A reverse mortgage is a type of home equity loan that is limited to folks age 62 and up and can only be taken out on a primary residence. It is similar to any ordinary mortgage except that it doesn't involve monthly payments assuming you will live in the home for the long term, the home is insured, and all property taxes and homeowners' association fees have been paid. The idea behind taking out a reverse mortgage is to convert your home equity into a cash flow without having to make monthly mortgage payments. However, there are some risks involved that you should be aware of.
How it worksThe lender will determine a reverse mortgage loan amount based on your age, the market value of your home, and current interest rates. The higher the value of the home, the older the applicant, and the lower interest rates are, the more someone can borrow against their home. The applicant's credit is also a consideration in the bank's decision whether to enter into this agreement. The homeowner can choose:
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- A single-purpose reverse mortgage: These are often offered by government agencies and non-profits in limited areas and are designed to cover a specific purpose, as designated by the lender for homeowners with low to moderate income.
- A proprietary reverse mortgage: These are similar to the single-purpose loans, but are designed for borrowers with higher home values.
- Home Equity Conversion Mortgages (HECMs): These are the most common type of reverse mortgage and are insured by FHA
Once you are approved for whichever loan you choose, closing costs will be included in the loan amount and you will be given your choice of payout method: lump sum payment, stream of payments (i.e., monthly installments), line of credit, or a combination of all the above. Keep in mind that a reverse mortgage is a non-recourse loan, meaning that the lender will always eat the difference if the eventual sale of the property does not cover the remaining balance of the initial reverse mortgage loan.
LimitationsAlthough included in the loan amount upfront, there are fees involved for the setup of the loan that should be taken into consideration.
- Sometimes the proceeds from a reverse mortgage loan may not be enough to cover all of your life's expenses. If you ever run out of money, selling your home to downsize is no longer an option. So you really need to make sure that this is the best plan for you.
- As a recipient of a reverse mortgage loan, your eligibility for certain government assistance programs may be limited, but Social Security and Medicare will not be affected.
- A reverse mortgage can be an impediment to passing your property onto your heirs when you pass away because your heirs will be responsible for the repayment of the loan. In this scenario, the heirs could either repay the loan balance of the reverse mortgage out of their pocket, or sell the property to repay the loan. Also, there always lies the opportunity cost of taking out a regular home equity loan with a better interest rate.
- The proceeds you receive from a reverse mortgage loan are not considered income for income tax purposes, so these payments are generally tax-free. However, any interest that accrues on the loan is not tax deductible. In the event you are unable to pay your property taxes, homeowner's association related fees, or even maintain the up-keep of the home's original condition, you could be forced into foreclosure.
- And you probably shouldn't take out a reverse mortgage if you believe you won't be living in your home for the long term, because if you ever decide to move out of your home for whatever reason, you will still be responsible for the repayment of the loan.
When considering options for supplementing your income during retirement, embarking on a reverse mortgage should be at the bottom of your list, all else being equal. However, this type of maneuver to turn home equity into an income stream can be favorable for older individuals who expect to live in the same home for the rest of their lives, or at least a very long time. Nonetheless, the decision to take out a reverse mortgage loan is a big one and involves a lot of planning, research, and decision making. Be sure to do your homework!
The article Should a Reverse Mortgage Be Part of Your Retirement Income Plan? originally appeared on Fool.com.
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