Reverse mortgages are surprisingly unpopular when you consider that they allow you to spend the assets locked in your home without having to sell them, protect you from depreciation of the home, and even pay you monthly checks (if you so choose) for as long You do this live like social security. Less than 1% of eligible homeowners have a reverse mortgage, according to a Brookings Institution report.
The word “reversed”, which evokes images of retreat and defeat, could be the problem. Or maybe it’s “mortgage,” which is nobody’s favorite financial product. It seems like taking out a reverse mortgage is an act of desperation by people who have no choice but to break out and spend their home nest egg.
This is unfortunate because a reverse mortgage can be a smart choice for a wide range of people aged 62 and over, including those who are far from desperate. Many people who are well prepared for retirement have most of their wealth tied up in tax-privileged savings plans like 401 (k). Pulling money out of the home they live in without having to sell it can be a great way to raise money for large expenses – for example, to fund home health care or their grandchildren’s education.
A reverse mortgage loan is like a regular mortgage loan, except that principal and interest payments are optional. The interest plus the withdrawn money will be added to the balance owed. The loan becomes due when the borrower moves out or dies. At this point, the borrower – or heir if the borrower has passed away – can keep the house by paying back the loan, selling the house to pay off the debt, or, if there is no equity left, handing the keys over to the bank . The loan is non-recourse so the borrower never owes more than the house is worth.
The borrower can withdraw money in a lump sum, a line of credit, or a series of monthly payments. The flat rate could be useful for someone who suddenly needs a lot of money. The line of credit is the most flexible. The monthly payments offer longevity insurance because they last for life, even if the amount paid out far exceeds the value of the home. (Lenders are insured against this eventuality with the Federal Housing Authority.)
However a borrower pulls money out of their home, the payments are not taxable because of the Internal Revenue Service greetings it as a loan, not as income.
Where taxes become a problem is at the time of sale. The seller owes capital gains tax on the difference between the selling price and the buying price. The tax is owed to the IRS even if the borrower has to surrender most or all of the sale price to the bank to pay off the loan. That goes for any home sale, of course, but it’s more likely to sneak up on reverse mortgage borrowers who haven’t planned well. A nice feature for heirs: if the borrower dies without ever leaving the home, no capital gains tax is payable on the sale.
A new convert is Laurence Kotlikoff, an economics professor at Boston University who is an expert in retirement planning. It was presented on a March 26th Webinar sponsored by reverse mortgage attorney Tom Dickson, founder of the Financial Experts Network, which hosts webinars for financial planners. The title of the webinar is, “Distinguished Economist Changes His View on Reverse Mortgages.”
Kotlikoff told the audience that one feature he has come to appreciate is the built-in protection against the depreciation of a home. The maximum amount that can be borrowed under a reverse mortgage increases each year at a pace indicated on the loan document. It is not limited by the real market value of the home, which could fall. “This is great insurance against a drop in home value,” Kotlikoff told the audience.
Another fan of reverse mortgages is Wade Pfau, a professor of retirement income at the American College of Financial Services. On his BlogAccording to Pfau, people should consider taking out a reverse mortgage when they are relatively young (62 is the minimum age for FHA-insured loans). For one thing, he writes, the money released “reduces the burden on the investment portfolio, which helps manage the risk of having to sell assets at a loss after market downturns”. On the other hand, the amount to which you are entitled to borrow increases annually. The earlier you start, the higher the cap can be. “Reverse mortgages have moved from a last resort to a retirement income tool that can be incorporated as part of an overall efficient retirement income plan,” writes Pfau.
An occasional misconception about reverse mortgages is that when a mortgage is taken out, the keys are turned over to the bank. In fact, the borrower retains ownership and can repay the mortgage at any time if they so choose. When people lose ownership of their homes, it may be due to non-payment of property taxes. However, this is not just true of mortgage reversal.
The high origination fees are a hurdle for many potential customers. In the webinar, Dickson gave an example of a 62-year-old with a $ 400,000 home qualified to take out $ 205,000. The initial fees could exceed $ 13,000 and reduce the proceeds to $ 192,000. Because of these origination fees, it doesn’t make sense to take out a reverse mortgage unless you plan to stay in a house for three to five years or more, Dickson says in an interview. (The longer the better.)
Two other reservations about reverse mortgages. For one, it’s worth looking around, as costs vary widely. Another reason is that the wealth you have in home should not be neglected. As Pfau puts it, “If this liquidity creates the temptation to use the proceeds improperly, it may be better to avoid it.”