Reverse mortgages: Are they worth it?

Biggest retirement mistakes
Biggest retirement mistakes

I've seen a lot of commercials on TV about reverse mortgages. How do they work and who should consider a reverse mortgage, if anyone? -- Judith Y., New York

It's hard to miss those commercials. They typically feature some B-list celebrity with an avuncular demeanor touting the advantages of getting cash from your home. But while reverse mortgages can be a useful retirement planning tool under the right circumstances — helping you to boost retirement income, pay off debt or or even buy a home there are potential downsides.

Toward that end, here are five things you need to consider before signing up.

1. The basics. You must be 62 or older to take out a reverse mortgage and the amount you can borrow depends on your age, interest rate and the value of your home.

Under the Department of Housing and Urban Development's Home Equity Conversion Mortgage (HECM) program — which is the program used most often by reverse mortgage lenders — a 65-year-old who owns a house worth $250,000 with no outstanding mortgage debt might be able to borrow as much as $127,000, according to the Boston College Center for Retirement Research, although fees and other restrictions may reduce the amount of cash you can initially get your hands on.

Under current rules, for example, you can't take more than 60% of the maximum loan amount at closing, unless you're using loan proceeds to cover "mandatory obligations," such as paying off an existing mortgage or making repairs required by the lender. In that case, you can draw more, although you'll incur higher fees.

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Reverse mortgages come with fixed or adjustable interest rates. If you opt for an adjustable rate, you can take the proceeds in a lump sum ($127,000 in the example above), lifetime payments ($8,600 a year), a line of credit ($118,500) or a combination of all three. An upfront withdrawal is the only option that comes with a fixed rate.

You don't have to repay the money you borrow as long as you remain in and maintain your house. When you (or you and your spouse) die or leave the home, heirs can repay the loan from their own funds or sell the house, in which case the sales proceeds satisfy the loan, even if they fall short of the outstanding balance. If the sale proceeds exceed the amount of the loan, the excess goes to their heirs.

2. The fees and costs can be substantial. First, there are the fees you would incur with a regular mortgage, such as an appraisal, title search, inspection, etc. Then there are the fees related to the HECM program itself: a mortgage insurance premium of 0.5% of the home's value at closing (2.5% if you draw more than 60% of the maximum loan amount), plus an annual mortgage insurance premium of 1.25% that's added to the interest rate on the loan.

Lenders may also charge an origination fee based on the value of your house, although the HECM program caps this fee at $6,000. Lenders may also charge up to $35 a month for servicing the loan. And, of course, there's the mortgage interest rate. In the case of an adjustable rate reverse mortgage, the rate is typically tied to benchmark like the 30-day LIBOR rate plus a margin, say, two to four percentage points.

These fees can add up. The upfront charges alone in many cases can easily total 3% or more of the value of your house (although these fees are almost always included in the mortgage as opposed to paid out-of-pocket). But many fees, as well as the loan interest rate, can vary from lender to lender, so it pays to shop around for the best deal.

3. Can you afford to maintain your home? Although you don't have to repay the loan as long as you remain in your home, the program also requires that you stay current with homeowners insurance and property taxes and keep the property in good repair (to maintain its market value). Otherwise, the loan could go into default and the lender could demand payment.

Starting in March, borrowers taking out a reverse mortgage will have to undergo a mandatory financial assessment to demonstrate they have the financial wherewithal to continue living in their home.

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Similarly, since the upfront costs of the loan can be steep, a reverse mortgage may not be a good choice if you don't plan to stay in your home a long time. If you end up leaving your house shortly after taking out the loan, you'll have handed over a good chunk of your home equity in fees for which you may have received only a small benefit.

Also, think hard before taking out a reverse mortgage as a line of credit that you intend to tap only in emergencies or if your nest egg begins running low. On the one hand, it's nice to have a reserve you can fall back on. But you'll be shelling out a substantial amount for that flexibility, as you'll incur all the upfront costs, plus interest, whether you draw on that reserve or not.

4. Understand what happens if a borrower moves or dies. In cases where both spouses are the borrowers on a reverse mortgage and one of the spouses dies, the surviving spouse has the right to continue living in the house without repaying the loan and to continue drawing down on funds if they are still available.

A problem can arise, however, if one spouse is not listed as a borrower on the reverse mortgage. When the borrowing spouse dies, the question is whether the non-borrowing surviving spouse must repay the loan to stay in the house or is entitled to remain in the home for life without repaying it. A lawsuit brought against HUD by non-borrowing spouses facing this issue is still pending.

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In the meantime, HUD has issued a ruling saying that with reverse mortgages closed after August 4, a non-borrowing spouse can remain in the house after the borrowing spouse dies, assuming the couple was married at the time of the closing, and that they occupied and continue to occupy the house as a primary residence and the non-borrowing spouse is listed on the loan documents.

The takeaway here is to make sure you understand the rights of anyone who may be living in the home has when one or both of the reverse mortgage borrowers die. For example, someone who marries a reverse mortgage borrower after he or she has taken out the loan or a child who had been living in the home would not be entitled to stay on without repaying the loan.

Before taking out a reverse mortgage, borrowers must participate in a mandatory counseling session with a government-approved counseling agency. The sessions can be done face-to-face or by phone and typically last 90 minutes. You can find a list of such agencies at HUD's site.

5. A reverse mortgage isn't your only option (and maybe shouldn't even be your first).

Reverse mortgages aren't the only way to draw on the equity in your home. Another alternative you might consider is trading down to a smaller and/or less expensive house. Granted, that would mean going through the hassle of moving, but trading down does have other potential advantages.

Depending on what you pay for your new digs — and incur in moving, selling and other costs — you may be able to come away with a house you own free and clear, with lower carrying costs and a pile of cash that you can live on. Combine the trade-down with a move to a less expensive part of the country, and you might lower your living costs, too. Finally, you would also still have the option of doing a reverse mortgage on the new home later on.

Trading down is an option you should also discuss with a reverse mortgage counselor. In fact, it might be worthwhile to pay a financial planner a flat fee of, say, $200 to $300, to run the numbers on both options.

Believe it or not, I haven't gotten into a lot of the nitty-gritty details of reverse mortgages. So before you even think of talking to a lender, I suggest you do a little advance research by checking out the Mortgage Professor and AARP sites.

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You should also know that, as with any financial product that involves a lot of money changing hands, there are all sorts of unscrupulous operators out there. In the case of reverse mortgages, that could be someone coercing you to use the proceeds for a costly home renovation that you may not need or a putative financial adviser whose goal is to get you to invest the proceeds in some sort of commission generating investment, such as an annuity.

So don't let yourself be swayed by the folksy manner of a TV pitchman. As with any financial product or service, you've got to look beyond the polished pitch.

Walter Updegrave is the editor of If you have a question on retirement or investing that you would like Walter to answer online, send it to him and email.

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An earlier version of this story incorrectly stated the maximum amount you could borrow if you're using the reverse mortgage to pay off "mandatory obligations." In that case, you can borrow more than 60% of the maximum loan amount.