What is a Reverse Mortgage?

What is a Reverse Mortgage?

A friend of mine called last week to say his mother was thinking of getting a reverse mortgage. He was stunned because he had no idea his mother was short on cash. His father had died four years ago, but his parents had planned well for their retirement. The news that his mom was having trouble making ends meet was unsettling.

He was willing to do anything to help his mom and asked me if getting a reverse mortgage was a good idea. After digging a little deeper, it turns out that my friend’s parents had planned well for retirement, but his mom had received some poor financial advice. So what is a reverse mortgage and when does it make sense?

Reverse Mortgage – The Plus Side

Thumb UpA reverse mortgage is a solution many homeowners find helpful in their later years of retirement when they lack cash. Their home is usually their largest asset and unlike other investments, such as savings accounts, stocks, or bonds, it doesn’t provide any income unless they take on a renter or two.

A reverse mortgage allows a homeowner to tap into their home equity. Basically a reverse mortgage is the reverse (hence its name) of a regular mortgage. Instead of you making a payment to a mortgage company or bank each month, the bank makes a payment to you.

Each month, a lender sends you a check that you can spend on food, clothing, travel, or whatever you wish. The money you receive each month is really a loan from the bank against the value of your home that is payable at some future time. Thus, a reverse mortgage allows you to stay in your home and use its equity to supplement your monthly income. The amount you qualify for can depend on factors such as your age, the current interest rate, the amount of equity you have in your home, and borrowing limits set by the lender.

Reverse mortgages can be set up to pay you a certain amount each month or as a line of credit that you can draw on whenever you like. In addition, since the monthly payment is a loan rather than income it is not taxed. Of course, since it’s a loan it will have to be repaid at some point in the future, but that can be at the time of your death, when you sell your home, or when the home no longer is your primary place of residence.

As a result, a reverse mortgage can provide additional or a steady income that is not taxable and that doesn’t have to be immediately paid back allowing you to stay in your home the rest of your life. What’s the downside?

Reverse Mortgage – The Down Side

Thumb DownOne shortcoming of a reverse mortgage is that it diminishes the estate you may want to pass on to your heirs or use for some other purpose. Because lenders don’t want to lose money on a reverse mortgage, they assume that you are going to live for many years. The closing costs and other fees can be many thousands of dollars. That is usually not a problem if you stay in the house for a long time. But if you die or sell the house within a few years of taking out the reverse mortgage, the fees and closing costs will have a substantial negative impact on your home equity.

Interest rates and fees can vary enormously depending on the location and the lender, which will have a tremendous impact on the size of the payment you receive. It is crucial that you compare rates, terms, and fees offered by several different lenders. The problem is it can be very difficult to compare the true costs of different loans. The best way is to compare each loan’s TALC or Total Annual Loan Cost. Federal law requires all lenders to disclose the timing of the payments you’re projected to receive as well as each loan’s TALC.

In addition, for many elderly homeowners, tapping into their home equity can be difficult to do psychologically. Most people work hard to pay off their mortgage. One of the American dreams is to own your own home free and clear.

The Bottom Line

The bottom line is that a reverse mortgage can make your retirement more enjoyable and give you greater financial independence by maximizing the potential of your equity in your home (financial types call this leveraging). However, it is critically important that you understand the ins and outs of this type of loan (or seek the advice of someone who has no stake in the decision – someone that doesn’t make their living from selling reverse mortgages) so that you reap the greatest benefit from that equity. For more information, see the Federal Trade Commission’s section on reverse mortgages here.

*Part of Financially Savvy Saturdays on brokeGIRLrich, Disease Called Debt and Frame to Freedom*

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The three authors, Bill Pratt, Mark C. Weitzel, and Len Rhodes, are industry leaders in personal financial education. Together, they have a combined 75 years of experience in banking, economics, and entrepreneurship. Now, they teach thousands of students personal finance concepts and decision making skills, author textbooks and public press books on personal finance, and help schools develop innovative personal finance literacy programs. Recently, they were instrumental in developing a personal financial management certification program for leaders in higher education. The other books in The Money Professor series include The Graduate’s Guide to Life and Money and Extra Credit: The 7 Things Every College Student Needs to Know about Credit, Debt & Ca$h. Their books, lectures, and programs give students, parents, and educators the tools and knowledge to make good financial decisions all their lives.

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