Reverse Mortgages: Viable Solution or Desperate Last Resort?

Marc Lichtenfeld, Chief Income Strategist, The Oxford Club Marc Lichtenfeld, Chief Income Strategist, The Oxford Club By Marc Lichtenfeld, Chief Income Strategist &
Steve McDonald, Bond Strategist,

Income Debate Series

Managing Editor’s Note: Reverse mortgages are a hotly debated topic among income-seeking retirees. Whether or not this controversial type of loan makes sense for you depends on your personal financial situation. In today’s special edition of Wealthy Retirement, Marc Lichtenfeld and Steve McDonald parse through the costs and benefits of this tricky income tool. They don’t see eye to eye on everything, but they do agree on several key points. Check out the video, then chime in with your two cents by leaving a comment.


Transcript:

Steve McDonald: Hi, everybody. I’m Steve McDonald. Welcome to a special edition of Wealthy Retirement. Today, Marc Lichtenfeld and I are going head to head once again. This time, on the topic of reverse mortgages. So, let me start.

Reverse mortgages. What do I like about them? Well, 40% of baby boomers have $20,000 or less saved, and a big percentage have nothing saved for retirement. Now, that probably means they’re going to get somewhere around $1,300 to $1,500 a month from Social Security. With only $20,000 or less saved, they’re in very, very bad straits.

So reverse mortgages are one of the solutions that are available to people. I agree that they can be a little expensive, but reverse mortgages allow you to stay in your house. A bank or a group will literally buy your house from you and pay you either a lump sum or monthly amounts. You get to stay in your house. You can use that income as a supplement. And, for people who are in the position where they haven’t saved enough, it’s a great lifeline available today.

Are they expensive? Marc is going to go into that. Just as with any other mortgage, you have an interest rate. And they do charge you a 1.25% fee to guarantee the loan. That means that even if your house drops to zero in value, you still don’t owe anything at the end of that. They can never take more than the value of the loan, which is not a perfect situation. It does add up, but I’m going to let Marc tell you all about that. Go ahead, Marc.

Marc Lichtenfeld: Steve, you used a key word: lifeline. That’s really who this is intended for… folks who need a lifeline. Those are the ones who should use it. People who are absolutely desperate and have no alternatives for cash, because reverse mortgages are very expensive. You mentioned that 1.25% fee. That’s for mortgage insurance.

When you buy a house, if you can put down 20% as a down payment, you don’t need mortgage insurance. But with a reverse mortgage, you will always be charged mortgage insurance. So that’s 1.25% annually every year on top of the interest rate you’re paying.

You also get charged another mortgage insurance fee upfront when you take out the loan. That can be anywhere from 0.5% to 2.5%. That will come off of the amount that you receive.

Lastly, these loans are expensive in terms of the interest rates. They are typically well over a point higher than what you might receive on a traditional loan. So if you borrow $100,000, over 20 years that debt will grow to $400,000. So these loans get expensive.

They compound monthly and annually just like a regular mortgage, except that with a regular mortgage, you’re paying down the principal. Here the money just keeps compounding higher and higher. That goes for any fees that you owe, including those 1.25% mortgage insurance fees and closing costs. All of these things just keep compounding month after month and become very, very expensive when it’s time to settle up.

Steve McDonald: Let me throw in one more point there. In a perfect world, we wouldn’t have reverse mortgages – because you’re right, these things aren’t cheap. But in a situation where it’s the only alternative to being evicted, which is a very real concern, I think it’s a viable option. As you said, I wouldn’t recommend it to everyone, but I think it’s viable.

Marc Lichtenfeld: Yeah, I do think it’s viable, as I said, to somebody who’s truly desperate. One of the other things that I want to talk about is what happens when it is time to settle up the loan. The triggers for closing the loan and paying it back are when the borrower passes away or moves out of the house.

As you mentioned, you can never owe more than the value of the house. So if you borrowed $400,000 but the value of the home decreased to $300,000, that’s actually somewhat of a good situation for your heirs because you couldn’t owe more than the $300,000.

That being said, your heirs could end up owing more than the value of the house in this scenario. Let’s say they owe $300,000, and the value of the home is $300,000. They’d have to pay the $300,000, plus 6% in commissions to the real estate agent. And they might have to pay other closing costs, which can be anywhere from 1% to 2%.

So your family or whoever inherits the property could be on the hook for tens of thousands of dollars, depending on the size of the loan. Chances are they’re not going to have that kind of money if you’ve been in such desperate straits that you had to take out a reverse mortgage. So that’s another area that I really don’t love about these reverse mortgages.

One other thing I do want to mention is that if you move out (let’s say you go to a nursing home or long-term care facility) and you’re out of the house for a year, the loan terminates. You have to pay it back. Chances are, if you’re in a long-term care facility, which is very expensive, you’re not going to have a lot of extra cash lying around to pay back that six-figure loan. So when it’s time to settle up, it’s not always a pretty picture.

