Reverse Mortgages: How They Can Enhance Your Retirement

Retired people may want to consider the reverse mortgage as a way to generate cash flow. But the reverse mortgage is not for everyone. If you are planning for retirement or are already retired, the reverse mortgage may be an option worth looking into. This Financial Guide explains how this cash-generating vehicle works.

There are three types of reverse mortgage plans available today: (1) FHA-insured, (2) lender-insured, and (3) uninsured. This guide describes the similarities and differences among them and discusses the benefits and drawbacks of each. Since each plan differs slightly, it is important to choose the one that best meets your financial needs.

The reverse mortgage is not without risk and negative aspects. Knowing the pros and cons will help you acquire the best possible deal should you decide to go with a reverse mortgage. Staying informed of your rights and responsibilities as a borrower may help to minimize your financial risks and avoid the threat of losing your home.

How Does A Reverse Mortgage Work?

A reverse mortgage is a type of home equity loan that allows you to convert some of the equity in your home into cash while you continue to own the home. Reverse mortgages operate like traditional mortgages, only in reverse. Rather than paying your lender each month, the lender pays you. Reverse mortgages differ from home equity loans in that most reverse mortgages do not require any repayment of principal, interest, or servicing fees as long as you live in the home.

The reverse mortgage's benefit is that it allows homeowners who are age 62 and over to keep living in their homes and to use their equity for whatever purpose they choose. A reverse mortgage might be used to cover the cost of home health care, to pay off an existing mortgage to stop a foreclosure, or to support children or grandchildren.

Note: Reverse mortgages are now available in every state except Alaska, South Dakota and Texas. But willing lenders may still be scarce in some places.

When the homeowner dies or moves out, the loan is paid off by a sale of the property. Any leftover equity belongs to the homeowner or the heirs.

General Rules That Apply To Homeowners

• To qualify for a reverse mortgage, you must own your home.
• The amount you are eligible to borrow generally is based on your age, the equity in your home, and the interest rate the lender is charging.
• Because you keep the title to your home, you are responsible for taxes, repairs, and maintenance.
• Depending on the reverse-mortgage plan you choose, your reverse mortgage becomes due, with interest, when you move, sell your home, die, or reach the end of the selected loan term.
• The lender does not take title to your home when you die, but your heirs must pay off the loan. The debt is usually paid off by refinancing it into a forward mortgage (assuming the heirs are eligible) or with the proceeds from the sale of the home.
• A real benefit of reverse mortgages is that borrowers can live in their homes as long as they like, even after they have completely exhausted their equity. Borrowers must do their best to maintain the value of the home with diligent upkeep.

How Payments Are Received

Depending on the lender, borrowers can choose to receive monthly payments, a lump sum, a line of credit, or some combination.

Tip: The line of credit offers the most flexibility by allowing homeowners to write checks on their equity when needed up to the limit of the loan

A few reverse-mortgage programs guarantee monthly payments for life, even after the borrower no longer lives in the home.

You can request a loan advance at closing that is substantially larger than the rest of your payments.

Tax Rules

The reverse mortgage payments you receive are nontaxable. Further, if you receive Social Security Supplemental Security Income, reverse mortgage payments do not affect your benefits, as long as you spend them within the month you receive them. This rule is also true for Medicaid benefits in most states.

Tip: To find out the exact impact of reverse mortgage payments on benefits you are receiving, check with a benefits specialist at your local area agency on aging or legal services office.

Interest on reverse mortgages is not deductible until you pay off your reverse mortgage debt.

Maximum Loan Amounts

Maximum loan amount limits are based on the value of the home, the borrower's age and life expectancy, the loan's interest rate, and whatever the lender's policies are. Maximums range (depending on the lender) from 50% to 75% of the home's fair market value. The general rule is: The older the homeowner and the more valuable the home, the more money will be available.

Example: A 65-year-old homeowner with a home worth $150,000 would be able to get a $30,000 lump sum or credit line. A 90-year-old homeowner with the same home could be eligible for as much as $94,000.

All reverse mortgages have non-recourse clauses, meaning the debt cannot be more than the home's value. Thus, the lender seeks repayment from heirs, family members, or the borrower's income or other assets.

Negative Aspects

Here are some of the downside aspects of reverse mortgages.

You Incur A Large Amount of Interest Debt

Reverse mortgages are rising-debt loans: The interest is added to the loan balance each month, since it is not paid currently, and the total interest you owe increases greatly over time as the interest compounds.

Note: Some plans provide for fixed rate interest. Others have adjustable rates that change based on market conditions.

