Reverse mortgages and their alternatives

Living off your home equity

Consumer Reports Money Adviser: February 2012

Home equity represents about 70 percent of the total assets of middle-income retirees, not counting Social Security and pension benefits. Many people, even those who hope to leave their house to their children, often have no choice but to tap their home equity when facing financial or health crises.

One option for people in such situations is to take out a reverse mortgage, which lets them draw on their home equity while continuing to live at home. But the loans are costly and complex, and many consumer advocates say they should be viewed as a last resort. So you might want to evaluate all possible options before you face such a crisis.

“The decision to tap home equity needs to be made as part of an overall financial plan,” says Barbara Stucki, vice president for home-equity initiatives at the National Council on Aging in  Washington, D.C. “You have to be mindful of the fact that home equity is finite, and that if you really run into problems you can lose your house.”

There’s no best way to draw on your home equity; all of the alternatives have their pluses and minuses. Here’s what’s important for you to know:

Reverse mortgages. The main attraction of these loans, which are available to homeowners ages 62 and older, is that they generally don’t have to be repaid until you die, move out of your house permanently, or sell it. The amount you can borrow depends on your age (the older you are, the greater the amount), current interest rates, and the value of your home. The lender gets the principal back with interest when you or your heirs sell the house. If it sells for more than the loan balance, your heirs keep the difference.

The Federal Housing Administration, which insures most reverse mortgages through its Home Equity Conversion Mortgage (HECM) program, protects lenders from losses if borrowers or their heirs can’t sell a house for more than its loan balance. After real-estate prices crashed in the late 2000s, the FHA increased the ongoing portion of the mortgage insurance premium that borrowers pay from 0.5 to 1.25 percent of the reverse-mortgage balance. That insurance, plus interest charges, loan origination and servicing fees, and closing costs make reverse mortgages expensive.

Lenders can foreclose if you fail to maintain your house, pay property taxes, or pay homeowners insurance premiums. Last fall, the agency told lenders they could start considering an applicant’s ability to make those payments before approving a loan. MetLife Bank, a major reverse-mortgage originator, is already doing so, and the Department of Housing and Urban Development is expected to start requiring lenders to do so within the next year.

Homeowners have several types of reverse mortgages to choose from. Fixed-rate reverse mortgages typically require borrowers to withdraw the full loan-limit amount at closing, and interest accrues immediately. With an adjustable-rate reverse mortgage, by contrast, you can draw on your equity only when needed, and interest accrues only on the funds you take. The proportion of fixed-rate reverse mortgages issued in fiscal 2010 soared to 69 percent, up from 11 percent the previous year.

If you need to borrow a relatively small amount of your home equity or if you don’t plan to stay in the house for very long, an HECM Saver loan, which the FHA introduced in 2010, is a better option. You pay an up-front mortgage-insurance premium of just 0.01 percent of the maximum amount you can borrow, compared with 2 percent for a standard HECM. On a $200,000 home, that means an up-front payment of only $20 vs. the standard $4,000. But loan limits are 10 to 18 percent lower, and interest rates have been 0.25 to 0.5 percent higher for Savers than standard HECMs, according to the AARP Public Policy Institute. Loan origination and other fees might also be higher.

So prepare to shop around if you’re considering a reverse mortgage. Before you call any lenders, you should talk with a counselor approved by the Department of Housing and Urban Development. Indeed, you must do so by law to qualify for a federally insured HECM. (To find a counselor in your area, go the HECM counselors website and click on “Consumer Resources.”) It also makes sense to consult a certified financial planner, a certified public accountant, or an elder-law attorney before you call lenders.

Home-equity loans or lines of credit. These loans are less expensive than reverse mortgages and might be appropriate if you need cash to make a major home repair, for example. Of course, you must have the means to make monthly payments or you won’t get a loan. Proceed cautiously if your income is fixed or your health is declining, because you might not be able to keep up with the loan payments. “You’re loading your house up with debt, and that can be risky,” says Charlie Farrell, an investment adviser with Northstar Investment Advisors in Denver. “You might lose your home if you can’t pay the loan.”

If you have a low income, find out if you qualify for city and county grants and low-cost home-improvement loans. For information about such loans and other reverse-mortgage alternatives for low-income seniors, go to the HUD website.

Downsizing. You can sell the old homestead, buy a more modest house or condominium that’s less costly to maintain, and invest the money that’s left. Or you can sell your house, invest the net proceeds, and rent a smaller one or an apartment. “If you get $300,000 for your house, you could pay $1,000 in rent for 300 months, or 25 years,” Farrell says. “If you earn 3 percent a year on your invested equity, it will last even longer—probably longer than you’re going to need it to last.”

How your family can help

If your children or other family members are in the right financial position, consider these options:

A sale-leaseback agreement. You sell your house to one or more of your children, and then rent it back using the cash you get from the sale. You might be able to exclude up to $250,000 in taxes from what you gain on the sale ($500,000 for married couples filing jointly). As landlords, your kids will get rental income and tax write-offs. Consult an accountant to make sure that the math works for your family and that the deal will pass muster with the Internal Revenue Service. You’ll have to prove that you’re conducting what’s called an arm’s length transaction. If you sell your house to your son for a fraction of its market value, for example, the IRS might contend that you gave him a gift and tried to dodge the gift tax.

A private reverse mortgage. You benefit because your children will charge you less than commercial lenders, your up-front costs will be lower, and there won’t be ongoing mortgage-insurance expenses. The interest rate you’ll pay, which the IRS sets each month, is lower than what commercial lenders charge. Plan to hire an accountant or attorney to help you structure the loan to satisfy the IRS and draw up a new deed and other paperwork.

Here is how it might work: Your child agrees to give you a monthly check and pay for any major home repairs. You agree to repay the loan principal and compounded interest, plus any money he spends on maintenance. Typically, your child will be paid back when he sells the house after your death.

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