How Safe Is a Reverse Mortgage?

By Markets

Image source: Getty Images.

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As we approach or begin retirement, many of us find that we could use more income. There are various ways to boost your cash inflows, such as a part-time job or dividend-paying stocks. Here's one more option you might consider: the reverse mortgage. Just what are reverse mortgages, and how safe are they? Let's delve into that.

Image source: Pixabay.

Meet the reverse mortgage

Getting a reverse mortgage is a lot like selling your home to a lender in exchange for money (in the form of a lump sum, an income stream, or a line of credit) while also being permitted to remain in the home for as long as you can. It's technically a loan, though. You typically borrow less than the home is worth, and the amount you owe increases over time as interest is applied to it. The loan doesn't have to be repaid until you die, sell the home, or stop living in it -- perhaps because you moved to a nursing home. At that time, the home can be sold to cover the debt -- or your heirs can pay it off and keep the home.

What's so good about it?

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The big upside of a reverse mortgage is that it can give you an income stream that can be very welcome in retirement. With millions of Americans underprepared financially for retirement, that's a big deal. After all, according to the 2016 Retirement Confidence Survey, among thoseaged 50 or older, only 30% had saved $250,000 or more for retirement, while fully 27% had saved less than $10,000! (Even $250,000 or $400,000 might not get you as far as you'd like.)

Reverse mortgage income is often tax-free, too, which is another big plus. And whereas some retirement-funding solutions require you to sell and downsize your home or even to move to a less costly region, reverse mortgages let you stay in your home while receiving payments.

Read the fine print and perhaps consult a financial pro before signing anything. Image source: Getty Images.

But is it safe?

Reverse mortgages can be a rather safe and effective way to boost your retirement income, but they're not without some drawbacks and downsides. For example:

  • You might be sold one with less-than-ideal terms by a pushy salesperson. Don't fall for hard sales pitches. If you're interested in a reverse mortgage, you're arguably best off approaching some solid lenders on your own and perhaps having an attorney or finance professional review the contract before you sign it.

  • You may not receive as much income through a reverse mortgage as you might have expected. The amount you can borrow depends on factors such as how much longer you (and your spouse, if you have one) are expected to live, the value of the home, the equity you have in it, and prevailing interest rates. Interest charges are added to the balance of the loan over time, and there are closing costs for the loan too, just as with regular mortgages. Closing costs and interest rates tend to be higher for reverse mortgages than for regular mortgages, too.

  • A reverse mortgage might not be quite the financial solution you thought it was -- because you'll still be responsible for home-related expenses such as property taxes, home insurance, home repairs and maintenance. Even worse, miss out on some of these payments, such as property taxes, and your lender might be able to closeout the loan, causing you further grief.

  • While a reverse mortgage giveth, it can also taketh. Receiving income from a reverse mortgage might hurt your eligibility for benefits such as Medicaid and Supplemental Security Income.

  • Once you leave your home, it will likely need to be sold to pay off the reverse mortgage. If you'd hoped to leave it to your children, you won't be able to do so unless they can come up with the funds to pay off the loan. Here's another scary scenario: Some people have run into troubleif they got sick and were out of their home for an extended time, such as in rehab -- as their lender then moved to close out the loan and take possession of the house.

  • Another dangerous scenario has happened more in the past than lately (due to new regulations), but you should be aware of it: In the past, when a reverse mortgage holder has died, the surviving spouse often ended up defaulting on the loan and facing foreclosure. Check the fine print in your contract and ask pointed questions. Better still, include your spouse in the loan, so that the loan isn't due until both of you no longer live in the home. (This can mean that you receive less money in the arrangement, since it likely lengthens the life of the loan.)

    Your equity in your home will shrink over time. Image source: Pixabay.

  • When some people have tried to refinance their mortgage, they've discovered that their equity is much smallerthan they thought, because holding a reverse mortgage shrinks your equity -- in part via accrued interest expenses over time.

  • Take note whether your reverse mortgage features a fixed interest rate or a variable one. In an environment of rising rates, know how quickly your rate would rise, as that will cost you more.

  • This danger related to reverse mortgage is more on you than on the loan itself: If you're not disciplined, you can spend too much of your reverse mortgage money too soon (especially if you've received it as a lump sum) and can end up in worse financial shape.

Clearly, deciding to get a reverse mortgage is not a slam-dunk, no-brainer decision. It might serve you very well and can be safe, but it also features a lot of drawbacks worth considering. Approach it with open eyes and be sure to explore other alternatives, too. It's not a bad idea to consult a financial advisor about it, too -- and not one who sells reverse mortgages. (You can look for a fee-only one at Alternatives to consider include dividend-paying stocks, annuities, or perhaps a home equity loan. Social Security will offer some income in retirement, too. The average annual benefit is only about $16,000, but a little strategizing can increase the amount you ultimately collect from Social Security.

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Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article.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.