Fewer Assets for Heirs

Reverse mortgages use up the equity in your home, leaving fewer assets for you and your heirs.

High Costs

The high up-front costs of reverse mortgage make them less attractive. All three types of plans (FHA-insured, lender-insured, and uninsured) charge origination fees and closing costs. Insured plans also charge insurance premiums, and some plans charge mortgage servicing fees.

Tip: If you are forced to move soon after taking the reverse mortgage (e.g., because of illness), you will almost certainly end up with a great deal less equity to live on than if you had simply sold the house. This is particularly true in the case of loans terminated in five years or less.

Tip: Your lender may permit you to finance these costs, so that you won't have to pay them up front. But they will be added to your loan amount. Because of the high up-front costs on all reverse mortgages, effective interest rates for short-term loans are out of this world.

Adjustable Interest Rates

With many reverse mortgage plans, interest rates are adjustable annually or monthly and tied to a public index, in some cases with limits on how far the rate can go up or down. Reverse mortgages with interest rates that adjust monthly have no limit. Bear in mind that the higher the rate, the faster your equity is used up.

In order to give a fixed rate, one lender requires appreciation sharing, with which it gets a part of any increase in the home's value over and above the debt. Another lender offers percent of value pricing, collecting a fixed percentage of the home's value when the loan comes due. The latter option can be very expensive if the loan must be paid off after only a few years.

Is A Reverse Mortgage For You?

Although a reverse mortgage may be the answer for house-rich and cash-poor retirees, they are not for everyone. For instance, if you plan to move a few years down the road or there is a possibility you will have to move-e.g., due to illness-the reverse mortgage makes no sense. They make the most sense for those who plan to stay in their homes permanently. Also, if you already have a substantial mortgage on your home, the reverse mortgage is probably not for you, since you will have to pay it off before you can become eligible.

If you want to pass your home to your children or heirs, the reverse mortgage is not a good alternative for you, since the lender will get most of the equity when the home is sold.

Other Alternatives

Besides the reverse mortgage, here are some alternatives to consider.

• Programs that help with real estate taxes, repairs. Many state and local governments have programs that provide special purpose loans to seniors for (1) the deferral of property taxes and (2) making home repairs or improvements. These loans can often prevent retirees' having to sell their homes. To find out whether your state has a special-purpose loan program for property taxes and/or for home repairs and improvements, contact your state agency on aging.

• The qualified personal residence trust. If you want to pass your home to your children or other heirs, this option should be considered, especially if your home is worth a great deal and you want to remove it from your estate for estate tax purposes. The QPRT trust allows you to keep the home for a certain amount of time with ownership eventually passing to your heirs.

• The sale-leaseback. You sell your home to your kids, and continue to live in it, paying them a fair market rent.

Note: Do not arrange a sale-leaseback without professional guidance.

How Federal Rules Help With Mortgage Shopping

Reverse mortgages are complex financial transactions, and a lot of calculations are required to make sure you are getting a good deal.

One of the best protections you have with reverse mortgages is the Federal Truth in Lending Act, which requires lenders to inform you about the plan's terms and costs. Be sure you understand them before signing. Among other information, lenders must disclose the Annual Percentage Rate (APR) and payment terms. On plans with adjustable rates, lenders must provide specific information about the variable rate feature. On plans with credit lines, lenders also must inform you of any charges to open and use the account, such as an appraisal, a credit report, or attorney's fees.

New rules require that total cost estimates illustrate at least three loan periods (short-term, life expectancy and long-term) and three likely appreciation rates (the predicted percentage increase in the home's value over the loan period).

Armed with these estimates from several lenders, borrowers can more easily match programs to their needs and shop for the best mortgage value.

A Summary Of Available Plans

This section describes how the three types of reverse mortgages - (1) FHA-insured, (2) lender-insured, and (3) uninsured-vary according to their costs and terms. Although the FHA and lender-insured plans appear similar, important differences exist. This section also discusses advantages and drawbacks of each loan type.

FHA-Insured

This plan offers several payment options:

• Monthly loan advances for a fixed term, or for as long as you live in the home
• A line of credit
• Monthly loan advances plus a line of credit

This type of reverse mortgage is not due as long as you live in your home. With the line of credit option, you may draw amounts as you need them over time. Closing costs, a mortgage insurance premium, and, sometimes, a monthly servicing fee are required. Interest is at an adjustable rate on your loan balance. Interest rate changes do not affect the monthly payment, but rather how quickly your loan balance grows.

