Reverse Mortgage Pitfalls

Reverse mortgages are a way for homeowners 62 years and older to draw an income (either in installments, a lump sum, or a credit line) against the equity they have built up in their homes. For many seniors in need of retirement income, reverse mortgages can help.

However, reverse mortgages come with disadvantages and pitfalls, including fees, restrictions, and the potential impact on your retirement health benefits to consider. Discover what you need to know before getting a reverse mortgage. 

Key Takeaways

• Reverse mortgages can help those near or in retirement receive cash from the equity in their homes, but at a price.
• Beware of high costs when considering a reverse mortgage, which can drain your home equity.
• If you cannot repay the loan upon your death, your kids might not inherit the family home since it will get turned over to the lender to satisfy the debt.
• Reverse mortgages could increase your liquid assets, potentially reducing the availability of Medicaid benefits.

What Is a Reverse Mortgage?

A reverse mortgage allows homeowners 62 years and older to convert their home equity into cash or an income stream. With a traditional home equity line of credit (HELOC) or equity loan, you borrow against your home and repay it in monthly payments.

Conversely, with a reverse mortgage, the lender draws from your home equity and pays you via a payment plan. You never pay any monthly payments. Instead, you repay the reverse mortgage loan when you sell the home, leave the home, or pass away in which the lender would sell it to recoup the money paid to you.

Since the mortgage lender will not receive any payments during the reverse mortgage draw period, they charge interest and fees that reduce your home equity. As a result, you can’t convert all of your home’s equity to cash since the lender allocates a portion of your equity as compensation for servicing the loan.

However, the lender’s risk is minimized since most reverse mortgages, known as home equity conversion mortgages (HECMs), are insured by the federal government and are available through Federal Housing Administration (FHA) lenders.

Beware of High Costs

Reverse mortgages come with an array of fees. Some are paid upfront, like your appraisal fee or credit report fee; others are paid over time, like the mortgage insurance premium or servicing fee. Here’s a look at the costs that can nibble away at the income you’ll receive from a reverse mortgage. 

1. Third-party charges: Closing costs from third parties can include an appraisal (average price is $450 but can be much higher depending upon location), title search (varies by loan amount and region), insurance, surveys, inspections, recording fees, mortgage taxes, credit checks, pest inspection (about $100), flood certification fee ($20–$30), and other fees.   
2. Origination fee: The origination fee compensates the lender for processing your HECM loan. The fees can vary by lender but are capped by the FHA. The lender may charge the greater of $2,500 or 2% of the first $200,000 of your home’s value and 1% over $200,000, for a maximum of $6,000.
3. Mortgage insurance premium: You must buy FHA mortgage insurance, which includes an upfront fee of 2% of the loan amount due at the closing. Also, you must pay 0.5% of the outstanding mortgage loan balance annually thereafter. The mortgage insurance guarantees you will receive the loan advances, and you can finance the mortgage insurance premium as part of your loan.
4. Servicing fee: Lenders or their agents charge servicing fees over the loan’s lifetime for providing ongoing services. Servicing includes sending account statements, disbursing loan proceeds, and ensuring loan requirements are met, such as paying real estate taxes and hazard insurance premiums. Lenders may charge a monthly servicing fee of no more than $30 if the loan has either an annually adjusting interest rate or a fixed interest rate and no more than $35 if the interest rate adjusts monthly. The lender sets aside the servicing fee and deducts it from your available funds at the loan closing. The monthly servicing fee gets added to your loan balance each month. Lenders might also embed the servicing fee in the mortgage interest rate.

Given the substantial up-front costs associated with the process, homeowners in need of liquidity who are considering selling their homes within the next several years probably would be better off applying for a more traditional line of credit, such as a home equity loan, a home equity line of credit (HELOC), or a personal loan.

Warning

Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, color, religion, sex, age, national origin, marital status, familial status, use of public assistance, or disability, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD). 

Your Kids Might Not Inherit the Family Home

Parents often want to pass the family home to the next generation, but a reverse mortgage can complicate estate planning due to the existing loan balance taken out on the home.

Selling the Home

When a reverse mortgage is taken out, even though the lending institution does not take title to the home, the homeowner has an obligation to repay the loan according to the terms of the agreement. In many cases, that repayment is made by selling the home and turning over the proceeds (or a portion) to the lender.

Life Insurance

A possible workaround to avoid selling the family home involves the family taking out a life insurance policy on the homeowner and making an adult child or the lending institution the beneficiary. Upon the homeowner’s death, the life insurance proceeds would repay the loan, avoiding the need to sell the property.

