May, 2003 Tax Newsletter

Reverse Mortgages

Whether or not you are elderly, everyone knows elderly people who might benefit from this month's Newsletter item. 

In addition to the over three-year-old bear market in stocks or stock funds, fixed income investors, many of them elderly, have also suffered. Even though falling interest rates did push bond prices up last year, many investors who owned bonds that matured or were called early saw their incomes drop dramatically when they reinvested their proceeds at significantly lower interest rates.

One way seniors can help bridge the income gap is through a reverse mortgage, a way to pull money out of your home without burdening yourself with monthly payments, as you would with a home equity loan.

While reverse mortgages are not suitable for everyone, low interest rates and rising home prices make them particularly attractive right now for those who can handle the high up-front fees and compounding interest charges.

Like an ordinary mortgage, a reverse mortgage is a loan. Instead of requiring monthly payments, the loan, plus interest, is repaid when the owner chooses -- or when the property is sold during the owner's lifetime or after his or her death.

Since there are no payments, one doesn't need a job or other income to qualify for a reverse mortgage. An applicant must use the property as a primary residence and must be at least 62 years old, though older homeowners can get larger loans.

If the home is sold after you die, your heirs will receive any money that's left once the debt, including interest, is paid. (Contrary to popular belief, the lender does not get the home.) If your heirs prefer, they can pay off the loan rather than sell the property.

Homeowners can take their loans as a lump sum, a fixed monthly income or a line of credit they can draw against whenever they wish.  As an example, a 75-year old who owns a $150,000 home could get a reverse-mortgage loan for nearly $98,000 today, compared to $84,000 when rates were one percentage point higher a year ago. There is no income tax, since the money is a loan rather than income.

The longer the loan is outstanding, the more interest is owed.  However, federal regulations limit the total amount owed to the value of the property. If the property value falls or if the homeowner lives to be very old, interest charges or money received on the monthly payment plan can exceed the property's value.  The older you are, the more money you can get. A 62-year old with a $150,000 home might get $83,000, while an 85-year old could get $113,000. This is a lender's risk and to minimize it they limit the initial loan amount, considering factors such as interest rates and the homeowner's life expectancy.  Also, if there is a previous loan on the property, a portion of the reverse mortgage must be used to pay it off.

In the same way, lower interest rates allow homeowners to lock in much larger loan amounts than they can get when rates are high. Once this loan amount is set, it is permanent, even if interest rates rise later. So it might be prudent to lock in now, while rates are low.

Although the homeowner doesn't make payments on the loan, low interest rates mean interest charges don't build up as much, so there's more money left for the homeowner or heirs after the loan is paid off.

As you might expect, there is a downside. The biggest one is fees, which can run substantially more than with a typical mortgage.  These include a fee of several hundred dollars to appraise the property, a loan origination fee of up to $2,000, an insurance premium paid at closing equal to 2 percent of the property's value, a monthly insurance premium that adds 0.5 percent to the loan rate and a monthly servicing fee of up to $35.

Another major drawback is that, since the borrower doesn't pay interest each month, interest charges compound -- interest is paid on interest.  Therefore, there is a likelihood of  paying much more interest than would be the case on a typical mortgage or home equity loan.  Because of this, it may make better financial sense to sell the home, buy a cheaper one and live off the difference.

The optimal candidate for a reverse mortgage is an elderly homeowner who wants to stay in a home, can't borrow elsewhere, needs the money and isn't concerned that compounding interest charges will chew away at the equity that can be left to heirs.

As each situation is unique, I would be happy to review your reverse mortgage potential or that of someone you know who may benefit.