Reverse Mortgages: Life Rafts or Life Anchors?

Reverse mortgages are growing in popularity, but retirees need to know that there are pitfalls associated with using one as a financial planning strategy.

Retirement should be like sailing off into the sunset on a gentle breeze. But seniors who make the wrong decisions with respect to their home equity could end up anchored in the ocean, with no land in sight.

Retiring with a reverse mortgage

On paper, the reverse mortgage is an ideal solution for the cash-poor retiree who owns a home. Reverse mortgages allow homeowners aged 62 and older to liquidate their home equity, without having to make repayments or sell the property. If there's any mortgage debt outstanding on the home, the reverse mortgage will pay it off. The rest of the funds available through the new loan can support the retiree's living expenses and maybe even a vacation or two.  Reverse mortgages are repaid when the home is sold.

The 2009 economic stimulus plan supports the reverse mortgage concept by increasing the loan amount available under the FHA's Home Equity Conversion Mortgage (HECM), which is an FHA-insured variation of the reverse mortgage. The FHA insurance protects the lender by guaranteeing repayment.  If the home is sold for less than the balance outstanding, for example, the FHA will pay the difference.

Retirement dream complications

There's an ugly side to reverse mortgages, however. This type of loan is complicated enough to attract the attention of predatory "advisors" who want to dupe unsuspecting homeowners. A common con is to convince the homeowner to invest the loan proceeds in fee-laden financial products, such as annuities and permanent life insurance. Often, the returns associated with those products are far less than what the homeowner is accruing in interest on the mortgage. In the long run, this situation leaves the homeowner without any home equity or cash reserves.

Timing and cost pitfalls

Other problems can arise if the homeowner doesn't understand the true cost of the loan, or doesn't select the right type of distribution.

The true cost of a reverse mortgage or HECM includes the interest that accrues over time plus the upfront fees, which can run as high as $6,000.  As a result, reverse mortgages only make sense when the homeowner intends to stay in the home for the foreseeable future. If the property is sold in a year or two, the upfront fees are essentially wasted.

HECM funds can be distributed in tenured monthly payments, or via access to a capped line of credit. The former are the most conservative option, because the borrower is guaranteed to receive those payments as long as he lives in the home. A line of credit gives him more flexibility, but increases the risk that the available funds will be consumed too quickly. That can be a damaging situation for someone who's on a fixed income-like floating out to sea without arranging for a ride back to shore.