I’ve been getting questions about reverse mortgages lately. It’s not surprising. Reverse mortgages are one of those financial planning tools that are very useful for a specific purpose, and for specific people, that has, unfortunately, been sold aggressively to others. Not all reverse mortgages are scams, but you have to understand what you are getting from reverse mortgage lenders when you sign up.
In other words, there is a lot more to a reverse mortgage than what you see on that television commercial or Facebook ad.
What Is a Reverse Mortgage?
Let’s start from the beginning so that we have a solid footing. What is a reverse mortgage?
The most common way to explain reverse mortgages is to say that the definition of a reverse mortgage is when a reverse mortgage lender gives you a lump sum of money for the equity in your home and then gets the home when you die. However, this is a little bit deceptive in that there is more to it than that. Let’s look a little deeper to see what is really going on.
First, let’s look at a regular mortgage, or a forward mortgage, if you will.
With a traditional mortgage, a bank gives you a lot of money in a lump sum (actually they give it to your title company who gives it to whoever you buy the house from) and you pay them back over time with regular payments. Thus, a reverse mortgage should be where you give the bank a lump sum and they pay you back over time with regular payments. However, this is NOT what a reverse mortgage is. That is an annuity, which is a very different thing.
In reality, a reverse mortgage is really more of a reverse life insurance policy.
In a regular life insurance policy, you make premium payments to an insurance company, and when you die, they pay out a lump sum to your beneficiaries. A reverse life insurance policy would be where a financial institution pays you a premium, and then when you die, you pay them a lump sum from your estate. This is much closer to how a reverse mortgage really works, but even that doesn’t fully describe it.
What Are Reverse Mortgages?
The best way to really understand what a reverse mortgage is, and how a reverse mortgage works, is to look at some scenarios.
For our reverse mortgage examples, we will assume a homeowner, age 72, with a house worth $300,000 that has a paid off mortgage. In other words, there are no current mortgages on the house; it is owned free and clear. In our example, the homeowner gets a $200,000 reverse mortgage. Let’s see what can happen.
Scenario #1: Moving
What happens if you have a reverse mortgage and want to move to a new home?
This is one of the big surprises that people don’t understand before they get a reverse mortgage. After signing up for a reverse mortgage, you cannot sell your home without the reverse mortgage lender’s approval. You may not be allowed to sell your home at all. If you can sell your home, you don’t just pay back the $200,000 reverse mortgage. You also have to pay interest, and penalties, and fees. It is NOT cheap.
So, one very big disadvantage of a reverse mortgage is that you probably can’t move or sell your house– ever.
If you are thinking of moving and renting it out, think again. Your reverse mortgage will clearly spell out who can live in the home. Usually, it is only you and direct family members. This can be a very big drawback, especially, if you need to move into a retirement home, or smaller house.
Scenario #2: Appreciation and Home Equity
Let’s say it has been a few years and your house is now worth $500,000 instead of $300,000. Good news, right? Maybe you would like to take out a home equity loan to do some things or help a grandchild go to college. After all, you have way more equity now than when you took out your reverse mortgage, right?
Unfortunately, that isn’t how it works. The reverse mortgage lenders have the rights to any future equity. It is one of the ways lenders make a profit on reverse mortgages. If your home is worth $100,000 more when you die, they make $100,000 in profit. You can’t take out any equity, it isn’t yours. All future increases in value belong to the reverse mortgage company.
Other Disadvantages of Reverse Mortgages
A partial list of reverse mortgage disadvantages:
- Selling home restrictions
- Moving restrictions
- Restrictions on who can live in the home
- Restrictions on what can be done to the home or property
- No participation in higher home prices
- No ability to further tap any equity
How Reverse Mortgages Work in Easy to Understand Terms
The best way to really understand how a reverse mortgage works is to change how you think about them.
What really happens with a reverse mortgage is that you sell your home for less than it is worth to a reverse mortgage lender. In exchange for the reduced price, the lender lets you live there rent-free, as a tenant (not an owner) until you die.
When you start thinking of it like this, a lot of the complexity disappears. Of course, you can’t sell your home, you already sold it. Of course, you can’t take out a home equity loan, you don’t own the house. Of course, you can’t have someone else move in, remodel, change too many things, or otherwise disturb the property; you have to ask the landlord first.
Legitimate Reverse Mortgages
The vast majority of reverse mortgages are legit. The part that seems like a scam is that they are aggressively sold to the wrong people. Since reverse mortgages are only available to older people, it can seem particularly predatory toward the elderly. Unfortunately, for a lot of people who get reverse mortgages, they don’t have very many options and may be too interested in the lump sum, tax-free payout, to truly listen to all of the negatives when weighing the pros and cons of a reverse mortgage.
If you read this and understand that doing this kind of mortgage severely limits your future options when it comes to your home, then you are ready to see who a reverse mortgage is right for.
Keep in mind that the amount of money you can get for a reverse mortgage depends upon two factors:
- How much equity you have in your home
- How old you are
Financial companies don’t do things without making a profit, and best reverse mortgage companies are no different. That means no one is going to give you 100% of your home equity, no matter how old you are. There would be no profit if you died too soon. The base amount is a percentage that depends upon, among other things, how likely they think the value of your home will rise, and how easy it will be to sell once you die.
That base percentage is modified by how old you are. This is where the insurance part of the transaction comes in. The lender can’t profit on the transaction until you die. The longer they have to wait, the more risk and the more it costs, because that money could have been earning interest or other return somewhere else. Therefore, all things being equal, the older you are, the more money you will get for your reverse mortgage.
Although you must be 62 years old to qualify for a reverse mortgage, at that age, you are only going to get a very small payout of your equity. After all, in that case, it is very likely that you’ll live 10, 20, or even 30 years before the lender can make a profit. That means they need to make a bigger profit when you finally do pass on.
Reverse mortgages really don’t make sense until you are at least 70 years old. At that point, you can expect a better payout from the lender. Even then, you need to consider what happens as if you live another 20 years. Do you really want to stay in that house (and do all the necessary maintenance) during that time?
For many people, there are better options. Be sure you explore all the options before choosing a reverse mortgage. In the end, it may be your best option, but make sure you understand all the pros and cons and that you know what other alternatives you have before making a life-long decision.