Reverse mortgages let homeowners who are 62 years and older liquidate their home equity. That can be a convenient way to generate extra cash for retirees whose net worths are primarily in their homes.
However, these specialized home loans also have costs and limitations that can make them problematic. Here are the most significant pros and cons of reverse mortgages to help you determine whether they make sense for your circumstances.
Note: This guide focuses on the Home Equity Conversion Mortgage (HECM), the most common type of reverse mortgage loan and the only one insured by the Federal Housing Administration (FHA).
Reverse Mortgage Pros
Reverse mortgages have several advantages that can make them attractive to homeowners. Here are the primary reasons to consider using them.
Cash Out Home Equity
The fundamental appeal of reverse mortgages is that homeowners can use them to convert their home equity into cash. That can be a saving grace for retirees having difficulty supporting themselves with their savings and Social Security benefits.
Unfortunately, financial issues plague a disappointingly high percentage of seniors in the United States, where most consumers struggle to accumulate the savings necessary to fund a reasonable retirement.
You generally need to save and invest at least 15% of your income over a 40-year career to retire on time, but the annual personal savings rate has averaged much lower for decades, with only a few exceptions.
As a result, roughly 80% of households with adults over 65 report struggling financially. Few Americans are genuinely secure, since medical or long-term care expenses can overwhelm even above-average retirement savings and Social Security benefits.
Fortunately, buying a home is something of a forced savings plan.
You must stay current on your monthly mortgage payment to stay in your house, so simply hanging onto a property inevitably means building equity.
As a result, you’re probably sitting on funds that can extend the life of your retirement portfolio if you’ve paid down the mortgage on your home for years. Reverse mortgages let you draw down those funds all at once or set up a series of recurring payments.
For example, you might receive $200,000 in cash upon closing the reverse mortgage or opt to withdraw $20,000 a year over the next ten years in equal monthly payments.
Because most people don’t pay income taxes out of pocket the same way they pay for food or rent, it’s easy to overlook the expense. However, taxes can significantly reduce the value of many retirement income sources.
Fortunately, the Internal Revenue Service (IRS) treats funds generated with a reverse mortgage like they do proceeds from a conventional mortgage. In other words, the cash provided is an advance, not income, and therefore, non-taxable.
Proceeds for a reverse mortgage go farther
As a result, proceeds from a reverse mortgage go farther than the cash you draw from taxable retirement accounts like traditional 401(k)s and Individual Retirement Plans (IRAs), or even Social Security.
For example, say you’re a 65-year-old retiree in Texas who’s married and files jointly with $30,000 in annual expenses. You’d need to withdraw roughly $33,500 from your 401(k) each year to support yourself and pay your federal income taxes.
In addition to helping you avoid losing money to taxes, the fact that reverse mortgage proceeds usually don’t count as income helps minimize their impact on your retirement benefits.
These often have income limitations, and earning too much in a single year can jeopardize them. For example, a two-person household in California must earn less than $24,353 to remain eligible for the local Medicaid program.
Stay in Your Home
If you’re a retired homeowner struggling financially, selling your home is often one of the best solutions to your problems. Not only does it convert your home equity into cash, but it also allows you to move to a new location.
That’s often beneficial since many retirees live in homes with wasted space. For example, couples that stay in the property where they raised their families after the children move away are probably paying for rooms they no longer need.
How can you reduce your housing payments?
If you sell your home, you can significantly reduce your housing payments by renting or buying a smaller house or apartment. Alternatively, you could move to a lower cost of living area.
However, selling isn’t a viable option for everyone. Not all seniors can save money by moving to a new location, and some may prefer to stay in their homes for other reasons, such as to be near family or avoid the stress of a move.
In these cases, a reverse mortgage would be a better option. You can use them to access your home equity without having to sell the property or vacate the premises.
Protection From Declining Home Values
One of the primary risks with most forms of home equity financing is that your loan balance could grow to exceed the underlying property value. That can happen if your property decreases in value or you miss debt payments and accrue extra interest.
If you or your beneficiaries need to sell your home while “underwater” like this, making up for that shortfall can be a significant financial burden.
For example, say you have a paid-off home worth $250,000. You take out a home equity loan for $200,000 and invest the proceeds in bonds to help fund your retirement.
Immediately after, your local real estate market crashes, causing your property value to plummet to $175,000. If you were to try to sell at this point, you’d need to make up the $25,000 difference between your equity and outstanding loan balance.
Fortunately, HECMs offer protection from that danger. Unlike home equity loans and HELOCs, they’re a form of non-recourse debt.
That means the lender can only collect on the balance by seizing the underlying collateral. They can’t come after you or your beneficiaries’ income or other assets to recoup their losses.
