What is a Reverse Mortgage?
A reverse mortgage is a special type of home loan. Like a traditional mortgage, it allows a person (the "borrower") to convert a portion of the "equity" in his or her home to cash. What makes a reverse mortgage different from a traditional mortgage is that no repayment is required until the borrower no longer uses the home as his or her principal residence (or fails to meet other obligations of the reverse mortgage such as paying real estate taxes).
Let's look at the following examples to contrast a traditional mortgage with a reverse mortgage.
Example 1 - Traditional Mortgage: Assume that borrower has a house worth $500,000 and wants to borrow $300,000 using the house as collateral. Further, assume that a lender is willing to make this traditional home loan for a 30 year term and at a 4% interest rate. Under these facts, the borrower will have to make monthly payments of $1,432 for 30 years. At the end of the 30 years, the loan would be paid off. If the borrower fails to make a monthly payment, the loan would be in default which means the lender could foreclose on the house. Further, if the borrower personally guaranteed the loan (which is usually the case), the borrower's other assets would be at risk if there was a default.
Example 2 - Reverse Mortgage: Assume the same facts as in Example 1, but instead of a traditional mortgage, the borrower obtains a reverse mortgage. If the borrower would be able to get cash from the reverse mortgage of $300,000 like in Example 1 (which is dependent on a number of factors which will be discussed in the newsletter), the loan would not have to be repaid so long as the borrower continues to live in the house. This means that the borrower would not be required to make monthly payments. The amount borrowed, plus interest, will be due when the borrower moves out of the house or dies. If the borrower dies and the borrower's estate cannot repay the amount borrowed plus interest, the house will be lost as collateral.
For people in need of funds and who plan on living in their house for a long time, a reverse mortgage may be something to consider. However, it is important to examine the advantages and disadvantages of a reverse mortgage before any decision is made. Although a reverse mortgage can provide extra cash for some senior citizens, it will not work out well for everyone. Most unbiased experts would suggest that when you are considering tapping the equity in your home, you should first see if there are other less costly alternatives available before jumping into the reverse mortgage market.
The purpose of this issue of e-Counsel is to provide a basic overview of reverse mortgages. It is not intended to give advise regarding any person's particular situation. Whether a reverse mortgage is right for a specific person depends on that person's individual facts and circumstances. If you have any questions after reading this newsletter, please do not hesitate to contact us.
Advantages of a Reverse Mortgage
A reverse mortgage has many advantages, including the following:
1. Financial Independence. A reverse mortgage can help a borrower maintain his or her financial independence and an adequate standard of living.
2. Guaranteed Place to Live. A reverse mortgage can provide assurance that a borrower can continue to live in his or her house for as long as desired (subject to certain restrictions like paying real estate taxes).
3. No Risk of Default. With a reverse mortgage, a borrower's home cannot be taken for failure to make a mortgage payment so long as the borrower continues to reside in the home. This is very different from a traditional mortgage where a default can result in the borrower losing his or her home.
4. Tax Free. The money from a reverse mortgage is typically tax free because it is structured as a loan when the borrower receives the borrowed funds.
5. No Restrictions. There are no real restrictions on how a borrower must use the funds borrowed with a reverse mortgage. The borrower can use the funds to invest, go traveling, get a hearing aid, purchase long-term care insurance, pay for college education for a loved one or anything else.
6. Generally Flexible Payment Options. A borrower can usually receive the reverse mortgage loan money in the form of a lump sum, annuity, credit line or some combination of these options.
Disadvantages of Reverse Mortgage.
A reverse mortgage has many disadvantages, include the following:
1. Higher Closing Costs. A reverse mortgage typically has higher closing costs when compared to a traditional mortgage. Therefore, as general proposition, reverse mortgages are more expensive than traditional home loans. One of the reasons reverse mortgages are more expensive is because the structure of the loan is different. Traditional mortgage lenders generally start being repaid as soon as the loan is made. Reverse mortgage lenders, on the other hand, may have to wait for many years before it sees repayment. In essence, the reverse mortgage lender is taking on the risk that the borrower will live to be 100 years old because, for that entire time, the lender cannot seek repayment. This additional or increased risk means the lender will want a greater return which is usually in the form of a higher interest rate and/or higher closing costs.
2. Money Borrowed From a Reverse Mortgage is Not Free Money. All banks and lenders are in business to make money. A reverse mortgage lender is no different. When it lends money that is secured by a mortgage on a home, the lender is entitled to be repaid what was lent, plus the interest. In the case of a reverse mortgage, the lender must wait for repayment until the borrower sells the home, refinances, or permanently leaves the home (i.e. passes away). Therefore, the lender will get paid, albeit at a future date.
3. Less Equity in Home. A reverse mortgage enables a borrower to access a portion of the equity in his or her home. Home equity is the difference between the value of the home and how much is currently owed on the home. If a borrower takes out money from the equity of his or her home, then the borrower will have less equity in the future. With a reverse mortgage, since payments are not currently being paid, accrued interest is added to the loan balance, which also reduces home equity.
