What Is the Downside of a Reverse Mortgage?

What Is the Downside of a Reverse Mortgage? article image.

A reverse mortgage enables homeowners, particularly those who are of retirement age, to borrow against the equity in their homes. One advantage of a reverse mortgage is that lenders don't typically have minimum income or credit score requirements, which can help homeowners looking to cover living expenses.

But a reverse mortgage comes with several downsides, such as upfront and ongoing costs, a variable interest rate, an ever-rising loan balance and a reduction in home equity. In light of those drawbacks, homeowners considering a reverse mortgage should weigh the alternatives, such as refinancing an existing mortgage or taking out a home equity loan.

What Is a Reverse Mortgage?

As its name suggests, a reverse mortgage is the opposite of a traditional mortgage loan. With a reverse mortgage, you don't borrow money to buy a house; rather, you tap into the equity of your home to take out a loan. A reverse mortgage is meant for homeowners who have paid off their mortgage or who have accumulated a lot of home equity.

Reverse mortgages frequently are marketed to retirement-age homeowners who want more money to cover living expenses but still want to hang on to their homes. One of the upsides of a reverse mortgage is that lenders characteristically don't impose income or credit requirements.

Proceeds from a reverse mortgage loan are usually tax-free, and not a penny of the loan needs to be paid back if the borrower stays in the home, pays property taxes and homeowners insurance, and covers maintenance expenses. That changes, though, if you sell or move out of the home, or if you (or in certain cases, your spouse) die. Those situations trigger the requirement for you, your spouse or your estate to repay the loan.

Three kinds of reverse mortgages are available:

  1. Single-purpose reverse mortgage: These loans, available from government agencies and nonprofit groups, are designed for just one purpose outlined by the lender. For instance, someone might use proceeds from a single-purpose reverse mortgage to tackle a home improvement project or pay property taxes. They're the lowest-cost option among reverse mortgages.
  2. Proprietary reverse mortgage: Proprietary reverse mortgages, available from private lenders, offer more flexibility than single-purpose reverse mortgages. Unlike single-purpose reverse mortgages, proprietary reverse mortgages usually don't come with restrictions on how you can spend the proceeds. This option can be especially attractive to owners whose homes carry high values and who want to borrow a substantial sum of money.
  3. Home Equity Conversion Mortgage (HECM). An HECM, insured by the Federal Housing Administration (FHA), is the most common kind of reverse mortgage. As of 2020, the HECM borrowing limit was $765,600. Although proceeds from an HECM can be used for any purpose, some homeowners might not qualify due to certain restrictions. These loans are available only to homeowners who are at least 62 years old.

Drawbacks of a Reverse Mortgage

Although a reverse mortgage enables an owner to tap into perhaps hundreds of thousands of dollars in home equity, there are several downsides to a reverse mortgage. Those include:

  • Various costs: Similar to a traditional mortgage, a lender typically charges several fees when you take out a reverse mortgage. Those can include a mortgage insurance premium, an origination fee, a servicing fee and third-party fees. For an HCEM, the initial mortgage insurance premium is 2% of the loan amount; on top of that, you'll pay an annual mortgage premium of 0.5%. You'll also pay an origination fee of $2,500 or 2% of the first $200,000 of your home value (whichever is greater), plus 1% of the amount exceeding $200,000; origination fees cannot exceed $6,000.
  • Variable interest rates: Most reverse mortgages have variable interest rates, meaning the interest rate that determines how much is added to your loan balance each month fluctuates throughout the life of the loan.
  • No tax deduction: Interest paid on a reverse mortgage can't be deducted on your annual tax return until the loan is paid off.
  • Less equity: A reverse mortgage can siphon equity from your home, resulting in a lower asset value for you and your heirs.
  • Potential home repairs: If your home isn't in good shape, you might need to make repairs before you can qualify for a reverse mortgage.
  • Possible early repayment: Aside from when a homeowner dies or moves out, the reverse mortgage loan might need to be repaid sooner than expected if the owner fails to pay property taxes or homeowners insurance, or if the owner isn't keeping up with home maintenance.
  • Medicaid eligibility. A reverse mortgage doesn't affect your Medicare or Social Security benefits, but it might affect your eligibility for Medicaid benefits.

Reasons Why a Reverse Mortgage Might Not Work for You

In addition to its downsides, there are three examples of when a reverse mortgage might be totally out of the question:

  1. You want to move fairly soon. Timing is important when it comes to taking out a reverse mortgage. If you're looking to relocate in the next few years, it might not be wise to saddle yourself with a reverse mortgage. Why? You're required to pay off the loan when you move out. Reverse mortgages are geared toward homeowners who plan to stay put for quite awhile.
  2. You can't handle the costs. Closing costs, maintenance expenses, homeowners insurance and property tax bills could strain your already stretched budget. Worse yet, a lender might tell you to pay off the loan right away if you've fallen behind on paying your homeowners insurance or property taxes.
  3. You hope to pass along your home to your heirs. A reverse mortgage can complicate matters if you leave your home to your kids or other heirs. For instance, what if your estate lacks the money to pay off the reverse mortgage loan? You heirs might have to scrape together the cash from their savings or sell the house to pay off the loan.

Alternatives to a Reverse Mortgage

While a reverse mortgage may not work for your situation, don't give up hope—it's not your only option for generating cash or saving money. Here are four alternatives:

  1. Refinance your existing mortgage. If you do a cash-out refinance, the money you gain from refinancing your current mortgage might be enough to pad your income.
  2. Sell and downsize. Selling your home at a profit and relocating to a smaller, less costly space could be the answer to your budget woes. You might even opt to rent a place so you can avoid the hassles of homeownership.
  3. Take out a home equity loan or a home equity line of credit (HELOC). A home equity loan or HELOC might be a less costly way to tap into your home equity. However, you must make monthly payments if you pick either of these options. Plus, unlike a reverse mortgage, you'll be subject to income and credit requirements.
  4. Look at other resources. Do you have some stock you could sell? Can you cash out a life insurance policy that you don't need anymore? Examine various financial options that don't involve jeopardizing ownership of your home.

Explore All Your Options

On its surface, a reverse mortgage might sound like an ideal way to use your home for income. However, both upfront and ongoing costs accompany a reverse mortgage, along with a variable interest rate. Another pitfall: Because interest and fees are tacked on to the loan balance each month, the balance increases—and as the balance goes up, your home equity goes down.

Because of the numerous downsides to reverse mortgages, be sure to explore all of your borrowing alternatives to ensure your finances don't end up going in reverse.