Ask The Expert: What Are Reverse Mortgages, And Is One Right For Me?

By Michael Vodicka
July 03, 2013

If you'd like us to answer one of your investing questions in our weekly Ask The Expert Q&A column, email us at editors@investinganswers.com. (Note: We will not respond to requests for stock picks.)

Question: I've heard about reverse mortgages, but I don't know much about them. How do I know if one is right for me, and how do they work?

Valerie, Seattle, Wash.

The Investing Answer: Housing has been one of the most controversial asset classes in the past 10 years. It produced big gains for many investors and homeowners and crushing losses for others. As the most widely held asset class in the country -- as of this year's first quarter, 65% of Americans owned homes -- homeownership provokes serious emotion on the Street.

Under that emotionally charged canvas, a controversial financial product is helping millions of homeowners fund their retirements.

Called a reverse mortgage, it is a special type of home loan that lets homeowners convert equity into cash.

In a traditional mortgage, the homeowner makes monthly payments to the lender, with a portion of those payments reducing principal and adding to equity. But in a reverse mortgage, homeowners extract equity from their home by receiving either a lump sum or monthly payments.

Congress created the reverse mortgage program in 1987 through the Federal Housing Administration (FHA). Although independent financial institutions actually offer the loans, the FHA establishes the rules and provides insurance for these mortgages.

With a reverse mortgage, the homeowner no longer has any obligation to make mortgage payments, but he or she has the option to do so with no prepayment penalties. Interest that accrues is added to the mortgage balance. The homeowner also retains the title of the home and the right to sell, restricted only by the balance of the mortgage.

Eligibility for a reverse mortgage is restricted to homeowners at least 62 years old and to houses that qualify as a primary residence. The mortgage on the house must also be small enough that it will be paid off with the proceeds from the reverse mortgage.

Because a reverse mortgage eliminates monthly mortgage payments for the homeowners, there are no minimum income or credit requirements.

Another big benefit of the reverse mortgage is that the proceeds from the loan are tax-exempt and may be used at the discretion of the borrower. Reverse mortgages are capped on homes valued at $625,000 or less, but a jumbo bracket does exist for homes exceeding that threshold.

For many retirees who saw their portfolios fall sharply during the financial crisis of 2008 and 2009, their homes are their most valuable asset. That makes the reverse mortgage a very tempting option for generating income and reducing or eliminating costly mortgage payments. But much like any investment and financial decision, there are risks.

High Fees And Expenses

Closing costs associated with a reverse mortgage are two to five times higher than a standard mortgage.
For the most popular type of reverse mortgage in the U.S., the FHA-insured Home Equity Conversion Mortgage (HECM), there a number of expenses homeowners are subject to.

  • Mortgage Insurance Premium (MIP) = 2% of the appraised value or 1.25% of mortgage balance
  • Origination fee based on the home's appraised value:

1.)    Appraised value under $125,000 = $2,500
2.)    Appraised value over $125,000 = 2% of the first $200,000 plus 1% of the value over $200,000, with a $6,000 cap.

  • Title insurance: regional
  • Title, attorney, and county recording fees: regional
  • Real estate appraisal = $300-$500
  • Survey (may be required) = $300-$500
  • Monthly Service Charge = $25-$35

Although some of these fees can be financed by the loan, many are required before the approval of the reverse mortgage, leading to costly out-of-pocket expenses.

Interest Payments And Principal Growth

Reverse mortgage holders can also be subjected to ballooning loan amounts through deferred interest payments. That's because the interest compounds on the principal if the borrower does not pay interest as it is charged. That could inflate the final balance to many times more than the initial loan value while little if any equity remains in the house for heirs. However, if the borrower makes all or most of the interest payments while living in the home, the final loan balance would be about equal to the original loan balance.

Still Responsible For Upkeep, Taxes and Insurance

Even though a reverse mortgage alleviates the financial burden of monthly mortgage payments, the homeowner must keep all taxes and insurance current. In a reverse mortgage, funds for taxes and insurance are not paid out of an escrow fund. They are paid directly by the homeowner, so a lapse in either taxes or insurance could result in a default on the reverse mortgage.

Potential Loss of Home

But compared to the greatest risk of a reverse mortgage, these first two risks look like speed bumps. Depending on the term of the loan, the reverse mortgage carries a high probability that the homeowner will eventually be displaced. Once the mortgage comes due, the borrower or heirs of the estate have an option to refinance the home and keep it, sell the home and cash out any remaining equity, or turn the home over to the lender. Once a reverse mortgage is called due and payable, the borrower (or the heirs) might be granted time extensions by the lender of  up to one year to make this decision.

If the property is turned over to the lender, the borrower or the heirs have no further claim to the property or equity in the property. The lender has recourse against the property, but not against the borrower personally and not against the borrower's heirs. Thus the mortgage is within the category known as "non-recourse limit."

One final thought: The reverse mortgage can be a great option for homeowners who are suffering from a shortage of cash but have equity in their homes. But its high fees and low rate of return and the potential loss of homeownership make the reverse mortgage an expensive source of liquidity that should be a last resort for most homeowners.

Homeowners interested in a reverse mortgage should contact the FHA's HECM program. HECM counselors provide information about eligibility requirements, financial implications and alternatives to acquiring an HECM and repaying the loan.

P.S.: A reverse mortgage is not the only option for people with an eye on retirement. There are other ways to generate income, including one in which you can collect checks month after month and year after year. Thanks to a new approach to investing we call the "Dividend Trifecta," thousands of regular people are living the life they want without the worries of a volatile stock market. Find out about this amazing strategy here.