10 Reverse Mortgage Pitfalls to Consider & How to Avoid Them
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If you or someone you love is considering a reverse mortgage, you’re probably attracted to the idea of having extra money available, on top of Social Security and savings, to help pay for bills and other expenses in retirement.
But you’ve likely also heard some negative things about reverse mortgages, which means you’re wary about potential scams and other unintended consequences.
This article will help you sort through all of that.
10 pitfalls of reverse mortgages
Despite the potential benefits (we’ll get to those later), there are a number of drawbacks to consider before taking out a reverse mor tgage.
Here are some of the biggest reverse mortgage pitfalls and how to avoid them.
1. You will owe more over the life of your reverse mortgage
Similar to a regular mortgage, reverse mortgages have both upfront and ongoing costs.
Upfront costs include:
- Lender fees from $2,500 to $6,000
- Closing costs that vary by loan
- Initial mortgage insurance premium that ranges from 0.5% to 2.5% of the home’s appraisal value
- Mortgage counseling that typically costs $125
Ongoing costs include:
- Mortgage insurance premiums at 1.25%
- Interest on the overall loan balance
These fees compound over time as the interest is continually applied to the total outstanding loan balance. Projections provided by the Consumer Financial Protection Bureau show how even a modest reverse mortgage can cost $31,900 over seven years, which is the average length of a reverse mortgage, or $178,000 if held from age 62 through an average life expectancy of 85.
These fees will always exist, but there are a few ways to minimize them:
- Only borrow what you truly need
- Borrow less than 60% of your initial principal limit in the first year
- Shop around both when taking out the reverse mortgage and when paying for the various appraisals and inspections before closing
- Pay the upfront costs out of pocket so that they are not folded into the loan
2. You are still responsible for other costs
A reverse mortgage will eliminate your monthly mortgage payment, but you are still responsible for other costs, such as property taxes, homeowners insurance and maintenance.
In fact, you are required to stay current on tax and insurance payments and to keep your home well-maintained in order to keep your reverse mortgage in good standing. Failing to fulfill those requirements could put the loan into default and cause the bank to foreclose on your home .
Before issuing a reverse mortgage, the bank will conduct a financial assessment to determine your ability to stay current on these expenses. If they deem this to be a risk, they may require a “set-aside,” which is a portion of your loan that is held by the bank in order to make sure there’s money available for these fees.
3. Interest is typically adjustable
Fixed interest rates are only available for lump-sum reverse mortgages, which come with their own set of potential problems.
If you opt for monthly payouts or a line of credit, your interest rate will be adjustable, which means it can potentially rise over time. And an increasing interest rate would speed up the growth of your loan, eating up your equity more quickly and leaving you with fewer options down the line.
One of the best ways to reduce your interest costs are to only borrow as much as you truly need and to shop around for your best interest rate before taking out your reverse mortgage. Borrowing less than 60% of your initial principal limit in the first year will also help to minimize your interest rate .
4. Reverse mortgage scams are common
Reverse mortgages are prime targets for scams both because they involve significant amounts of money and because they are sold to older consumers.
Consumers are pitched reverse mortgages as a way to free up cash to put into “investment opportunities” or to buy other properties and flip them for a quick profit. Contractors will suggest taking out a reverse mortgage in order to pay for costly home improvements. Even family members often pressure older parents to get a reverse mortgage so that they can get their hands on some of that money sooner, rather than waiting for their inheritance.
The FBI offers a number of tips for avoiding reverse mortgage scams. In general, you should avoid any unsolicited reverse mortgage offers, make sure you understand the pros and cons of any decision you make, and work with an independent reverse mortgage counselor before making a final decision.
5. Reverse mortgages can impact your government benefits
A reverse mortgage will not affect your eligibility for Social Security or Medicare. But it can affect your eligibility for Medicaid and Supplemental Security Income (SSI).
Reverse mortgage income does not count against the limits for either of these programs, but a lump sum that isn’t spent right away will count as an asset and can put you over the maximum limits. It’s important to structure any lump-sum payout carefully so as to avoid making yourself ineligible for these benefits.
6. You could outlive your reverse mortgage
Home equity is often one of the major sources of wealth for retirees. In fact, the Consumer Financial Protection Bureau found that, as of 2013, home equity accounted for almost 20% of all assets held by consumers age 65 and older, more than any other source of wealth.
That’s a valuable resource, but a limited one, and a reverse mortgage decreases its value. If you take out a lump sum, a term monthly payout, or a significant line of credit early in retirement, you may find that you have little to no home equity left later on if an emergency arises, you want to move, or you otherwise need funds to support your lifestyle.
One way to minimize the chance of this happening is to choose a “tenure” monthly payout that provides a fixed monthly payout for as long as you keep the reverse mortgage, even if the loan balance outgrows your home value.
You can also limit your borrowing in the early stages of retirement, which will leave more of your home equity available to help you handle unforeseen circumstances later in life.
7. You cannot take out a reverse mortgage on a secondary residence
You can only take out a reverse mortgage on your primary residence, which means that you have to spend the majority of the year in the home. You will have to certify in writing each year that the home continues to be your primary residence, and you typically have to notify your lender if you plan on being away from the home for more than two months at a time .
If the home no longer qualifies as your primary residence, the entire outstanding balance becomes due.
8. You may lose your home to foreclosure if you’re away too long
Along those lines, being away from your home for too long can cause it to lose primary residence status, put your loan into default, and allow the bank to foreclose if you do not pay the loan back in full.
If you have a reverse mortgage, you can lose your home to foreclosure if you are:
- Away from your home for more than six months of the year for nonmedical reasons.
