Most homeowners of retirement age have seen the pitches – often colorful brochures that arrive in the mail – promising to solve their cash-flow problems by tapping the equity in their homes.
A so-called reverse mortgage is a special kind of loan, available only to people in their sixties and older.
The “reverse” part means that, instead the amount owed being steadily paid down, the debt grows. Eventually, the lender gets its money back when the house is sold, either by the borrower or, after the borrower’s death, by the estate. So, needless to say, a reverse mortgage is suitable only for people in very particular circumstances.
First is that they should intend to remain in their home for the rest of their lives. Because the loan steadily reduces their equity, they may not get enough from a sale to buy a new place to live.
Second is that the mortgage term should be realistically matched against the borrower’s life expectancy. For example: a 65-year-old homeowner who takes out a 15-year reverse mortgage might be forced to sell when reaching 80 if refinancing isn’t affordable.
Finally, it may be a bad fit for someone who wants to leave a significant estate. If most of the home’s value has to be repaid to a lender, little is left as an inheritance.
But even when a reverse mortgage is a good option, legal and financial complexities mean you should always proceed with caution, making sure you understand all the implications.
Many an older person gets to retirement with plenty of wealth on paper – owning a valuable house – but “cash poor.” As an alternative to selling out and downsizing, reverse mortgages were designed to address this problem. They allow drawing on that wealth to supply either a lump sum or a steady flow of cash.
As a rule, the amount borrowed and all the interest that accumulates over the life of the loan isn’t repaid until the last surviving borrower sells, moves out or dies. A borrower can use the proceeds for anything. If paid out monthly, it could be a necessary income supplement. It might be used for major medical expenses… or even to finance travel to “bucket list” destinations.
Now for the pitfalls.
First is that closing costs typically are higher than on conventional mortgages. That’s a strong disincentive for anyone who intends to stay in their home for just a few years. And for some borrowers, the proceeds might push them over the income limits to be eligible for Supplemental Security Income (SSI) or Medicaid.
For people who need those kinds of public assistance, a “single purpose” mortgage may be helpful. In North Carolina, a state agency offers a program for elderly homeowners whose income qualifies them. Used for repairs or to pay off back taxes, these loans often comes with low or no closing costs, and sometimes don’t require repayment at all after a certain number of years. The loans can come from local governments or aid agencies and may involve deferral of certain property taxes.
At the other end of the income scale, owners of very valuable properties may find a private “proprietary” loan, sometimes called a “jumbo,” to be most suitable.
But for most seniors, the best option is a non-subsidized, federally insured reverse mortgage. Officially known as a Home Equity Conversion Mortgage, this comes from a commercial mortgage lender. The Federal Housing Administration insures HECMs. That protects homeowners against such dangers as a drop in their property’s value, or bankruptcy by the lender.
To qualify for a HECM, everybody listed on the deed must be 62 or older. A homeowner over 62 who co-owns the property with a younger spouse may still be eligible for the loan, but that younger spouse can’t be one of the borrowers.
Because of the potential dangers of reverse mortgages, the government requires that borrowers get special counseling from an approved agency. The point is to make sure nobody takes out a reverse mortgage without thoroughly exploring their housing options and understanding exactly how a HECM works.
One important piece of good news is that this kind of loan doesn’t carry income requirements or even require a good credit score. Lenders can choose to consider whether the borrower can keep up with maintenance and repairs, insurance and property taxes. This is important, because a reverse mortgage can be canceled if the homeowner neglects these important obligations and lets the collateral deteriorate.
Sometimes lenders require that proceeds are put into a fund to pay those charges. Alternatively, a borrower may authorize the lender to pay taxes and insurance from any monthly payments. One other important rule – the home that backs the reverse mortgage can’t have any other liens. It is possible to use reverse-mortgage proceeds to pay off other debts, though.
How much can be borrowed depends on several factors. The older the borrower, generally the higher the loan limits. The more valuable the property, of course, the more that can be borrowed against it, up to an FHA ceiling on the home’s valuation. That’s now $625,000. And if interest rates rise, the principal amount may be reduced to ensure that all the accumulated interest can eventually be paid off.
Other complexities, which I won’t try to get into, involve how much of the total borrowed can be paid out during the loan’s first year, how the various fees and closing costs can add up, and how the insurance on the loan is paid for. There are also provisions for spouses to remain in the home after the borrower’s death.
Interest on a HECM can have a fixed rate if the full amount is paid out on closing. If the borrower wants monthly payments, or the option to draw on a line of credit, the rate must be variable. Adjusted annually, that interest can’t go up more than two percentage points a year or more than five points during the life of the loan.
As I mentioned earlier, some reverse mortgages have a fixed term. When that’s up, the cash advances stop, and the loan and interest may become due and payable. Alternatives include getting a single payment up front, taking monthly advances for as long as the borrower lives in the home, or setting up a line of credit.
So, when does the reckoning come? Usually that’s when the last surviving borrower dies or moves out, such as to assisted living or a nursing home. If the owner or estate wants to keep the property, the loan can be repaid from other sources. If that’s not desired or possible, then the property must be sold. If the property happens not to command enough money to fully repay the reverse mortgage, the lender takes the loss. The borrower or the estate isn’t responsible for making up the shortfall.
Because the stakes are high and the rules are complex, it’s always wise to consult with an experienced estate planner before committing to such a major step. That’s the best way of ensuring that a reverse mortgage is in harmony with the rest of your estate planning.
Old North State Trust, LLC (ONST) periodically produces publications as a service to clients and friends. The information contained in these publications is intended to provide general information about issues related to trust, investment and estate related topics. Readers should be aware that the facts may vary depending upon individual circumstances. The information contained in these publications is intended solely for informational purposes, is proprietary to ONST and is not guaranteed to be accurate, complete or timely.
Susan Willett is the director of trust services and oversees all aspects of trust administration for Old North State Trust, LLC. Old North State Trust, a North Carolina chartered trust company, provides: asset management services; income, estate and trust tax consulting; retirement planning and administration; and trustee and estate services to both individuals and businesses. Old North State Trust professionals have many years of experience and for over a decade have assisted clients in identifying and reaching their financial goals. For more information, visit www.oldnorthstatetrust.com or call 910-399-5470.
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