Reverse Mortgage Cons
Reverse mortgages offer several attractive benefits, but they also come with considerable drawbacks that diminish their utility. Here are the ones you need to understand to make an informed decision.
You need to build some amount of equity in your residence to use any form of home equity financing. Lenders won’t let you borrow against your home without enough meat on the bone to cover your closing costs and still benefit.
Unfortunately, reverse mortgages have noticeably higher equity requirements than most alternatives. Though the specifics vary between lenders, you generally need at least 50% equity in your primary residence to complete one.
Meanwhile, you can generally qualify for a home equity loan or HELOC with as little as 20% equity in your home. That makes reverse mortgages much less accessible than their counterparts.
Make sure you actually have enough for a reverse mortgage
Some retirees have been in their homes long enough to build sufficient equity for a reverse mortgage, but not all. For example, if you refinanced too recently or suffered significant drops in property value, a reverse mortgage may be out of reach.
To calculate your home equity, subtract the outstanding balance on your mortgage or any other home equity financing arrangements from your property’s fair market value.
For example, say that you buy a house for $300,000 with a $30,000 down payment. $30,000 divided by $300,000 equals 10%, which means you’d have 10% equity in the property.
Closing Costs and Interest
Reverse mortgage fees are often more expensive than the charges involved in other means of liquidating your home equity. For example, your closing costs will likely be higher than if you sold your home or took out a HELOC.
In addition to being higher, reverse mortgage costs are more complicated than those involved in a traditional mortgage. In fact, they’re so complex that borrowers must go through specialized counseling before receiving a loan.
While the terms vary between providers, you’ll generally incur some expenses.
- Upfront mortgage insurance premium that equals 2% of the mortgage balance
- Annual MIP that equals 0.5% of the outstanding mortgage balance
- Origination fees up to the greater of $2,500 or 2% of the first $200,000 plus 1% of the remaining balance (not to exceed $6,000 total)
- Third-party charges, which can include an appraisal, title search, surveys, inspections, recording fees, mortgage taxes, credit checks, and more
- Interest rates higher than those of a regular mortgage
- Monthly service fees up to $30 for annually adjusting or fixed interest rate accounts up to $35 for monthly adjusting interest rate accounts
Fortunately, you don’t have to cover these expenses out of pocket. You can pay for the upfront costs with funds from your reverse mortgage and roll the ongoing expenses into your loan balance, in which case they’re not due until you no longer live in the home.
Heirs Will Inherit Less
As long as you stay current on your required property taxes, homeowners insurance, and ongoing maintenance, your reverse mortgage balance won’t come due until you sell, move out, or pass away.
However, that doesn’t mean the accounts are free. The cost is merely deferred, and your heirs will probably feel most of the impact. The longer the account remains outstanding, the more it will erode your home equity and reduce the value they’ll inherit.
Fortunately, they won’t have to pay anything extra, even if the balance grows to exceed the underlying property value. However, if your reverse mortgage is outstanding for too long, you may have little to no remaining equity.
Be sure and get a fixed rate
For example, say you have a paid-off home worth $400,000. You then use a reverse mortgage to cash out $200,000 of your home equity in a lump sum. The loan carries a fixed interest rate of 7%.
The balance remains outstanding for ten years, during which time the value of your home increases by 3% each year. Even if you ignore all the other ongoing reverse mortgage costs, your home equity would still decrease significantly each year.
Check your math on your home value and the reverse mortgage
After a decade, the home value would be roughly $537,567. However, the value of the reverse mortgage would have increased to $393,430. As a result, your heirs would only stand to inherit, at most, $144,137.
Watch — Could Violate Other Retirement Benefits
Many retirement benefits are need-based, which means you might not qualify for benefits if your income or assets exceed certain thresholds. As a result, taking out a reverse mortgage could impact your eligibility if you don’t plan well enough.
While reverse mortgage proceeds generally don’t count as income, the cash they generate definitely still counts as an asset. Because of this, you can inadvertently disqualify yourself from some programs by liquidating your home equity too quickly.
Check that you don’t mess up your eligibility for specific benefits
Most notably, reverse mortgages can jeopardize your eligibility for Medicaid and Supplemental Security Income (SSI), both of which generally include asset limitations, though Medicaid programs vary between states.
For example, say you live in California and rely on Medicaid for your health insurance. You and your spouse have $150,000 in your 401(k) accounts, but your expenses will deplete your funds within five years, even with your Social Security benefits.
Fortunately, you have $200,000 in home equity, and you want to use a reverse mortgage to liquidate it. However, in 2022, couples are ineligible if they have more than $195,000 in countable assets, which includes cash and securities.
As a result, taking out more than $45,000 in a lump sum using a reverse mortgage would put you over the asset limitation and disqualify you from Medicaid.
