What exactly is a reverse mortgage?
You may have heard the term “reverse mortgage of CHIP mortgage” before on TV or in an advertisement, but may be questioning what exactly it means and if it would benefit you.
A reverse mortgage is a specialized lending product that provides short-term cash for people who are over 55 years of age, have substantial equity in their home (or own it free and clear), and still plan to live in the home for many years to come Does this last line matter? Qualifying is relatively easy and that is why people lean towards taking out one of these loans. Homeowners can receive anywhere from 20-55% of a home’s value through a reverse mortgage. They offer an attractive lending option for people that often do not have a steady source of income to qualify for other types of loans. In cases where large expenses arise such a hefty medical bill, a home repair, or if the retiree simply wants additional income to help them through retirement, a reverse mortgage seems like an ideal solution to free up some of your home’s equity for some tax-free income.
Enticements of reverse mortgages are that the homeowner will not have to make monthly payments, will never owe more than the value of the home, will never be forced to sell or move (unless they fail to pay property taxes, insurance, and maintain the home). At first glance, it appears to be an ideal situation for the homeowner, but as the saying goes, “if it’s too good to be true”, it likely is.
Disadvantage of Reverse Mortgages
Reverse mortgages result in a steady erosion of home equity. Rather than paying down a mortgage, the mortgage balance increases at an alarming amount. Due to the risk that the lender must take in lending out the funds, these reverse mortgages are designed to accrue and compound interest for the duration of the loan. With high prepayment penalties, closing fees, and above market interest rates, a snowball effect occurs and the payout amount ends up being much higher than expected.
You may not have people to leave the property to, or benefit from its equity, but what happens if 1) you do need to move later in life or require the equity to be placed in an extended care facility, 2) you pass away before your spouse, 3) you fail to pay property insurance, or incur a cost that affects your ability to maintain the home, etc? Suddenly what seemed like an easy income solution has left you with a big financial problem, and in some cases a foreclosure. A situation many do not want to be in, especially in one’s Golden Years.
We recently had a retired client with a reverse mortgage on his title, who got behind in property tax payments. The municipality was wanting to commence offering the property for sale. Looking for a solution to pay off the arrears and avoid foreclosure on the home, he learned that he no longer had enough equity in his home to borrow against it anymore. The compounded interest owing that came from the reverse mortgage diminished all of the remaining equity in the home. Within a matter of years, this poor gentleman went from owning his home free and clear to having less than 20% equity, not even being able to sell the house, and therefore inevitably losing the home.
In another recent case, a title owner took out a reverse mortgage ten years earlier for $341,000.00. The recent payout statement received showed a balance owing of $592,000.00. The prepayment penalty and (mostly) interest had amounted to over $250,000.00 within a ten year period! The home was deemed not worth much more than this amount, so she could not sell or realize any equity from her home.
If it sounds too good to be true….
As appealing as it may sound on the surface when looking at using your home as a source of income, it is so very important to carefully weigh the risks of borrowing against other options that are available to you. With reverse mortgages, the interest normally accumulates faster than the value of the property, so you are rarely ahead of the game. Your home is used as an ATM machine to your detriment.