Reverse Mortgages Part Three: What are the Disadvantages?

Jacqueline Marshal* and her husband Tom* were comfortably retired when Tom died unexpectedly. Because both of them had been drawing a Social Security pension, Jacqueline’s monthly income was reduced by $700 a month (the smaller of the two pensions) upon Tom’s death. Jacqueline considered replacing the bulk of that lost cash flow by taking out a reverse mortgage loan against their paid for house, but, after further study, decided not to. She was disappointed to learn that the reverse mortgage would only allow her to access a fraction of her home equity. A further concern was that, if she decided to move some day, her choices would be limited because of the reduction in home equity the reverse mortgage would create. So Jacqueline decided to forego the reverse mortgage, tighten her budget and stay in her home. Five years later, when home maintenance became a greater burden, she decided to sell her home and purchase a condominium. Because she had not given up her home equity for a reverse mortgage loan, Jacqueline was easily able to afford the condominium. She is now very thankful that she decided against the reverse mortgage.

Now…lest you infer from the title and opening vignette that I am dead set against reverse mortgages, please understand that this post is part of a four part series.

In “Reverse Mortgages, Part One: Digging Beneath the Surface”, we attempted to demystify reverse mortgages. Reverse Mortgages Part Two explained some advantages of reverse mortgages. Part four of the series will be a summary post.

So…before we investigate the disadvantages of a reverse mortgage, let’s review the definition and essential facts:

Definition of Reverse Mortgage

A reverse mortgage is the opposite of a traditional mortgage. With a traditional mortgage, the borrower builds equity in his house by paying down a loan taken against the house. With a reverse mortgage, the borrower gives up home equity in exchange for payments from the lender.

Essential Reverse Mortgage facts

• The home owner must be at least 62 years old to qualify for a reverse mortgage.
• The home must have substantial equity.
• Credit scores are irrelevant.
• Any previous mortgage will be paid off by the reverse mortgage.
• You can receive your payments by lump sum, monthly payments, line of credit or any combination.
• The borrower retains the title on the house, meaning that he is responsible for all taxes, insurance and maintenance

Now: what are the disadvantages of a reverse mortgage?

• Hard to understand

Reverse mortgages are confusing. It seems like you are getting a loan without having to ever pay it back…not true. The loan options themselves are confusing: lump sum, line of credit, monthly, or combination? The interest rate you are paying is confusing: does it apply only to the loan amount or to all other fees as well? I do not say that the complexity of the reverse mortgage transaction should rule it out; I am saying that you should never buy anything you don’t understand and this complexity makes it a disadvantage.

• They are expensive

A reverse mortgage is more expensive than a traditional mortgage. Why? Because the lender is taking the risk that, should you live to be 100 years old, he will not receive any payment for that entire time. He is also risking that the house will appreciate in value over those years. How do he cover this risk? By charging service fees, higher interest rates and greater closing costs.It is not a panacea

Some would have you think that “letting your house pay you” will simply be a dream come true. Not necessarily so. You still own the house, meaning you are responsible for all taxes, insurance and maintenance. In fact, failure to perform basic maintenance could nullify the reverse mortgage agreement, meaning that all loans would come due. If that were to happen, would you be able to pay those loans? Probably not, or you wouldn’t have needed the reverse mortgage in the first place.

• Little or no inheritance for kids

This may not be important, but reverse mortgages will consume most or all equity in the home, leaving little for the descendents.

• Could affect other benefits

Although the reverse mortgage is a loan and therefore not considered income, it could (according to Consumer’s Union) nevertheless affect your eligibility for some federal or state assistance, including Medicaid or Supplemental Social Security Income (SSI).

• Reverse mortgage sales people

While the reverse mortgage industry has reined in most of the culprits who would prey on senior citizens, there are still some that need watching. Many do not understand the loan themselves, so they either skirt your questions, give you wrong answers, or need to “get back to you”. Others simply say whatever it takes to get the sale.

• Limits future choices

A reverse mortgage today could give you less choices sometime in the future. For example, what if the day comes when you are no longer able to take care of the house? Without the reverse mortgage, one choice would be to sell your house and purchase a smaller house or a condo. However, the reverse mortgage may have drained the equity you once had and greatly eliminated those choices. You need to think clearly about the “what ifs” of a reverse mortgage.

Learn More About Reverse Mortgages – these links will help:

Federal Trade Commission

About.com

AARP

* denotes fictional names

Have you or any of your family members had a reverse mortgage?  Did you understand it?   Any surprises?  Would you recommend it to others?

photo credit: aturkus

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Carnival of  Money Stories 2 hosted by Len Penzo dot com

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Carnival of Financial Planning hosted by The Skilled Investor