- Away from your home for more than 12 consecutive months for medical reasons.
If you are facing either of those situations, you’ll either have to sell your home to pay off the loan, pay it off with other assets, or risk foreclosure.
9. If you pass away with a reverse mortgage, your heirs could be left responsible
The details about what happens with your reverse mortgage when you die can be fairly complicated, and this resource from the Consumer Finance Protection Bureau offers a good summary.
If you have a co-borrower who lives with you, or if you have a spouse who is not a co-borrower but who was married to you when you took out the reverse mortgage and has lived in the house continually since then, that person can generally continue living in the home without having to pay off the loan, even after you die.
Otherwise, your loan will generally have to be paid back at your death. If your heirs do not have the assets to pay off the loan, the home will likely have to be sold in order to settle the debt.
However, there are two positive stipulations here:
- Your heirs will only have to pay the lesser of the full loan balance or 95% of the home’s appraised value in order to keep the house .
- If the loan balance is greater than the value of the home, the mortgage insurance will pay the difference without putting that burden on your heirs.
10. It may cost more than you gain by delaying Social Security
Some financial advisers will recommend taking out a reverse mortgage at age 62 in order to fund living expenses while you delay Social Security. The logic is that since delaying Social Security increases your benefit, you will come out ahead in the long run despite the costs of the reverse mortgage.
However, research from the Consumer Financial Protection Bureau shows that this is unlikely to work out. In the projections they run, a reverse mortgage that is kept for the average duration of seven years will cost approximately $2,300 more than the extra lifetime benefit gained from delaying Social Security to full retirement age. And if you keep the reverse mortgage for your lifetime instead of paying it off early, you will end up spending about $149,000 more than the extra Social Security benefit.
It is certainly possible for this strategy to work, as that same report shows. But it requires having the funds required to pay off the reverse mortgage as soon as you claim Social Security benefits, which is difficult for many retirees to do.
Alternatives to a reverse mortgage
Before committing to a reverse mortgage, it’s important to consider the other options available to you. Depending on your situation, these alternatives may accomplish the same goal at a much lower lifetime cost.
Here are some alternatives worth considering:
- Working past age 62: Continuing to work, if possible, can delay the need for retirement income, allow you to add to retirement savings, and increase the Social Security income you are eligible to receive.
- Waiting to take out a reverse mortgage: If you don’t need it immediately, waiting might allow you to build up more equity, claim a larger payout, and reduce the odds of outliving your loan.
- Take in a renter: The extra income could offset some of your expenses.
- Reduce your living expenses: Reducing discretionary living expenses or applying for government assistance with utilities, food and other necessities can reduce your need for income.
- Ask family for assistance: If your family is in a position to help financially, it could be a way for you to get the help you need while still being able to pass your home down to your children.
- Borrow against equity through other means: A home equity loan or line of credit may be a less expensive way to access your equity, though they each have income and credit requirements and typically require a monthly payment.
Frequently asked questions about reverse mortgages
What is a reverse mortgage?
A reverse mortgage allows you to access the equity you’ve built in your home and use it to pay your bills and other expenses.
By taking out a reverse mortgage, you are taking out a loan against the equity in your home that can be paid out in three ways :
- A lump sum
- Regular monthly payouts
- A line of credit, allowing you to borrow money as needed
You can even receive money in a combination of those methods , giving you flexibility to match your loan to your specific needs.
With that background, let’s discuss some of the reasons why it may or may not make sense to take out a reverse mortgage.
What are the benefits of a reverse mortgage?
While you should absolutely approach a reverse mortgage with caution, there are some good reasons to at least consider it.
Here are a few of the major potential benefits.
1. Supplemental income
A reverse mortgage can provide additional monthly income, which can make it easier to pay your bills and handle other expenses.
You can choose to receive monthly payouts for a set number of years, or you can choose the “tenure” option that allows you to receive a fixed monthly payout for as long as you maintain the reverse mortgage, even if the loan balance exceeds your home’s value.
This additional income can make it a lot easier to handle your expenses, and it can also relieve your children of the responsibility of providing financial assistance.
2. Emergency funds
The line of credit option allows you to minimize the costs of your reverse mortgage by not borrowing money until you need it, while at the same time ensuring you’ll have money available if a big, unexpected expense suddenly arises.
When you’re otherwise living on a fixed income, this can provide a valuable security blanket.
3. Can’t owe more than your home is worth
No matter how much you borrow or how long you receive payouts, you can never owe more on a reverse mortgage than your home is worth.
If, when you sell your home or pass away, your home is worth more than the outstanding balance on your reverse mortgage, you or your heirs will receive the remaining equity.
If the outstanding balance on your reverse mortgage is greater than the value of your home, the difference will be paid by your mortgage insurance. This ensures that you will never have to pay for the reverse mortgage with other funds.
4. Stricter regulations
Most reverse mortgages are made through the FHA’s Home Equity Conversion Mortgage (HECM) program. This is a government-backed program that both insures the loan and places a number of strict requirements on lenders to minimize the odds of consumers being taken advantage of.
Should I get a reverse mortgage?
In the right situation, a reverse mortgage can be a powerful way to use your home equity to fund your living expenses.
But there are a number of potential reverse mortgage pitfalls, and scams are common, so you should proceed with caution.
Always make sure to evaluate all options available to you, understand exactly what you’re agreeing to and what the trade-offs are, and be wary of anyone who proactively pitches you a reverse mortgage, especially if you feel like they’re trying to pressure you into a quick decision.