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Right Financial Plan: Reverse Mortgages

By Larry Swedroe

Updated on: July 30, 2010 / 5:38 PM EDT / MoneyWatch

Retirees are often house rich but cash poor, their homes being their largest assets. There used to be just three significant ways to get equity from a home:

Sell it
Rent it
Borrow against it using either a cash-out refinance or a home-equity loan

Reverse mortgages present a fourth option, allowing homeowners to receive some of the home's equity without moving or making regular loan repayments. Reverse mortgages provide an alternative financing method (though an expensive one) that can help homeowners maintain their independence as well as an adequate standard of living.

People who take out reverse mortgages often:

Have a regular need for additional funds
Live on a fixed income with their home equity as their most significant asset
Do not plan to leave their home to their heirs

Reverse Mortgage Features Reverse mortgages resemble conventional mortgages in that lenders pay homeowners based on the equity in the home. The biggest difference is that with a reverse mortgage homeowners do not immediately begin paying back the loan. Generally, the loans are not due until the home is no longer the homeowners' principal residence. Money received from reverse mortgages is not taxable and typically does not affect homeowners' other assets or their Medicare or Social Security benefits.

Borrowers can repay reverse mortgages with other assets but typically repay them by selling the home. Any equity remaining after selling the home belongs to the homeowners or their heirs. Most reverse mortgages have a nonrecourse clause, meaning the debt cannot be passed along to the estate or heirs.

The amount borrowers receive depends on several factors, including:

Age
The current interest rate
Loan fees
The home's appraised value or the Federal Housing Administration's (FHA's) mortgage limits for the area, whichever is less

Because the maximum amount available is partly dependent on age, the longer borrowers wait before taking out a reverse mortgage, the greater the amount available. Many reverse mortgages have no income restrictions. Generally, borrowing limits increase when there is more equity in the home, the borrowers are older, and interest rates are at low levels.

Loan Considerations Reverse mortgages involve several costs: origination fees, other up-front closing costs, as well as service fees during the term of the mortgage. Private mortgage insurance may also be required.

The amount owed on reverse mortgages generally grows over time. Interest is charged on the outstanding balance and added each month. If the debt exceeds the value of the property, the FHA or lender would take the losses due to the nonrecourse nature of most reverse mortgages.

Interest rates on reverse mortgages can be either fixed or variable. Because borrowers retain the titles to their homes, they remain responsible for property taxes and all other homeowner expenses. Failing to pay property taxes or maintain homeowners insurance puts borrowers at risk of the loan becoming due.

Eligible Property Types The home must be a one-to-four unit property, which includes townhouses, detached or manufactured homes, and units in condominiums. Condominiums must be FHA-approved.

How Are Payments Received? In addition to taking a lump-sum payment, borrowers have five options:

Tenure -- Indefinite equal monthly payments
Term -- Equal monthly payments over a certain time period
Line of credit -- A set amount borrowers can draw from whenever necessary
Modified tenure -- Combination of line of credit and tenure
Modified term -- Combination of line of credit and term

Tomorrow, we'll look at the characteristics of specific types of reverse mortgages and a few other items you should consider.

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