Reverse Mortgages and Estate Planning: What You Need to Know
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If you’ve spent any time on the internet or watched television in recent years, you’ve probably seen hundreds of advertisements for reverse mortgages by now. The pitch is simple: You can supplement your retirement income with a loan you won’t have to pay off as long as you own and live in your home.
As you view those ads, there’s one key question that should come to mind: What’s the catch?
After all, you don’t get something for nothing. The trade-off with a reverse mortgage is that in exchange for providing you with extra retirement money, the equity in your home will be reduced. This can have a significant impact on your estate.
While a reverse mortgage may be the right choice for you, it is a choice you should not make without understanding that trade-off. This article will explain how reverse mortgages work while looking at the following issues:
- Implications reverse mortgages have for your estate
- How reverse mortgages work as retirement income
- Questions to ask when considering a reverse mortgage
- Reverse mortgage scams to watch out for
For starters, how does a reverse mortgage work? Most reverse mortgages today are federally insured through the FHA’s Home Equity Conversion Mortgage (HECM) program, and these HECM loans are subject to the following restrictions:
- At least one borrower must be 62 years or older
- You must own your home outright or a have a low enough mortgage balance to be paid off upon closing of the reverse mortgage
- You must have the financial resources to keep up with taxes, insurance, and maintenance on the home
- You must use the home as your primary residence
A reverse mortgage uses the equity in your home as security. In this sense it is like a home equity loan, but with two important exceptions. First, with a reverse mortgage, the loan does not have to be paid back until the borrowers pass away or no longer live in the house. The second difference is that though they can be received in one lump sum, reverse mortgage loan proceeds are often paid in regular increments, so the amount you have borrowed starts small but increases over time. This is why they are known as reverse mortgages — rather than you making regular payments to the lender that steadily reduce what you owe, the mortgage lender provides you with regular payments that steadily increase what you owe.
What makes this concept work is that the loan can be paid off from the sale of your house, before or after you die. Since borrowing against equity effectively reduces the net value of your home available to your estate when you die, it is important to weigh the trade-off between the impact on your estate and the supplemental income a reverse mortgage makes available.
Reverse mortgages and your estate
If you plan on leaving an estate to your heirs, you should recognize that a reverse mortgage will reduce the value of that estate.
Your estate amounts to the value of your property when you die, net of any money you owe. Your home may be part of that estate, while a reverse mortgage is a loan that will increase the amount of money that you owe. Thus, if you have a reverse mortgage, your estate will receive the net equity value from your home, which is the market value of the property minus the balance of your reverse mortgage.
How high might the value of that reverse mortgage be? You can borrow up to the appraised value of your home or the FHA limit of $679,650, whichever is less. A reverse mortgage calculator can help you figure out how much you may be able to borrow based on your specific property and circumstances.
Whether or not this leaves anything left for your estate depends on two things that happen after you sign up for the loan:
- Fluctuations in the value of your home. Real estate prices go up and down over time, and these changes will impact the amount of equity from your home available to your estate. If real estate prices rise steadily over time, your estate should benefit from those increases. However, if real estate prices happen to have fallen between the time you borrow the money and when you die, the amount you owe would exceed the value of your property and thus your estate would receive nothing from that property.
- Your pace of borrowing. Money from a reverse mortgage can be received upfront in one lump sum, but often it is received gradually over time to be used as supplemental retirement income. When you receive the money gradually, it means the equity in your home would be reduced more slowly. In this case, there is a greater chance that the value of your home would still exceed the amount you’ve borrowed by the time you die, thus leaving some equity for your estate.
Besides the options of receiving money from a reverse mortgage via a lump sum or regular payments, you can also set up a line of credit that lets you borrow the money only as needed. The value of this is that the more slowly you receive money from a reverse mortgage, the more likely that there will still be equity left in your home for your estate upon your death.
Reverse mortgages as retirement income
While a reverse mortgage will reduce the value of your estate, the positive trade-off is that it can be used to supplement your retirement income. You can handle this in a variety of different ways:
- If you receive a lump sum upfront: In this case, the total value you can borrow will be available to you immediately, and you can draw on that for retirement expenses. However, this will mean that you will be responsible for handling that money and budgeting your expenses in a way that will continue to meet your needs throughout your lifetime. Borrowing the full amount upfront also maximizes the interest expense on the loan, since you will be charged interest on the total principal value of the loan from day one.
- If you receive a monthly payout: You can set up your loan so that you receive regular monthly payments, either for a specified period of time or until your maximum borrowing amount is reached. This seems to be a logical way to use a reverse mortgage for retirement income, but a key consideration here is to make sure you have a plan for what you will use for retirement income should you live beyond when monthly payouts are available. Some people use a reverse mortgage as a temporary measure so they can maximize their Social Security payouts by delaying when they start to receive those benefits. However, a study by the Consumer Financial Protection Bureau found that the borrowing costs of a reverse mortgage used in such situations typically exceeds the added lifetime benefit from delayed Social Security payments.