The FHA-insured reverse mortgage allows you to change the way you are paid at little cost. This plan also protects you by guaranteeing that loan advances will continue to be made to you if a lender defaults. However, the downside of FHA-insured reverse mortgages is that they may provide smaller loan advances than lender-insured plans. Also, loan costs may be greater than with uninsured plans.

The most widely available plan is the Federal Housing Administration's Government-insured Home Equity Conversion Mortgage (HECM) program. To qualify for an HECM loan, homeowners must be at least 62 and live in a single-family home or condominium that is their principal residence. Under this program, the amount of equity homeowners may borrow against depends on where they live, as well as on prevailing interest rates.

For people who have more expensive homes or who need to borrow more, there are alternatives. A program from the Federal National Mortgage Association grants larger reverse mortgages on home equity.

Tip: Most private reverse mortgages are not insured. Only the strength of the lender backs whatever promises it may make as to payments and other terms. So if you are looking to a reverse mortgage for future income, rather than a lump sum up front, you are better off in a federally insured program.

Counseling is required before homeowners can apply for an HECM loan. This counseling allows homeowners to discover whether a reverse mortgage is really the best answer to their cash-flow problems.

Tip: For an approved counselor, contact any HECM lender.

Lender-Insured

These reverse mortgages offer monthly loan advances or monthly loan advances plus a line of credit for as long as you live in your home. Interest may be assessed at a fixed rate or an adjustable rate, and additional loan costs can include a mortgage insurance premium (which may be fixed or variable) and other loan fees.

Loan advances from a lender-insured plan may be larger than those provided by FHA insured plans. Lender-insured reverse mortgages also may allow you to mortgage less than the full value of your home, thus preserving home equity for later use by you or your heirs. However, these loans may involve greater loan costs than FHA insured, or uninsured loans. Higher costs mean that your loan balance grows faster, leaving you with less equity over time. Some lender-insured plans include an annuity that continues making monthly payments to you even if you sell your home and move.

Tip: The security of these payments depends on the financial strength of the company providing them, so be sure to check the financial ratings of that company.

Annuity payments may be taxable and affect your eligibility for Supplemental Security Income and Medicaid. These review annuity mortgages may also include additional charges based on increases in the value of your home during the term of your loan.

Uninsured

This reverse mortgage is dramatically different from FHA and lender-insured reverse mortgages. An uninsured plan provides monthly loan advances for a fixed term only-a definite number of years that you select when you first take out the loan. Your loan balance becomes due and payable when the loan advances stop. Interest is usually set at a fixed interest rate and no mortgage insurance premium is required.

Tip:If you consider an uninsured reverse mortgage, think carefully about the amount of money you need monthly, how many years you may need the money, how you will repay the loan when it comes due, and how much remaining equity you will need after paying off the loan.

If you have short-term but substantial cash needs, the uninsured reverse mortgage can provide a greater monthly advance than the other plans. However, because you must pay back the loan by a specific date, it is important for you to have a source of repayment. If you are unable to repay the loan, you may have to sell your home and move.

Recommended Books

• Ken Scholen, Reverse Mortgages for Beginners: A Consumer Guide to Every Homeowner's Retirement Nest Egg, (NCHEC, 1998), ISBN 0963011987.

• David Bridewell, Reverse Mortgages: A Lawyer's Guide to Housing and Income Alternatives, (American Bar Association, 1997), ISBN 1570734062.

To obtain a free copy of the FTC's Best Sellers- a listing of all the FTC's consumer and business publications-write to:

Public Reference
Federal Trade Commission
Washington, DC 20580

Government and Non-Profit Agencies

• To obtain a current list of lenders participating in the FHA-insured program, sponsored by the Department of Housing and Urban Development (HUD), or additional information on reverse mortgages and other home equity conversion plans, write to:

AARP Home Equity Information Center
American Association of Retired Persons
601 E St., NW
Washington, DC 20049

• A free information kit, including an extensive state-by-state Reverse Mortgage Lenders List, is available from the American Association of Retired Persons (AARP). Address a postcard to:

D15601
AARP Home Equity Information Center EE0756
601 E St. NW
Washington, DC 20049

• For additional information, you also may contact the:

National Center for Home Equity Conversion
7373 147 St. West Suite 115
Apple Valley, MN 55124

• If you have a question or complaint concerning reverse mortgages, you may write:

Correspondence Branch
Federal Trade Commission
Washington, DC 20580

(Although the FTC generally does not intervene in individual disputes, the information you provide may indicate a pattern or practice that requires action by the Commission.)