Personal Finance > Your Home
Home as tax-free income
graphic December 4, 2001: 8:00 a.m. ET

Reverse mortgages can cushion seniors, but they're not for everyone.
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  • AARP's primer on reverse mortgages
  • National Center for Home Equity Conversion
  • National Reverse Mortgage Lenders Association
  • Frequently asked questions about reverse mortgages
  • Reverse mortgage lenders list
    NEW YORK (CNN/Money) - If you're 62 or older, own your home and are feeling pressed for cash, you have the option of using your house as a source of tax-free income.

    That's because you're eligible to apply for a reverse mortgage, which is a loan against your home equity. You may receive the money in one of four ways, however you choose: a lump-sum payment, a monthly payment, a line of credit or some combination of these. In most instances, there is no restriction on how the cash is used and it's not subject to income tax.

    What's more, unlike in a traditional mortgage or home-equity loan, where you pay the loan back on a monthly basis, you only have to repay a reverse mortgage when you die, sell your home or no longer use it as your primary residence, whichever comes first. Payment is usually achieved through sale of the house, but it may be paid using other funds, and ownership remains with borrowers and their heirs until the house is sold. Lastly, you - or your estate - will never owe more than the value of your house, no matter how high your loan balance is when the mortgage is paid.

    But a reverse mortgage is no free lunch. It's a complex -- and potentially expensive - product. It's so complex, in fact, that you are required to receive counseling before applying for one. And there are several key factors to consider when deciding whether a reverse mortgage is right for you.

    A quick primer

    Originally designed for retirees interested in keeping their homes but whose incomes aren't sufficient to support them, reverse mortgages have typically been used to help people on low fixed incomes make ends meet, make needed home repairs or pay for large medical bills that otherwise would be unaffordable.

      graphic REQUIRED READING  
  • Don't pursue a reverse mortgage until you've read AARP's thorough primer on the subject.
    More recently, however, some people whose CDs or IRAs have been hammered by the drop in interest rates and stock prices have applied for reverse mortgage lines of credit as a security cushion, said Dave Brown, a reverse mortgage program counselor with ECHO, a housing counseling agency in California. And some people have been looking into them as a way to improve their retirement lifestyles, said Peter Bell, president of the National Reverse Mortgage Lenders Association, a nonprofit trade group.

    The risk assessment lenders use in making reverse mortgages differs significantly from a traditional loan. Your age and life expectancy, your house's value and your equity are the prime considerations. Your income, other assets and credit history (unless you're filing for bankruptcy) don't have any bearing at all. "It's a very simple underwriting," Bell said.

    One of the greatest appeals of reverse mortgages is that you can be guaranteed a source of money for as long as you need it, even if you live beyond your life expectancy.

    You pay for that guarantee however, through interest, higher-than-usual closing costs, servicing fees and in many cases insurance premiums that protect the lender from the possibility that the loan payments will exceed the value of your home. Those costs can be and often are added to your loan balance, but they will be subject to interest. All interest on your loan balance is tax-deductible, but you or your estate may only take that deduction when the loan is paid back.

    Besides cost, another potential downside is that since you spend part or all of your home equity before you die, a reverse mortgage reduces what you are able to leave your heirs. But for some people, leaving an inheritance behind is not important; or their adult children wish to see them live in greater comfort today. In that case, if there are no other financial resources to draw on, a reverse mortgage may be a solution.

    How it works

    Currently there are only three reverse mortgage providers: The Federal Housing Administration (FHA), a part of the U.S. Department of Housing and Urban Development (HUD); Fannie Mae; and Financial Freedom Senior Funding Corp., a subsidiary of Lehman Brothers Bank, SSB that has created jumbo proprietary reverse mortgages that can provide larger advances on high-priced homes than do FHA or Fannie Mae.

    Between them, there are only a handful of reverse mortgage products -- the most popular of which is FHA's federally insured Home Equity Conversion Mortgage (HECM) -- and the lender pool is limited to those approved by the three providers. (For the most current list of lenders, click here.)

    Reverse mortgages carry adjustable interest rates. HUD and Fannie Mae rates are pegged to the 1-year Treasury bill, Bell said. If you get a mortgage that adjusts annually, you'll pay a rate 210 basis points above the yield of the 1-year Treasury. If your mortgage adjusts monthly, your rate will be 150 basis points over the 1-year. And if you get a jumbo proprietary mortgage from Financial Freedom, the rate will be 400 to 500 basis points above the 6-month LIBOR index. Generally speaking, the proprietary rates are higher, Brown said.

    When shopping for a reverse mortgage, your counselor should show you how all the products and payment options compare in terms of overall cost. Toward this end, lenders are required to give you what's known as a Total Annual Loan Cost estimate.

      graphic HOW MUCH CASH COULD YOU GET?  
        AARP has a reverse mortgage loan calculator that estimates how much you might qualify for based on your age, location and home value.
  • To get your estimate, click here.
    Closing costs, which are often wrapped into your loan balance, are based on the value of your house. If you have a $240,000 home, the closing costs on a HECM may be about $10,600, Brown said. That includes the origination fee, equal to $2,000 or 2 percent of your mortgage, whichever is higher. Your closing costs also include FHA insurance premiums - equal to 2 percent of the maximum claim amount, which is an estimate of how much you'll owe, including interest, at the end of the mortgage. But your insurance costs don't end there. You also must pay half a percent on your loan balance every year.

    With all reverse mortgages, how much you receive depends on your age (you must be at least 62), current interest rates and your home's value. The older you are, the more you're eligible for. With a HECM or Fannie Mae mortgage, there are also caps on how much you can borrow. With the HECM, the cap is based on where you live. In 2001, the highest HECM cap is $239,250; in rural areas, it is considerably less.

    For low-income seniors who depend on Medicaid and Supplemental Social Security, it's critical that they don't receive more in monthly reverse mortgage payments than they're going to spend. Money from a reverse mortgage that sits in a bank account may put a retiree over the allowable limit for liquid assets set by these public-assistance programs.

    Consider all your options

    In deciding whether to get a reverse mortgage, consider that in exchange for financial security, you trade in part or all of the equity in your home.

    If you have other resources to draw on first or if you want to leave your heirs the full value of your home, it may not be the right solution for you.

    Certified financial planner Nancy Flint-Budde of Clifton Park, N.Y., thinks a reverse mortgage should be a last resort for most people. "The costs are prohibitive," Flint-Budde said, particularly for people with outside investments. What's more, she added, given the HECM caps, you need to be sure the amount you can get is enough for your long-term needs.

    For those who have investments, Flint-Budde recommends first reallocating your portfolio to produce more income. After that, if your nest egg needs some time to recover, consider getting a home equity line of credit to bridge the gap, since the cost of setting one up is significantly less than a reverse mortgage and you only need to pay it back if you tap the line. graphic


    AARP's primer on reverse mortgages

    National Center for Home Equity Conversion

    National Reverse Mortgage Lenders Association

    Frequently asked questions about reverse mortgages

    Reverse mortgage lenders list

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