The Risky Way Retirees Use Reverse Mortgages for Extra Income

If you’re approaching retirement, you’re probably already aware that taking Social Security at age 62 results in getting a much smaller benefit than someone who waits until full retirement age. For most retirees today, full retirement age is 66 or 67, but you can earn an even larger pay out if you can wait till age 70 to start tapping in to your benefits.

Living off your existing savings while you wait the extra eight years to start receiving Social Security benefits can be challenging. For that reason, an increasing number of financial experts are encouraging retirees to use a reverse mortgage as a source of additional income while they wait to start drawing on their Social Security benefits.

Using a reverse mortgage for extra income in retirement can be risky — so risky, in fact, that the Consumer Financial Protection Bureau (CFPB) recently spoke out against it.

“A reverse mortgage loan can help some older homeowners meet financial needs, but can also jeopardize their retirement if not used carefully,” CFPB Director Richard Cordray said in a statement. “For consumers whose main asset is their home, taking out a reverse mortgage to delay Social Security claiming may risk their financial security because the cost of the loan will likely be more than the benefit they gain.”

Still, retirees with significant equity built up in their homes might be tempted to tap into that equity to bridge the gap between when they retire and when they can maximize their Social Security benefit.

A quick recap of what a reverse mortgage is and how it works:

A reverse mortgage is a special type of home loan that allows homeowners age 62 and over to withdraw a portion of the equity they have in the home. Instead of paying interest and fees each month that amount is added to your overall loan balance. When you no longer live in the home, the total loan must be paid back and you will pay no more than the value of the house. With a reverse mortgage you are no longer responsible for the regular monthly payments on your mortgage loan but you are required to keep the home in good condition, as well as paying the property taxes and homeowner’s insurance.

Most reverse mortgages are federally insured by the Home Equity Conversion Mortgage (HECM) program, which requires a strict set of rules and regulations that must be met in order to qualify. Some of those requirements include: occupying the property as your principal residence, continuing to live in the home and not being delinquent on any federal debt. The U.S. Department of Housing and Urban Development has a full list of requirements here.

The pros of using a reverse mortgage

Using a reverse mortgage can provide some additional, predictable income during retirement. Whereas relying solely on your investments could result in unstable returns depending on your portfolio. But a reverse mortgage loan isn’t a bottomless source of cash.

The amount of money you can receive from a reverse mortgage first depends on your principal limit. That’s the amount a lender will be willing to loan you based on a several factors, like your age, the value of the home and the interest rate on your loan. This is where older borrowers have an advantage. According to the CFPB, “loans with older borrowers, higher-priced homes, and lower interest rates will have higher principal limits than loans with younger borrowers, lower-priced homes, and higher interest rates.”

Another big advantage of reverse mortgages are that the proceeds are generally tax free and will not affect Medicare payments.

The risks of a reverse mortgage

It reduces the amount of equity you have in the home, which can complicate a future sale. The equity in your home is generally defined as the amount of ownership you have in a property less any remaining debt. With a regular mortgage you borrow money from the bank and pay down the balance over time. With each payment the loan balance goes down and your equity increases.

You’ll lose home equity. Since a reverse mortgage allows you to borrow from the equity you have in the home, your debt on the home increases and the equity is lowered. A reverse mortgage may limit the options for someone looking to sell their home in retirement, because the loan must be paid upon the sale and there may not be enough equity left to purchase a new home.

It increases your overall debt. As seen in the images above, a reverse mortgage reduces the amount that you own in your home and adds that amount back into your loan balance. This increases your overall debt.

The cost of a reverse mortgage can outweigh the benefits of increasing your Social Security payments. Though you are borrowing from the money you’ve paid into your home, a reverse mortgage isn’t free. Just like your regular initial mortgage you will have to pay interest and fees. Reverse mortgages are very similar and usually include costs such as: mortgage insurance premiums (MIP), interest, upfront origination fees, closing costs and monthly servicing fees.

In the figure above, the CFPB estimates a reverse mortgage will cost $21,600 for someone who uses the option from age 62 to age 67; but the lifetime gain in Social Security from 62 to 67 is $29,640.

Monetarily, in this scenario a reverse mortgage makes sense. However most borrowers use a reverse mortgage for seven years not five as in the previous example. This would bring the cost to $31,900, approximately $3,900 which is more than the lifetime benefit of waiting until 67 for Social Security.

You’re putting your home at risk. You could also lose your home if you no longer meet the loan requirements. This includes not living in the home for the majority of the year for non-medical reasons or living outside of the home for 12 consecutive months for healthcare reasons.

