Are Reverse Mortgages a Good Idea for Retirees?

What They Are and How They Work

Reverse mortgages are home loans available to homeowners aged 62 and older who have substantial equity -- typically more than 50 percent -- in their homes. Unlike a traditional mortgage, the borrower does not need good credit or a job, although you cannot be delinquent on any federal debt, such as federal taxes. The chief distinguishing factor of this loan is that the borrower does not have to make any payments as long as he continues living in his home. Instead, the property itself repays the loan through its equity.

You have many options with a reverse mortgage. You can take one out on your existing home or use it to finance a new home. You can take out the money on your existing house as a lump sum, line of credit or monthly payment. You can choose between a fixed and adjustable interest rate on the lump sum loan. You can use the money for any purpose, although if you have an existing loan you must pay it off before or at closing with the loan proceeds or separate funds.

How much money you receive depends on a complex formula integrating your age, the value of the home up to a cap of $625,500 and prevailing interest rates for the loan. The older you are, the more your house is worth and the lower the interest rate, the higher your final loan amount will be. A unique feature of the line of credit is that the unused portion of the line grows at an interest rate of one-half percent over the rate you are charged on the used portion.

One of the well-reported downsides of a reverse mortgage is its cost. Prior to 2010, closing costs ran from between $7,000 and $20,000, according to the Federal Reserve Board, comparing disfavorably with an average of about $3,000 for a traditional mortgage. A large part of the cost arises from mortgage insurance, which is needed to repay lenders in case the house does not appreciate enough to repay the outstanding loan balance. In response to the high costs, the Department of Housing and Urban Development initiated the HECM (home equity conversion mortgage) Saver, which reduces the mortgage insurance premium substantially in exchange for a lower loan amount. Even the Saver closing costs are higher than costs associated with a traditional loan but, of course, you start paying back a traditional loan immediately. Not so with the reverse mortgage.

The loan comes due when you die, sell the home or move away for 12 months. Because you are not required to make payments on the loan (although you can if you really want to), the interest compounds on the principal. When the loan finally comes due, which could be decades later, depending on how long you live, the outstanding loan balance could be several times the original loan balance. Because the reverse mortgage is a non-recourse loan -- that is, neither you nor your heirs are personally responsible for repayment, you don't need to really worry about the balance. If you were planning on leaving your home to your children, there may not be any equity left after it is sold to repay the loan.