Consider consulting with an insurance agent to determine the best way to ensure that proceeds from such a policy are sufficient to satisfy the outstanding loan. Keep in mind that life insurance premiums for someone old enough to qualify for a reverse mortgage will be exceptionally high.

Reverse Mortgages May Impact Medicaid Benefits

For a reverse mortgage to not affect one’s Medicaid payments, the loan must be structured very carefully. Medicaid has financial eligibility criteria, including limits on how much in savings you can own before qualifying for benefits. For example, a lump-sum payment from a reverse mortgage might count as an asset that needs to be spent down before you can qualify for Medicaid benefits.

However, according to LongTermCare.gov, a U.S. Department of Health and Human Services website, “As long as you spend the payments you receive in the month that you receive them, the money is not taxable and does not count towards income or affect Social Security or Medicare benefits.” Such payments also do “not count as income for Medicaid eligibility.”

Medicaid’s resource limits are based on the same limits as Supplemental Security Income. If your assets are worth more than $2,000 for an individual or $3,000 for a couple, this could make someone ineligible for Medicaid. However, if you receive monthly payments for ongoing expenses but don’t accumulate savings, preventing your asset total from exceeding the resource limit by the first of every month, you might still qualify for Medicaid.

Individuals currently receiving—or who anticipate receiving—Medicaid should consult a Medicaid expert or financial advisor to understand the potential ramifications of taking out a reverse mortgage.

Other Potential Pitfalls

While the lending institution may not go after your heirs for money, nor is it entitled to take more than the appraised value of your home, there are several items usually located in the fine print of these contracts that may raise alarm bells.

• You could be forced to sell. Some reverse mortgages have clauses that state the loan must be repaid if the last surviving borrower permanently moves out of the home. This raises the concern that you could (hypothetically) be in the hospital receiving treatment for a medical condition and be released to find that your home is in foreclosure. In fact, you would have to have lived somewhere else (such as a nursing home or assisted living facility) for more than 12 consecutive months—a situation that counts as a “permanent move” and can trigger the requirement to sell your home.
• You are responsible for other payments. Because homeowners remain responsible for all taxes, insurance, and upkeep on the home, failure to pay taxes or maintain adequate insurance could cause the loan to be called in.
• You might get less than you expected. Keep in mind that the property is subject to an appraisal. So, while you might have put large sums of money into your home over the years, there is the chance that it’s worth less than you paid for it. As a result, the proceeds that you receive as part of the reverse mortgage process may be less than you anticipated.

What Is an Alternative to a Reverse Mortgage?

A good alternative to a reverse mortgage is having robust retirement savings and investments to live on. If you do not have the savings to support your lifestyle in retirement, downsizing your housing and your budget could lead to a more comfortable retirement than a reverse mortgage. If you cannot or will not downsize and have no savings, then a cash-out refinance, a HELOC, or selling the home to family members and having them rent it to you may be a better option.

Could I Lose My Home If I Go Into a Nursing Home?

Yes. If you do not physically live in your home for more than 12 consecutive months, even if it is involuntary on your part, your reverse mortgage will become due, and you could lose your home to foreclosure if you can’t afford to pay it off.

For Whom Is a Reverse Mortgage a Good Idea?

A reverse mortgage is a good idea for someone who:

• Lives in a paid-off (or nearly paid-off home)
• Is unable or unwilling to downsize and cannot afford their current lifestyle
• Doesn’t want to leave their home to an heir or a charity upon their passing
• Doesn’t have the income or credit history to qualify for other loan products
• Doesn’t have sufficient savings to cover their lifestyle
• Is comfortable with the risk of losing their housing if they end up in a nursing home or assisted living facility for more than a year after an illness or a fall.

For Whom Is a Reverse Mortgage a Bad Idea?

Reverse mortgages have extremely high fees compared with other options and are usually a bad idea for most people. They are an especially bad idea for anyone with a family home that they want to leave to their heirs. People inheriting the home may not be able to pay off the reverse mortgage. However, if the family does have the money to pay off the reverse mortgage, they may be better served financially by avoiding the fees of the reverse mortgage and having the inheriting family members slowly purchase the home from the person who needs the extra cash from the reverse mortgage.

The Bottom Line

Reverse mortgages are a great way for homeowners who are 62 years or older to tap into the equity in their homes, either in installments or in a lump sum. However, it is critical to be aware of the potential downsides before entering into such an agreement.