You’re putting your heirs at risk.  When you pass away your heirs will have to pay back the loan, usually by selling home. If there is money left over after the sale, they can keep the difference. However, if the loan balance is more than the value of the home and they want to keep the home they will need to pay the full loan balance or 95% of the appraised value, whichever is less according to the CFPB.

When does it make sense to use a reverse mortgage for income in retirement?

In general, Chartered Financial Analyst Joseph Hough says reverse mortgages are best for retirees who are in good health and expect to live long after retirement. Also, it can be one of the few options retirees have when their retirement income is simply not high enough to cover their basic needs.

Speak with a financial advisor who can help you weigh the particular pros and cons with your specific situation. Every person is different, and there is no one size fits all answer.

When does it not make sense?

A reverse mortgage may not be a good fit for those in bad health due to the risk of losing the home. If you’re planning on selling your home, having a reverse mortgage can complicate the issue because it reduces the amount of equity you have. You could be left in a scenario where the proceeds of the sale do not cover a purchase of a new home because of the cost and fees associated with reverse mortgages.

What are some other ways I can maximize my SS benefit?

Working beyond 62 may be the best option to maximize your Social Security benefit. Doing so allows more time to save for retirement and pay off any debt. You could potentially increase your overall Social Security benefits if your latest year of earnings is one of your highest. Also, if you’re married, consider coordinating your Social Security decisions with your spouse. Other alternatives to a reverse mortgage include selling your home and downsizing to a less expensive place or selling your home to your adult children on the condition you get to live rent-free, says Houge.

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Should I Get a Reverse Mortgage?

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Q. I’m on a fixed income and money is tight. I own my home without a mortgage but I’m not sure if I should use it for my expenses. Should I consider a reverse mortgage?
— Worried senior

A. Taking a reverse mortgage to fund your living expenses in retirement is not a decision you should make lightly. Your decision could change the course of your finances for the rest of your life.

A reverse mortgage is a type of mortgage that allows you to take out the equity of your home over time either as a payment, lump sum or line of credit, said Bryan Smalley, a certified financial planner with RegentAtlantic in Morristown.

The size of the payment is based on the homeowner’s age and value of the home, he said.

“Unlike a traditional forward mortgage where you send principal and interest payments to the bank to build your equity over time, with a reverse mortgage, the bank sends you payments over time which reduces your equity and builds up the debt you owe on the home,” Smalley said.

No payments are owed to the bank until you move, sell the home or pass away. At one of these events, the bank gets paid what is owed to them by selling the property and taking back what is owed, Smalley said.

Anything above that amount goes on to the home’s owner or their heirs.

Similar to a traditional forward mortgage, in setting up a reverse mortgage, there are closing costs and interest accrues over the course of the loan.

Smalley said these costs tend to be higher for a reverse mortgage and are often included in the mortgage note and accrue interest. That means it’s important to shop around and price compare the costs of a reverse mortgage.

The most common type of reverse mortgages are Home Equity Conversion Mortgages (HECM) which are provided by private banks and insured by the Federal Housing Administration, Smalley said.

He said to secure this type of reverse mortgage, one must be at least age 62, own their home outright, use the home as their primary residence and not owe any debt to the federal government. The person taking out the mortgage must also be able to service their other housing related expenses such as property taxes and insurance costs. All applicants are required to attend a consumer information session with an approved counselor.

Before you take out a reverse mortgage, Smalley said you should consider your alternative options to tapping into the equity of your home to fund your living needs.

One option is a home equity loan, which is a loan out against the equity in your home.

“Interest has to be paid on this loan no matter if you are using the money or not but the home remains the asset of the owner,” Smalley said.

Then there’s a home equity line of credit (HELOC), which allows you to borrow against your home equity to the degree you need the funds, meaning you are only paying interest on the amount borrowed.

The interest rate on the HELOC is typically a variable rate which can go up in a rising interest rate environment, Smalley said.

If borrowing against the equity in your home does not seem attractive to you, you always have the alternative of selling your home and either downsizing or deciding to rent, Smalley said.

“Downsizing allows you to access the equity in your home without then having to pay interest on it and it keeps a roof over your head that you own,” he said. “Renting allows you to take out the full equity in your home and use it to live on and it may help you lower your living expenses by eliminating some of the costs such as property taxes.”

While seniors typically have stronger credit because they’ve had more time to build up a credit history, it’s still wise follow smart spending habits, like making loan payments on time and keeping debt levels low, to stay creditworthy. You can see where your credit currently stands by viewing your two free credit scores each month on Credit.com.

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Image: Dean Mitchell

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