Unlocking your home equity
More people are using reverse mortgages to finance retirement, but the costs are steep.
(Fortune Magazine) -- The housing rescue package that Congress scrambled to pass in July was aimed primarily at stemming foreclosures and shoring up Fannie Mae and Freddie Mac. But it also contains provisions that make reverse mortgages a better deal for older homeowners who want to turn their equity into cash.
Lawmakers are paying attention to reverse mortgages because these once-marginal products have exploded over the past decade, thanks to low interest rates and rising home values. The federal government, which backs more than 90% of all such loans through the Home Equity Conversion Mortgage (HECM) program, guaranteed 107,400 reverse mortgages last year, up from 7,900 in 1998. What's more, an industry group estimates that even after the drop in housing prices, seniors' equity in their homes was worth $4.2 trillion at the end of 2007. With slimmer savings and pensions than their parents had, more boomers will probably be turning to reverse mortgages when they retire. But these products are much more complicated than your garden-variety loan, so before you rush to download an application, you have to do some homework.
Reverse mortgages are like home-equity loans, with a few key differences. First, they're available only to people age 62 and older. The amount you can borrow depends on your age, the value of your home, and interest rates (check out AARP's calculator at rmaarp.com for an estimate). You can choose to receive your money in a lump sum, monthly installments, or a line of credit. There are no monthly payments to make - and therefore you don't have to meet an income requirement to qualify.
In fact, you needn't repay the loan until you move out of your house, sell it, or die: The debt is settled with the proceeds from the sale of your home. If there's money left over, it goes to you or your heirs. But what if your house sells for less than what you owe? (That's not an idle question in a time of plunging home prices.) Don't worry. The federal government covers any shortfall for HECM loans, and for others the mortgage holder simply eats the loss.
So far, the reverse mortgage sounds like a pretty sweet deal. But you know it can't be that simple, and it isn't. Reverse mortgages turn out to be a very expensive way to borrow. The basic rates are currently lower than those on home-equity loans - the monthly adjustable rate for HECM loans is now around 4.3%, vs. 5.3% for home-equity lines of credit - but reverse mortgages are "rising debt" loans: The interest you owe is tacked onto the balance, eventually becoming a substantial portion of your overall debt, and you end up owing interest on the interest, compounding the cost.
Borrowers are also hit with an avalanche of upfront charges, including origination fees; the cost of the appraisal, title search, and the like; and a 2% mortgage insurance premium for all HECM loans. The new law brings some relief: It limits origination fees to 2% of the loan up to the first $200,000 and 1% of the rest, with a cap at $6,000.
Whether a reverse mortgage is worthwhile depends on your situation; for those who qualify for a home-equity loan and can make the monthly payments, that's usually the better option. Another factor is how long you will be in your home. It doesn't make sense to pay the fees if you plan to move within a few years. Since borrowers remain responsible for maintenance, taxes, and homeowners' insurance, selling your house to trade down or rent may be a cheaper way to tap your home equity.
In the past some reverse-mortgage brokers pressured borrowers to buy investments like deferred annuities with the proceeds of their loans. The new law prohibits lenders from requiring borrowers to buy investments or insurance products as a condition of getting the loan. Indeed, you should never take out a reverse mortgage to buy investments. To get the kinds of returns that would cover the interest on the loan, you would need to take on a level of risk that's unacceptable when your home equity is on the line.