How Reverse Mortgages May Back You Into a Corner

— -- You’ve probably seen the many commercials on television where actors plug reverse mortgages. They talk generally about the benefits of this financial product, but fail to tell viewers exactly what a reverse mortgage is.

Reverse mortgages are a way to get money out of your home through a contract with a lender who provides cash or a line of credit in return for interest and initial fees. These products can be structured as short-term loans that let borrowers get money as a lump sum, draw it down gradually over time through the line of credit or receive a payment based on the borrower’s life expectancy. Reverse mortgages don’t have to be as great as the equity you have in your home; borrowers can get a smaller amount.

Consumers of these loans are typically older people who need cash to pay living expenses in retirement but have substantial equity in their homes. Advertisements for reverse mortgages have become more commonplace since the market meltdown of 2008–09 sliced into the retirement resources of millions of Americans.

Many people who take out these loans have not saved enough to meet all their expenses in retirement or have had unforeseen expenses or market losses that have depleted their savings. Yet they don’t want to sell their homes. Some see reverse mortgages as a way to solve their cash problems and also stay in their homes. Yet, compared with other types of loans that use homes as collateral, some reverse mortgages can be costly because of interest rates charged and various up-front fees.

Many of these loans don’t require repayment as long as occupants are still living in the home with the understanding that the lender will take possession of the house upon their death. There are three basic types:

Single-purpose reverse mortgages. Offered by state and local government agencies and nonprofit organizations, these tend to be the least expensive. Most low- and moderate-income homeowners can qualify.

Federally insured reverse mortgage. Also known as Home Equity Conversion Mortgages (HECM), these are backed by the U.S. Department of Housing and Urban Development.

Proprietary reverse mortgages are loans from private financial companies.

HECMs and the proprietary variety are often more expensive than regular mortgage loans. HECMs have no income or medical requirements, and carry no restrictions on how borrowers can spend the money. All three involve home appraisals to assess the level of collateral. Whether a reverse mortgage is a good option for you depends on various factors, including:

Your health. If you anticipate that your or your spouse’s health will probably decline in the next few years to the point where an assisted living facility is needed, it may not be worth it for you to incur debt from the typically high up-front costs of a reverse mortgage. If the borrower vacates without having repaid the loan, the lender can force the spouse out if he or she isn’t on the loan as a borrower. To prevent this, both husband and wife should be on the loan as borrowers.

The condition of the house. When you have a reverse mortgage, you’re usually still responsible for all of your home’s upkeep, including maintenance (as well as utilities, taxes and property insurance). To protect their collateral, lenders typically require a certain level of upkeep. If you have to spend most of the cash you get from the loan on this upkeep, this may defeat your purpose — to get cash. Now that people are living longer, they end up doing a lot more maintenance on their homes during retirement. For example, decades ago, a retiree might pay for one roof replacement. Now, it could be two.

The stability of the neighborhood. You may want to stay in your home through retirement because you like the neighborhood. But over time, the neighborhood could go downhill, making it less pleasant to live there. You may like the neighborhood because you’re friends with your neighbors. But many of these friends will probably move out during retirement, seeking a less-expensive abode than a house with a few bedrooms that have been empty since the kids grew up.

Your plans for long-term care. If you and your spouse were to go into a nursing home at different times, would you have the funds to pay for both the upkeep of the home and a nursing home?

The terms of the reverse mortgage. Would it allow you to lease the house? What repairs have to be made over the rest of your life? Can the contract be cancelled? Under what conditions? What happens if the value of the loan is more than the house’s value? How big is the house? Is it more than one story? If so, what if you can no longer climb the stairs and have to install a stair lift?

Considering the costs of upkeep for a home, moving is often a good idea. Why pay to heat and air-condition empty bedrooms? Taxes and maintenance also take a toll on retirement income. Many people don’t consider these downsides of staying because they’re so sentimentally attached to their homes that they can’t think objectively about the costs of staying there. Some stay with the rationalization that they need a big place to put up the family during holiday visits, although these visits amount to just a few nights each year.

The fundamental paradox of the reverse mortgage market is that because people won’t sell the homes they largely or wholly own, they need a reverse mortgage to stay in them, and then they’re trapped financially and otherwise; they can’t afford to pay, so they must stay. If you own your home, selling it and getting an apartment or a small condo can free you from routine upkeep that can grow more burdensome as you age and free up cash needed to pay retirement expenses.

One reason people want to keep their homes during retirement is because paying them off was a lifelong goal achieved. But if you get a reverse mortgage because you feel you should necessarily stay in the home, you’re more trapped in some ways than you were when you had a mortgage. Then, at least, you could have moved out and leased the house to a tenant.

Because of the high costs of many reverse mortgages, it’s a good idea to consider all the alternatives before signing up for one. Whether a reverse mortgage is right for you depends on a range of factors and should not be entered into without a lot of deliberation.

This column is the opinion of the author and in no way reflects the opinion of ABC News.

Byron L. Studdard, a CERTIFIED FINANCIAL PLANNER™ practitioner, is founder and president of Studdard Financial, LLC, a fee-only financial advisory firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. Studdard has been listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research organization). He can be reached at Byron@studdardfinancial.com. If you have a question for him, send him an email and he will try to answer it in an upcoming column.