Should You Get a Reverse Mortgage?

By Markets Fool.com

A reverse mortgage can be a way for senior citizens to get extra income to help out with day-to-day expenses, but they aren't for everyone. Before you consider a reverse mortgage for your retirement income needs, it's important to know exactly what you're getting into and the pros and cons of this type of loan. With that in mind, here's a rundown on reverse mortgages, so you can determine whether or not it's a good option for you.

Continue Reading Below

What is a reverse mortgage?

As the name implies, a reverse mortgage works in the exact opposite way of a traditional mortgage loan. Instead of you making payments to the bank and building equity in your home, the bank makes payments to you in exchange for your home equity.

You can choose to receive payments from a reverse mortgage in a single lump sum, as a series of monthly payments, or as a line of credit. Or it may be possible to receive some combination of these three options. Generally, a lump sum loan will come with a fixed interest rate, while the other options come with a variable rate.

A reverse mortgage isn't paid back like other loans, where payments are made over time. Rather, the reverse mortgage is paid back when you sell the home, die, or vacate the property for longer than 12 months. And it's important to mention that reverse mortgages are nonrecourse loans, which means that there is no way for the lender to get their money, other than from the sale of your home. If you owe $300,000 on a reverse mortgage and your home only sells for $200,000 after your death, the lender can't sue or take any other action to recoup the $100,000 difference.

Are you eligible?

Continue Reading Below

To get a reverse mortgage, certain conditions must be met.

  • You must be at least 62 years old -- reverse mortgages are intended to provide income to seniors.
  • Your need to have enough equity in your home to justify the reverse mortgage.
  • Your home needs to conform to HUD standards. This means it needs to be a single-family home, two- to four-unit property, condominium, townhouse, or manufactured home that was built after June 1976.
  • The home must be your primary residence.
  • You need to remain current on your property taxes and homeowner's insurance for the life of the loan.
  • Finally, the bank approving your reverse mortgage must be the first lienholder on the property. Any existing mortgages must be paid with the proceeds from the reverse mortgage.

The amount you can borrow with a reverse mortgage depends on your age, your home's value, and the interest rate on the loan, and can vary significantly based on these factors. To get an idea of how much you might be able to get, the National Reverse Mortgage Lenders Association provides this calculator that can give you a good estimate.

Know the costs and other drawbacks

A reverse mortgage obviously has its good points. You'll get extra money to help out with day-to-day expenses, and you'll never have to pay it back in your lifetime. You keep the title to your home, and the money you receive will have no effect on your Social Security or Medicare benefits.

However, reverse mortgages aren't cheap. You'll have to pay an origination fee, mortgage insurance premium, appraisal fee, and various closing costs. These fees can easily add up to 3%-5% of the loan amount, or even more.

Not only are the fees and closing costs high, but the compounding effect of interest over time can also leave you with a pretty big balance relative to the amount you borrowed. For example, let's say you obtain a $50,000 reverse mortgage, which you choose to receive as a lump sum with a 5% annual interest rate. Here's how this can add up over time:

Years Since Origination

Loan Balance

Total Accumulated Interest

1

$52,558

$2,558

2

$55,247

$5,247

5

$64,168

$14,168

10

$82,351

$32,351

15

$105,685

$55,685

20

$135,632

$85,632

Another drawback of reverse mortgages is that you'll own less of your home as time goes on. In the previous example, you can see just how quickly your home equity can erode as interest builds. So if leaving your home to your children or other loved ones is important to you, it's probably best to avoid reverse mortgages.

Is it right for you?

Whether or not a reverse mortgage is right for you depends on your financial situation. You can probably borrow money with a home equity line of credit that comes with significantly lower fees, but the downside is that you'll have to pay that money back.

If you want to boost your retirement income, and aren't worried about leaving your house to heirs or maintaining your equity, a reverse mortgage can be a great way to get some much-needed cash in retirement.

The article Should You Get a Reverse Mortgage? originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.