- If you set up a line of credit: Setting up a line of credit can be a good way to manage borrowing costs because you only borrow money as you need it. However, since there is a limit on how much you can borrow, you will have to control how quickly you access your line of credit to make it last. The more slowly you borrow, the more money will be available to borrow over the life of the loan because you will have to spend less on interest and mortgage insurance premiums.
Questions to ask yourself before considering a reverse mortgage
To help you weigh the implications of the trade-off between supplementing your retirement income and reducing the value of your estate, here are some questions you should ask before taking out a reverse mortgage:
What if your reverse mortgage exceeds your home’s value?
Though reverse mortgages are designed to stay within the equity value of the borrower’s home, it is possible that the amount owed might exceed the value of the home. This can happen if the borrower lives an unusually long time and thus accrues more interest and fee expenses on the amount owed than was anticipated. It can also happen if the value of the home declines over time.
If your reverse mortgage exceeds your home’s value and you want to sell the property, you are only responsible for paying the lender an amount equal to the appraised value of the home. Any additional amount owed on the loan is covered by mortgage insurance.
If your reverse mortgage exceeds your home’s value and you die, your estate is only responsible for paying the lender 95% of the appraised value of the home. The estate will not have to make up any remaining amount owed, which is covered by mortgage insurance.
Can life insurance pay off your reverse mortgage?
If your heirs choose to keep the home, they can pay off the loan balance without selling the property. In this case, they can use any source to finance the loan repayment, including a new mortgage on the property, proceeds from your life insurance if they are the beneficiaries or other sources of wealth.
With this as an option, as part of your estate plan, you should review how the amount of life insurance you have compares with the size of the reverse mortgage debt you are likely to accumulate, and who the beneficiaries of your life insurance are. Using life insurance to provide a means for your heirs to pay off a reverse mortgage probably makes the most sense if you have an existing life insurance policy you have paid into for a long time. By the time you are older, it may not be cost-effective for you to get a new life insurance policy for the purpose of paying off any remaining mortgage debt after you die.
What happens to other residents of the home if you die without paying off the loan?
This is a key consideration if you have people living with you who depend on your home as a residence. Repayment of the reverse mortgage comes due when the last surviving borrower dies. Thus your estate plan should take into account what other residents will do for housing if your estate is required to sell your home, especially if a reverse mortgage has eaten substantially into your equity.
If you have a spouse or other long-term residents at your home, consider making them co-borrowers when you sign up for the loan. This has two important advantages. They won’t have to pay off the loan immediately when you pass away, and they can continue to receive money from the loan if it has not yet reached its dollar limit. Keep in mind though that the youngest co-borrower must be at least 62 years old to qualify for an HECM loan.
A spouse living in the property who is not a co-borrower might still be able to continue living there without repaying the loan immediately after you die. If the non-borrowing spouse was married to the borrower at the time of the loan and was identified in the loan documents, then the loan does not have to be repaid until that spouse dies or sells the property.
If there are no co-borrowers and you do not have a spouse who qualifies for the above protection, then the loan will have to be repaid upon your death. Thus any other residents will have to come up with the means to repay the loan without selling the home, or else make other housing arrangements. This is something you might want to provide for in your estate plan.
Watch out for reverse mortgage scams
The FBI warns that the tremendous growth in the popularity of reverse mortgages has been accompanied by an increase in fraudulent activity related to these mortgages. These often include using the reverse mortgage in connection with another financial transaction such as:
- A property-flipping scheme
- Using loan proceeds to finance investments
- Foreclosure avoidance
Here are some tips to protect yourself:
- Do business only with financial advisers known to you
- Do not sign anything you don’t understand
- Don’t let anyone talk you into buying a house for the express purpose of getting a reverse mortgage
- Compare reverse mortgage proposals from multiple lenders to make sure you are getting reasonable terms
- Run any proposal by an independent reverse mortgage counselor
Is a reverse mortgage right for you?
Given the trade-offs reverse mortgage present — providing extra retirement income now vs. reducing the value of your estate when you die, is this kind of loan right for you?
The best way to answer that is if you have weighed the costs and benefits of a reverse mortgage against alternatives such as:
- Taking Social Security benefits earlier
- Downsizing your home
- Taking a home equity loan to meet short-term financial needs
- Adjusting your budget to live within your retirement income without borrowing
You should shop around to find a reverse mortgage lender with the most competitive terms, and then see if those terms are more attractive than the above alternatives.
Remember, you have to consider not just the cost of borrowing, but what the loan will mean in the long run for you and other residents of your home. It is important that you know how you will continue to pay for the costs of living in the home, like property taxes, homeowners insurance, and maintenance. Otherwise, you may be forced to sell before you are ready. You should also consider what will happen to your spouse and other residents of your home after you die.
As with all financial transactions, a reverse mortgage is something you should consider only if you fully understand the implications — for both your retirement finances and your estate.