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What you should know about reverse mortgages

They're sometimes called "loans of last resort," criticized for their often high costs and sometimes misleading advertisements. But if you're a senior without sufficient savings, a reverse mortgage may be your best -- or only -- option if you need additional retirement income.

"It's a need-based loan," said Bob Bozanic, a loan agent for Lineage Lending. "It's for people who have been in their house for a long time and want to stay there, but they need to tap their equity for living expenses."

But such loans aren't for everyone. Read on to learn about how reverse mortgages work and when they're appropriate?

What's a reverse mortgage?

It is a loan that allows homeowners over the age of 62 to tap the equity in their homes. Designed to help people who are house-rich, but cash-poor, the loans pay the homeowner in one of several ways: through a lump sum; a line of credit; via monthly payments; or through a combination of a lump sum and monthly payments. The amount you can borrow depends on your equity in the home, reverse mortgage loan limits and your age. The older you are, the more equity you can tap.

To illustrate, let's look at two hypothetical examples.

John is 65 and owns a home that's worth $450,000. He's got a $50,000 balance on his mortgage, which costs him $1,000 a month. He wants to retire but knows that he'll only receive $2,000 a month from Social Security, and his monthly expenses, including his mortgage, amount to $4,000 a month. He has little savings to close the monthly gap. He could get a reverse mortgage that would pay off his $50,000 loan balance and then pay him a stipend of $1,053 per month for the rest of his life. That would close the gap between his income and expenses, at least for the early years of his retirement, allowing him to save any cash he has for emergencies and to deal with future inflation.

Also consider Dorothy, who is 85 and in ill health following a stroke. Her children have been paying for full-time caregivers so that she can remain in her home, but at a cost of $15,000 a month she's quickly running out of cash. She has a home that's worth $300,000 and is paid off. She can get a reverse mortgage that would provide a line of credit of up to $200,792 that her kids can use to pay her expenses when her other assets are depleted.

How is the loan repaid?

The loan is repaid when the borrower dies, moves, sells the home or goes into default. (Defaults occur if the borrower fails to pay property taxes or homeowners insurance on their property.) The loan is repaid from the proceeds of the home sale. If the balance of the loan is greater than the value of the home, the borrower's heirs can simply hand over the bank the keys. If the borrower dies with home equity remaining, his or her heirs can sell the home, repay the loan and keep what's left of the proceeds.

What's the catch?

The loans have high up-front costs. According to the National Reverse Mortgage Lenders Association, the allowable up-front fees and charges on John's loan could add up to as much as $10,879. Dorothy's loan has maximum fees of $8,908. Some lenders charge less than the maximums, however. Moreover, the fees do not need to be paid in cash. They're typically rolled into the balance of the loan.

Borrowers also pay interest on the outstanding loan balance. The rate of interest will vary based on the type of reverse mortgage that you receive. Most reverse mortgages are made at variable rates of interest. The rates are low today, but would rise if market interest rates rise.

In addition, the loans have come under fire because some unscrupulous investment sales people have talked seniors into taking out lump-sum reverse mortgages to "reinvest" their equity. That can result in disaster when the investments don't pay enough to make the loan worthwhile, or when the whole investment is a scam aimed at tricking the senior out of his or her equity.

Why not get an ordinary mortgage?

To qualify for a traditional mortgage, you must have sufficient income to pay on the loan. The same holds true with a home equity line of credit. With a reverse mortgage no payments are due while the borrower is alive, so the loan is primarily based on the equity in the home. However, new underwriting standards will also look at whether borrowers have enough income to pay their property taxes and insurance, which should help deter defaults.

Where can I find out more about reverse loans?

AARP devotes a section of its website to reverse loans, their uses and risks. The National Reverse Mortgage Lenders Association is also a good reference and offers a calculator to determine the maximum loan amount that you could get, the payment options, and the maximum fees and charges that could be levied on that loan.

Additionally, anyone who seeks a reverse mortgage is required to get loan counseling. Seniors should take advantage of the counseling and have an in-depth conversation about why they need the money. The reason? There may be other options, suggests Peter Bell, president of the National Reverse Mortgage Lenders Association. That's simply because many local government and charitable programs also aim to help needy seniors.

If the financial need is relatively small, these other programs may be the better bet. For instance, if you were getting a reverse loan to pay, say, property taxes or to do a necessary but relatively minor repair, you may be able to get a property tax waiver or find a charitable or government grant able to pay that cost. But if that expense is just the tip of the iceberg and a senior is living a life of penury when he or she has ample equity, the reverse mortgage may be just the ticket.