax deduction may substantially reduce the taxability of this income.
How Do I Decide Which Option Is Best?
Learn more about reverse mortgages and other options by:
- Visiting the U.S. Department of Housing and Urban Development (HUD) website.
- Attending a free reverse mortgage counseling session offered by a HUD-approved mortgage counselor. For a list of these counselors, go to http://www.hecmresources.org.
- Talking to a bank or mortgage lender and obtaining a quote for the current interest rate, fees, and monthly payments for a traditional mortgage.
- Discussing the option of a charitable annuity with the charity or a regional charitable organization that can act on behalf of the charity.
Jon Beyrer, CFP, EA, is Vice President of Financial Planning at Blankinship & Foster, LLC, and a member of the Financial Planning Association and National Association of Personal Financial Advisors.