Fortunately, you can receive your reverse mortgage proceeds in several other ways
- Tenure plan: Similar to an annuity, this option provides you with guaranteed equal monthly payments for as long as you live in the home. The total can exceed your home equity if you live long enough.
- Term payments: Much like a home equity loan, this arrangement provides a fixed monthly payment for a set period, such as ten years.
- Line of credit: Instead of withdrawing funds immediately, you can set up your reverse mortgage as a revolving line of credit and borrow against it when necessary.
- Hybrid plans: For maximum flexibility, you can combine the annuity or term payment options with a line of credit. That way, you’ll have a steady income with the ability to borrow more whenever you want.
To protect your eligibility for any other retirement benefits you may have, consider drawing down your funds over time using one of these methods instead of a lump sum. It’s a good idea to consult with a financial advisor to help you determine the best option.
Reverse mortgages require that you retain ownership of your home indefinitely. While some seniors are happy to stay in their homes for life, they may struggle to keep up with the required maintenance as they age.
An apartment is usually manageable for a long while, but keeping a house in good shape is often too physically demanding for seniors. For example, few elderly individuals can climb ladders to clean gutters or shovel snow out of their driveways.
Unfortunately, taking out a reverse mortgage raises the stakes further. Failing to maintain your residence properly could violate your terms and cause your outstanding balance to come due immediately.
Can you keep up with upgrading requirements?
That’s exceedingly rare, but seniors who lack the physical attributes necessary to keep their homes in line with health and safety standards could run into trouble.
If you don’t have younger family members in the area who can help maintain your property and lack the capital to pay for help, taking out a reverse mortgage might not be the best idea.
Would it be better to sell and downsize?
Instead, you’d likely be better off selling your home and downsizing to a more easily manageable property, such as a condo with a homeowner’s association that handles all the external maintenance.
Reverse Mortgage Requirements
Though none are especially challenging, reverse mortgages have many eligibility requirements. In addition to being a homeowner and at least 62 years old, you must also meet the following criteria:
- Principal residence: You can only execute a reverse mortgage using your primary home. Investment properties aren’t eligible for the loan product.
- Significant home equity: Lenders typically want you to have at least 50% home equity to get a reverse mortgage. Others may require you to own the property outright or to pay off any existing mortgage balance with your loan proceeds.
- Current on federal debt: If you’re delinquent on any federal debts, such as income taxes or student loans, you won’t be able to qualify for a reverse mortgage.
- Sufficient financial stability: To get your reverse mortgage, you must demonstrate that you have the means to afford your property tax, homeowner’s insurance, maintenance, and repair costs.
- Property maintenance standards: Your property must be in reasonably good condition to get a reverse mortgage. After ordering an inspection of your home, lenders may require repairs before closing.
- Reverse mortgage counseling: Because reverse mortgages are such complex and risky financial transactions, consumers must receive counseling from an approved agency to get a loan.
Notably, reverse mortgages are one of the few financial products that don’t require credit. Since they typically don’t involve taking on any debt obligations, lenders don’t need to worry about your credit score.
Taking out a reverse mortgage isn’t a decision to make lightly. Not only does it affect your living situation for the rest of your life, but it also impacts the inheritance you’ll be able to leave for your heirs once you pass away.
As a result, you must take the time to do your due diligence. In addition to calculating the financial repercussions, consider the effect of the decision on your lifestyle, happiness, and relationships.
Ask yourself some pointed questions
- Would I be happy living in this property forever?
- Am I healthy enough to maintain this home indefinitely?
- Do my heirs hope to move into this property once I pass away?
- Are there any more affordable alternatives available?
- How will this arrangement impact my spouse if I pass away first?
In addition to consulting a financial expert, it’s wise to discuss this decision with your beneficiaries and closest relatives, especially if they’re supporting you or you expect them to in the future.
Bottom Line: Should You Get a Reverse Mortgage?
Reverse mortgages are relatively uncommon. In 2020, there were only 43,000 reverse mortgage originations across the United States. For context, there were 869,000 HELOC originations that same year.
In many cases, you’d be better off selling your home, using a different form of home equity financing, or meeting your financial needs in some entirely unrelated way.
If you meet certain specific requirements, a reverse mortgages may be a good idea
- You’re happy to stay in your home for the rest of your life
- You’re healthy enough to maintain the property or have adequate help
- You don’t care about leaving the asset to your heirs
- You’ve built a significant amount of home equity
- You can afford your taxes, insurance, and maintenance costs
- The arrangement won’t impact your other retirement benefits
As always — watch out for the terms
Finally, you must be completely confident in your understanding of the process. Not only do reverse mortgages have complex terms and conditions, but scam artists often seek to take advantage of seniors interested in the arrangement.
For resources to help you avoid these scam artists or to complain about one, visit the Consumer Financial Protection Bureau.