Editor’s Note: Through our Financial Literacy archive, we hope to uncover strategies you may not have encountered before as well as offer straightforward opinions about financial choices that, though popular, are not in your best interest.
Marc’s Amazon best-seller You Don’t Have to Drive an Uber in Retirement shares the same goal – in fact, in addition to discussing reverse mortgages in more detail, Marc fills his book with actionable techniques for optimizing your income and protecting your savings.
– Mable Buchanan, Assistant Managing Editor
Why is it that washed-up TV stars from the 1970s and 1980s always seem to end up in commercials aimed at fleecing you?
Erik Estrada hawking real estate in California right before the housing bust? Sure, that makes sense. I don’t think he’s done much since CHiPs.
But my heart broke when I saw Henry Winkler, who you may fondly remember as “The Fonz” from Happy Days, peddling reverse mortgages. And now even Tom Selleck of Magnum, P.I. and Jesse Stone fame has become a reverse mortgage pitchman.
Selleck’s client, American Advisors Group, hopes that his devilishly handsome mustache will goad you into using an expensive financial product that can cause more harm than good.
Let me just say right upfront – I’m not a fan of reverse mortgages.
That doesn’t mean they’re a bad choice for everyone. Certainly, some people can benefit from one. But let me explain why I believe that, most of the time, taking out a reverse mortgage is a poor decision.
Surely you’re familiar with a traditional mortgage. You buy a house, take out a loan and pay off that loan each month.
A reverse mortgage is, well, the reverse of that.
The loan balance is repaid only after you die or move out of the house.
Reverse mortgages are available only to people age 62 or older. You might choose a reverse mortgage if you’re having a tough time making ends meet and you need a source of supplemental income.
After all, a reverse mortgage allows you to receive lots of cash, and you don’t have to pay it back until you die (or move out). Sounds great, right?
Not so fast.
Fees, Fees and More Fees
These mortgage loans are typically expensive. They can cost thousands of dollars, much of which comes out of the money you receive.
In addition to the typical closing costs and title insurance fees that you’d pay to your lender, reverse mortgages include mortgage insurance premiums. (A regular mortgage would too if the borrower’s down payment were less than 20% of the home’s value.)
Typically, someone who takes a reverse mortgage would have enough equity in their home that they wouldn’t need to pay traditional mortgage insurance.
But with a reverse mortgage, that doesn’t matter. They still have to pay the mortgage insurance.
The insurance premium will be 0.5% if you take out less than 60% of the appraised value of the home and 2.5% for a loan of more than 60%. On a $300,000 home, that’s $7,500.
You will also pay a mortgage insurance premium of 1.25% annually. But this fee doesn’t come out of the sum you receive. Instead, it compounds over the life of the mortgage, and it’s repaid with interest when the loan is paid back.
But as they say on TV, “Wait, that’s not all!”
A monthly service fee of $30 to $35 is also deducted based on your life expectancy. So if your life expectancy is 100 months, that means an extra $3,000 to $3,500 will be deducted from the amount you receive.
Paying It Back
When you pass away, your estate has up to a year to pay back the loan. It cannot owe more than the home’s value at the time the loan is repaid.
That can present a problem, though.
Let’s say that when your heirs go to sell your home, it’s a weak housing market and they have trouble selling it – or they sell it for the appraised value, which matches what you owe on the loan.
After closing costs and 6% realtor commissions, they’re in the hole. They still owe that money.
Here’s an example: You owe $300,000 on a reverse mortgage. Your home is appraised at $300,000. Your heirs sell the home for the appraised value. They pay $2,000 in closing costs and $18,000 in commissions.
They receive only $280,000 at closing, and they have to pay the additional $20,000 out of their own pockets.
Let’s consider another scenario – let’s say you have to move out of your house and into an assisted living facility. The rules are the same. You or your family has one year to pay back the loan (in most states).
Generally, assisted living facilities aren’t cheap. Chances are you and your family would need every dollar you could get from selling your house.
But if you owe a significant portion or all of your home’s equity to the lender, it would leave little extra to pay for your care.
When Compounding Doesn’t Work in Your Favor
And don’t forget, a reverse mortgage loan compounds just like a regular mortgage does.
You know how when you bought your house with a $100,000 loan, you really paid back about $300,000 because of the interest over all those years? The same thing happens here.
The only difference is that, with a regular mortgage, you’re paying down principal and interest every month. With a reverse mortgage, you pay nothing.
Instead, all that interest compounds year after year. If you’re fortunate enough to live a long time and stay in the house, that compounding adds up to a big sum of money.
The bottom line? Reverse mortgages can be a lifeline for retirees who are out of cash and have equity in their homes; but for most people, they’re not nearly as cool as Fonzie would have you believe.
The next time a washed-up TV star tries to sell you something, tell them, “Up your nose with a rubber hose.”