Reverse Mortgages: Pros and Cons
The United States has been the source of most of the world’s financial innovations over the last half-century, including index funds, junk bonds, financial derivatives, and many more. The life cycle of these products often follows a curious path. The products begin as designs on a figurative drawing board. When they are actually introduced, they draw sharp reactions on both sides. They are either the greatest things since sliced bread, or they are a snare and a delusion, a scam dreamed up by wise guys to fleece the average citizen.
Over time, these polar views moderate and eventually disappear. That is because virtually any investment or financial product is good for somebody. Otherwise, there would be no reason to develop it in the first place. The other side of the coin is that it is also bad for somebody. Otherwise, everybody would flock to it and it would attract no criticism. Ultimately, the product’s virtues and defects become clear and generally recognized. At that point, all that remains is to route it to the right people and insulate the wrong people from it.
This pattern has repeated over and over again. One recent product is still in its infancy, attracting both enthusiastic endorsements and vocal condemnations. This is the reverse mortgage.
Reverse Mortgage Basics
A conventional mortgage allows you to borrow money to gain the right to make regular payments that gradually purchase equity in a house. As the name implies, a reverse mortgage simply reverses this general process. You, the mortgagee, borrow money in order to gain the right to receive payments backed by home equity that you already possess.
The use of equity to gain leverage is hardly a new idea; home-equity loans and lines of credit have been in use for ages. The new wrinkle in a reverse mortgage is that the homeowner/mortgagee is allowed to remain at home until he or she dies or decides to move. When the homeowner vacates, ownership transfers to the mortgage-holder and the house is sold to repay the loan.
Reverse mortgages have become popular with elderly homeowners; indeed, the mortgage contract ordinarily requires that the mortgagee be age 62 or older. It is not unusual for elderly homeowners who have depleted their financial assets to want to tap their one remaining sizable asset in order to finance the rest of their life. Unfortunately, that would ordinarily require the sale of the house. Not only would they have to pay for alternative living arrangements (another house, an apartment, or an eldercare facility), but they would also lose the comfort and independence of living in their longtime residence. Reverse mortgages are a way of having their cake (house) and eating (selling) it, too.
The popularity of reverse mortgages has attracted criticism from commentators who claim that the elderly are being misled about their value. Rather than react emotionally to reverse mortgages, homeowners should dispassionately review their pros and cons (i.e., their benefits and costs).
Reverse Mortgage Pros
There is no doubt about the biggest “pro” of reverse mortgages: the ability of the homeowner to continue living in the home as long as possible. After all, the homeowner has to live somewhere. As long as the home is the preferred residence, the homeowner can continue to receive part of the return from home ownership – the residential services it provides – by selling the rights to the other source of value, which is the equity. This is a genuine and sizable economic benefit, and it largely accounts for the popularity of the device.
There are other benefits as well. If any additional money is still owed on the house, the equity can be used to pay it off. The remaining equity can be taken in regular payments, a lump sum of money, or stored in a line of credit for use in emergencies. Finally, unlike most other loans, reverse mortgages do not require the borrower to meet stringent qualification tests. If the homeowner is age 62 or older and has sufficient home equity, he or she will normally qualify.
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Reverse Mortgage Cons
Despite its undeniable benefits, a reverse mortgage is not a free lunch. There are economic costs involved that may make it inadvisable for some elderly homeowners. These include:
- High front-end fees and expenses – As with conventional mortgages, reverse mortgagees incur closing costs, monthly service fees, and mortgage insurance costs. In the aggregate, these can run from 4-8% of the loan value. These costs reduce the amount of equity available for you later on.
- High interest rate on the loan – Reverse mortgages carry higher interest rates than conventional loans, all other things equal. This derives from the principle of “time preference”: people always want to receive a benefit sooner rather than later. Since your date of death is uncertain, the lender may have to wait quite a while to get their money. The higher interest rate is necessary to compensate them for this waiting time.
- Loss of the home-mortgage interest deduction – You don’t actually pay interest on the reverse mortgage until the loan is paid off, either after your death or surrender of the house. Thus, this is one form of mortgage interest that is not tax-deductible. In this case, your opportunity cost is the loss of the home-mortgage interest deduction, since you could have gotten a different loan (home equity, say) that would have preserved this deduction.
- Possible unfavorable interest-rate tradeoff – If your home still carries a mortgage, you may be paying a lower interest rate than the prospective reverse-mortgage rate.
- Possible expiration of loan-repayment immunity – Your immunity from loan repayment expires one year after you leave the house. If you enter a medical-care facility, you may lose your equity after one year and be unable to pay for a big-ticket treatment item such as Alzheimer’s disease.
- Loss of legacy value – As your equity is gradually depleted, your potential legacy to surviving family members grows smaller and smaller.
- Loss of supplementary government benefits – Possession of the reverse mortgage itself, which is less liquid than a conventional mortgage, may compromise your eligibility for Medicaid or supplemental Social Security benefits, which set a very low threshold for allowable assets.
- Lack of incentive to live frugally – A reverse mortgage may be an easier out than revision of your budget or tax planning regime. This may make it too easy for you to forego making hard choices that would have long-run benefits.
When Do Reverse Mortgages’ Pros Outweigh Their Cons?
Several of the drawbacks of reverse mortgages arise when the mortgagee leaves the home alive. This suggests that the best candidate for a reverse mortgage is a homeowner aged 75 or older, in spite of the fact that much younger people can qualify. At 75 or older, chances of you moving out before death are reduced.
A reverse mortgage reverses the logic of a conventional mortgage. Instead of borrowing money to gain the right to make payments to gradually acquire home equity, a reverse mortgage allows you to borrow money to receive payments that gradually deplete the equity you already own in the house. Its chief advantage is that you can stay in the house until you die or voluntarily choose to move out. Reverse mortgages also allow you to receive your equity in gradual payments, a lump sum, or as a line of credit. Qualification is relatively easy, requiring only that the reverse mortgagee be age 62 or older and have sufficient home equity.
The economic costs of reverse mortgages include their high front-end fees and expenses, their relatively high interest rates and possible unfavorable interest-rate tradeoffs, their loss of legacy value and potential supplementary Medicaid and Social Security benefits, the possibility that exit from the house will trigger loan repayments and siphon off money that could otherwise pay your medical expenses, and their lack of incentive for belt-tightening.
The best candidates for a reverse mortgage are aged 75 or older and rate to die in their house rather than surrender it.
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