I had a request from Peter Jeppson, a great friend of Total Financial Health, LLC, to explain what a reverse mortgage is for one of his clients. Reverse mortgages get a bad rap, and they are admittedly not for everyone, but they can be an EXTREMELY important tool for protecting seniors in some of their financial planning. Here is my explanation:
Peter,
Here is a quick explanation of reverse mortgages, which get a bad rap sometimes, but it’s mostly because people don’t understand them. You can read a good article on them (also called a HECM, home equity conversion mortgage) here:
http://en.wikipedia.org/wiki/Reverse_mortgage
A reverse mortgage replaces a traditional mortgage and provides the client with cash and no payment, either in lump sum or in monthly installments, at the client’s discretion. If someone pulls out a reverse mortgage they do not have to make payments, ever, as long as they are alive. They are typically given to borrowers over 62 years of age. The reason there are no payments is that each month that no payment is made the equity in the home goes down as the absent payment amount is added to the principal balance each month.
Here is an example of one of my recent clients. Client was strapped on monthly payments and owed $140k on a home that appraised at about $250k. They were 72 years old, so they were allowed a reverse mortgage up to 72% (the same percentage as their age) of the value of the home. This allowed for a loan of $180k, netting them almost $30k after closing. So, they had $30k in their pockets and no payment for the rest of their lives. Their payment was $1006 each month, so this gained them just over $12k a year. The $30k could be used for anything; there are no restrictions on it use. There is even a new program (four years old) where you can pull out a HECM and use the proceeds for the purchase of a new primary residence; still no payment on the HECM, ever, unti the client passes away.
There are two drawbacks to HECM loans. First, the up front costs are higher than a traditional mortgage, as is the interest rate. The rate is typically about .5% higher than traditional mortgages; the closing costs are significantly higher because you pay up front mortgage insurance, and yearly mortgage insurance. However, all costs are rolled into the loan so there are no out of pocket costs. Second, a HECM usually does not allow much equity to be passed along to an estate or heirs as you lose equity each month. However, if the client passes away and there is still equity, the estate or heirs can still buy it back from the bank at the principal balance owed at the time. If you think about it, passing a home on to heirs can become burdensome for the estate, because they have to keep up payments on it until it is sold, so this may not be an issue for most clients.
Overall, the overwhelming majority of clients who pull out HECM loans are very satisfied for what it does for them.