4. Low-Income Assistance. If a borrower is currently or will be eligible to receive federal or state low-income assistance (like Medicaid), the borrower should be careful that proceeds from a reverse mortgage does not disqualify the borrower from that assistance.
5. Reduction of Inheritance for Beneficiaries. Many people dismiss a reverse mortgage because they want to be sure their home goes to their loved ones at their death. The reason for this is that since the borrower is not making monthly mortgage payments on the loan, the loan balance is rising on a monthly basis as the outstanding balance accumulates interest. Because of this, there is the possibility that there might not be any equity in the property at the time the loan is due. This means that the value of the house will be used to pay off the loan.
Reverse Mortgage Details.
1. Who Can Qualify for a Reverse Mortgage? In general, to be eligible for a reverse mortgage, a borrower must at least:
- Be age 62 or older;
- Own a home outright or have a low mortgage balance that can be paid off at closing with the proceeds from a reverse mortgage;
- Live in the home that secures the reverse mortgage (generally the home can be a single family home or a 1 - 4 unit home as long as one unit is occupied by the borrower).
These requirements make sense if you think about it. Payments on a reverse mortgage are not due so long as the borrower lives in the house and there is always the possibility that a borrower will live in the house for life. If reverse mortgages were made to younger people, this can be a very long time. Therefore, you have the 62 or older age requirement. Further, since the house secures the loan, and the loan balance increases as interest accrues and is unpaid, no other lender will be permitted to have a security interest in the home. Finally, since a reverse mortgage by definition is not required to be repaid while the borrower lives in the home, there has to be a "physical presence" requirement.
2. How Much Money Can Be Borrowed With a Reverse Mortgage? The amount of money that can be borrowed with a reverse mortgage depends on a number of factors, including the age of the borrower, current interest rates, the value of the home, and mortgage insurance premiums. There are many calculators that are available on the Internet which can provide a rough estimate of the amount that can be borrowed with a reverse mortgage.
3. How Is a Reverse Mortgage Repayed? Once the property is sold - and this can be during the homeowner's lifetime or after his or her death - all or a portion of the sale price of the property pays back the loan.
4. Will a Reverse Mortgage Leave the Borrower in Debt at Death? A reverse mortgage will not leave you in debt when you die beyond the value of your home. A reverse mortgage lender can never require more repayment than the value of the home when it sells. This is called a non-recourse loan. When you die the sale of the home settles the loan. The lender does not have recourse to your other assets or to your heirs. If the loan ends for some reason (such as you move to an assisted living facility), the house will have to be sold or the loan paid off some other way. If you plan to leave your home to your children to inherit, think twice before you take out a reverse mortgage.
5. Will the Borrower Still Have an Estate That Can Be Left to Heirs? When you sell your home, you or your estate will repay the cash you received from the reverse mortgage plus interest and other fees, to the lender. The remaining equity in your home, if any, belongs to you or to your heirs. Because the loan balance increases by unpaid interest, there is a good chance the entire value of the house will ultimately be used to pay off the loan.
What Questions Should I Ask if I Am Thinking About a Reverse Mortgage?
As we noted at the beginning of this newsletter, whether a reverse mortgage is right for a particular person depends on that persons facts and circumstances. To help determine whether a reverse mortgage may make sense, consider the following questions:
- How much do you need to borrow?
- Is there a way to meet your needs that does not involve getting a reverse mortgage?
- How long do you plan on living in your house?
- Will a reverse mortgage make you or your spouse ineligible for any government benefits, currently or in the future?
- Do you qualify for a reverse mortgage?
- How much will the reverse mortgage cost in fees and interest even if there are no "out of pocket" costs?
- What happens if I have to go into a nursing home?
- What will you or your heirs have left after the loan is paid off?
- Are there any early repayment penalties?
- What are your obligations under the reverse mortgage, such as home maintenance, property taxes and insurance?
We hope this newsletter gave you a basic understanding of reverse mortgages. As always, if you have any questions or comments regarding the contents of this issue of e-Counsel, please do not hesitate to contact us.
CIRCULAR 230 DISCLOSURE
Under U.S. Treasury Department guidelines, we are required to inform you that (1) any tax advice contained in this communication is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or by any party to market or promote any transaction or matter addressed herein without the express and written consent of Helfrey, Neiers & Jones, P.C. and the Law Office of Richard C. Petrofsky, (2) Helfrey, Neiers & Jones, P.C. and the Law Office of Richard C. Petrofsky imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein, and (3) any fees otherwise payable to Helfrey, Neiers & Jones, P.C. or the Law Office of Richard C. Petrofsky in connection with this written tax advice are not refundable or contingent on your realization of federal tax benefits from the advice contained herein.