Reverse Mortgage: A Path to Tax Free Retirement Income
Reverse Mortgage Explained
A reverse mortgage (also known as a home equity conversion mortgage or HECM) is a loan available to people who are age 62 or older who want to convert part of the equity in their home into a payment stream. An advantage of a reverse mortgage is it allows the borrower to remain living in their home while eliminating a mortgage payment, which lowers their overall living expenses. A second advantage is that reverse mortgage payments are not income, they are a return of equity, so the payments are not taxed. The amount of money that can be accessed by a reverse mortgage depends on the age of the borrower, how much equity they have in their home, along with current interest rates.
Reverse Mortgages Come with Restrictions
To be eligible for a reverse mortgage a homeowner must live in the property as their primary residence for at least six months per year. Borrowers can only access a portion of their home's equity as the lender wants to be sure the loan and interest can be paid back when the property is eventually sold. Also, the homeowner may no longer have a mortgage payment, but they are still responsible for paying the property taxes and property insurance.
To be approved for a reverse mortgage the property must be in good condition, and it cannot be a mobile or manufactured home. The homeowner is also responsible for keeping the property properly maintained. The reverse mortgage stays with the property until the loan is paid back, usually after the borrower dies or leaves the home and the home is sold. Any sales proceeds left after paying off the loan would be given to the sellers or their heirs.
Reverse Mortgage Example
A couple, aged 70, has a home that is paid off and is valued at $525,000. At their age and using an interest rate of 3.25% they could access $285,000 through a reverse mortgage after paying $7,700 in fees. The $285,000 could be drawn down as needed or the couple could convert this loan into payments over a 15-year period and would receive $1,583 per month. After the couple dies or moves out the proceeds from selling their home will pay off the loan and the balance is left to their heirs.
Why People Choose a Reverse Mortgage
The reverse mortgage appeals to seniors because it is a way to access the equity in their home without having to sell their home and move. The loan balance can be drawn down only as needed to supplement a broader retirement strategy which can include retirement accounts, pensions, or Social Security Retirement Benefits. Some seniors use a reverse mortgage to supplement their income to delay taking Social Security Retirement Benefits until they reach age 70. This allows them to maximize their monthly Social Security Retirement Benefits.
A reverse mortgage works best if it is one part of a broader retirement strategy and not the primary source of retirement income, as the balance of the loan may be exhausted when the borrower still needs retirement income. Seniors who faced financial challenges, such as during the COVID-19 pandemic or the global financial crisis (2007-2009), were more likely to consider a reverse mortgage to bolster their monthly finances.
Risks with a Reverse Mortgage
Like many financial products, the devil is in the details and when reverse mortgages first gained prominence in the late 1980s some came with excessive fees which tarnished their reputation. Since then reverse mortgages have become more regulated. However, some reverse mortgages still come with high fees that make them an expensive way to access your home’s equity. For example, the initial mortgage insurance premium charged is 2% of the property value up to a maximum amount, and the mortgage insurance annual renewal fee is 0.50% charged annually on the outstanding balance of the loan.
Borrowers must also have sufficient resources to keep paying their insurance, maintenance and taxes; if not they could default on the loan and lose their home in foreclosure. Also, if a borrower must vacate the property they are not complying with the terms of the loan and could default. In a 2019 report, the U.S Government Accountability Office (GAO) found that defaults increased from 2% of loan terminations in 2014 to 18% in 2018, mostly due to borrowers failing to meet occupancy requirements or paying property taxes and insurance.
To help ensure that borrowers recognized all the risks with reverse mortgages, there is a requirement to attend a counseling session from a U.S. Department of Housing and Urban Development-approved counselor. This helps borrowers to better understand their loan options and to go through a financial assessment to ensure they are in a position to successfully manage the loan.
Alternatives to a Reverse Mortgages
There are alternatives to a reverse mortgage. One option is to access your home's equity through a home equity line of credit (HELOC). This is a far less expensive option, but a HELOC is requires monthly payments unlike a reverse mortgage. Like a reverse mortgage, the loan proceeds are not taxed as income.
A second option is a cash out refinance which allows a borrower to take equity out of their home, but, like a HELOC, this still requires monthly payments to repay the loan. The fees for refinancing a home are similar but usually a little lower than purchasing a property. With both a HELOC and a cash out refinance the borrower is able to stay in their home, but failure to repay the loan would lead to default and foreclosure.
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