Steve McDonald: You are essentially selling your house. You’re not moving out of your house, but you’re essentially selling your house. They’re giving you a lump sum or a set monthly amount for a fixed period of time, depending on how you want to draw from it. But as with the sale of any house, you’re going to have closing costs. Is there going to be enough money to pay the closing costs? That’s something I think you can probably work into the plan when you initially take the money if you’re that concerned about your heirs.

But let’s look at some other applications. Sometimes people look at these as only an all or nothing. You take all of the equity out, or you take nothing. That’s not the case. For example, there are lines of credit that you can set up that don’t cost you anything to set up, really. Nothing to speak of. And you don’t have to use that cash. That’s an emergency fund – a slush fund if you will – on the side. You can take the money from that and pay off your house. Sixty percent of reverse mortgages are used to pay off existing mortgages.

There’s always the possibility at the end of the deal that somebody’s going to have to pay a closing cost… but what’s the alternative? If a person is in desperate straits, do you let them be evicted? That’s basically what it’s going to come down to for a lot of people.


But one of the more interesting applications for this thing is to delay taking taxable distributions. We all have the 401(k) and the IRA problem. When we have to take money out of these, it’s all taxable. So if you retire, let’s say at your full retirement age of 66, but you want to delay taking your benefits, that’s another application. So you could use the money from a reverse mortgage to delay taking your benefits. Then, you could get the higher Social Security benefits and use some of the cash for those four years to pay your bills.

The other possibility is using reverse mortgage funds to avoid taking your taxable distributions for as long as possible. When that money comes out of your 401(k) or out of your IRA, it’s taxable. But if you have this line of credit set up, you can actually take money from this tax-free. But I wouldn’t advise using all of it. You don’t want to get stuck in the situation where your heirs are getting stuck with big bills.

There are a lot of practical applications for reverse mortgages. I agree with some of your points, Marc, but I’m in a different position. I’m older. I look at these things a little differently, from a different angle, but there is an application here for this.

Marc Lichtenfeld: Yeah. As we’ve both been saying, in most cases reverse mortgages are an option for someone who’s really desperate to stay in their home and doesn’t have a lot of alternatives. I will disagree with what you were just talking about – using the money to delay taking money out of a retirement account. I’m very conservative, and I don’t recommend taking on extra debt when it’s not absolutely necessary.

So to me the idea of incurring these costs and having to pay, let’s say, a 4.5% to 5% interest rate on a loan in order to defer taking money that is available already isn’t a wise financial decision. Yes, you have to pay taxes on your distributions, and in the case of Social Security, perhaps you’d receive less if you deferred for a little while longer… but I just don’t like the idea of taking on unnecessary debt.

Steve McDonald: Yeah, I don’t like unnecessary debt either. In fact, I generally don’t  encourage taking on debt. When we started this, I said reverse mortgages are a lifeline. There is some flexibility that makes them a little less of a lifeline for some people, but as far as incurring more debt, it beats the heck out of living in the street or having to move into your kid’s basement.

Marc Lichtenfeld: I certainly can’t argue with that. One other thing I did want to say is that you have to be fairly savvy or at least competent with your money management skills. It’s very often desperate homeowners and seniors who take out reverse mortgages, and often these people aren’t paying their property taxes because they are in such desperate straits. Even once they get the money from the reverse mortgage, they’re not maintaining the home, which is required under the terms of the reverse mortgage.

So you can take this money, but if you’re not paying your property taxes, you can be foreclosed on. Or you could end up needing long-term care, for example, but perhaps in the home, you borrow $100,000 to $200,000. That money goes very quick if you need 24-hour care in your home. After two or three years, the money’s gone. You can’t afford the care, and you have to move out of the house because you have no more money and you can’t afford the care and you have to go into a nursing home.

So you have to be very careful with the money you receive and know that you can manage it properly.

Steve McDonald: Yeah. I couldn’t agree more about the cash management. But one of the things that’s required now is a check of your ability to pay your taxes or your insurance. It’s required, just like a credit check, as if you were getting a regular mortgage. You’re required to demonstrate that you have the money to pay your taxes and insurance because a huge number of these things defaulted before the new regulations went into effect. So it’s definitely something you have to think about.

My last point is, as I said in the beginning, that if you’re going to be put out of your house for taxes, you’re going to be put out of your house for taxes whether you take this or not is what it comes down to.

Marc Lichtenfeld: Right. My last point is if this is a product that you’re interested in, please be sure you completely understand all the fees and all the procedures for loan repayment because sometimes these things are not very clear. Reverse mortgages are a complicated product. They can certainly help some people, but they can do a lot of harm if you don’t know exactly what you’re getting into.

Steve McDonald: I couldn’t agree more. Know the facts. Know the cost. If you don’t understand it, pay an accountant or pay an attorney to help you navigate the costs and benefits.

Marc Lichtenfeld: Absolutely.

Steve McDonald: So, Marc, thank you so much. Once again, excellent exchange. Good points. I win.

Marc Lichtenfeld: We’ll see about that. We’ll see what they say in the comments section.