The Risks and Rewards of Reverse Mortgages

As the worst financial crisis since the Great Depression guts real estate values, hammers 401(k)'s, and drives job losses higher, a disconcerting number of older Americans are facing a threat they never expected to encounter during their golden years: home foreclosure. In a first-of-its-kind study released last fall, AARP reported that Americans ages 50 and older accounted for more than a quarter of all home foreclosures and mortgage delinquencies in the second half of 2007. "The impact of a foreclosure is often more significant for older households, as they have less time and ability to recover the financial losses," the report concluded. "The problem is likely growing, as homeowners increasingly carry mortgage debt into their retirement years." But a unique type of loan enables seniors 62 years and older with enough equity in their home to tap a sizable chunk of cash and kiss their house payments goodbye. And for those who understand its features—as well as its risks—a reverse mortgage can be a valuable tool for reducing the financial pressures that arise in modern-day retirement.

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A reverse mortgage is a loan, secured by a house, which gives seniors access to the equity they've built up in their home. Unlike a traditional mortgage, the loan doesn't call for borrowers to make monthly payments. Instead, they receive cash—in monthly installments, a lump sum, or a line of credit—that doesn't have to be repaid for as long as they live in that home. The loan balance is due when the homeowner relocates or dies, and it's typically repaid with the proceeds from the sale of the home. "[If] you need some of your money that is stuck in your house like in a block of ice, we basically come in with a pick and dig it out for you," says Jeffrey Lewis, chairman of Generation Mortgage. "Seniors have a tendency to have lumpy demands for their money, and sometimes the only place to get it is the house."

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Since its inception in 1988, the Federal Housing Administration's program for reverse mortgages—which it calls "home equity conversion mortgages"—has expanded considerably. From 157 loans in 1990, the program grew to more than 112,000 last year, with the agency handling roughly 90 percent of all reverse mortgages today. In February, Congress raised the program's ceiling for reverse mortgages to $625,500, making even more funds available to seniors. The total amount of cash accessible depends on the borrower's age, the value of the home, and interest rates. Homeowners in their early or mid-60s can most likely borrow around 50 percent of what their home is worth, and an 80-year-old can probably borrow about 70 percent. And since lenders scrutinize the house—rather than the borrower—as the source of repayment for the loan, "it doesn't matter what your credit history is as long as you don't owe the government taxes or you are not behind on an FHA mortgage," says Josh Denney, associate vice president of public policy at the Mortgage Bankers Association.

Seniors are free to use the cash for whatever they please: to supplement a fixed income, cover rising living expenses, or take care of unexpected medical bills. "I have seen it used for people who still have a mortgage and for whatever reason they really can't afford [it]," says Ellen Bernards, a certified reverse mortgage counselor in Madison, Wis. "Sometimes people just say, 'You know, I have got a lot of money in the house. I want to spend it.'"

If handled properly, a reverse mortgage can be a nice way for seniors to reduce living costs or pay off expenses. But the product's potential risks have left some government officials unnerved. In a June speech, Comptroller of the Currency John Dugan said: "I am struck by some of the similarities to the risks of subprime mortgages: a vulnerable customer class; complex product features that can be difficult to explain and can be susceptible to deceptive marketing; nontraditional, asset-based underwriting; and the potential for skewed incentives for key distributors of the product." To help consumers better understand the product, U.S. News spoke with a number of reverse mortgage experts to pinpoint the potential pitfalls. Here's a look at three possible hazards and how to sidestep them.

1. Incomplete counseling: Before obtaining the loan, borrowers are required to speak with a reverse mortgage counselor who has been certified by the Department of Housing and Urban Development. (A list of approved counselors is available on HUD's website.) But in a report released in late June, the Government Accountability Office found deficiencies in HUD's counseling efforts. Although counselors in general provided accurate information about the main features of the product, they overlooked some key details. For example, seven of the 15 housing counselors the GAO examined failed to discuss with borrowers all of their alternatives to reverse mortgages.

That's significant because in many cases, a reverse mortgage isn't the best option. The product comes with upfront fees that make it unattractive for short-term financing, so anyone planning to change residences within a year or two should probably stay away. (And such fees can make products like home equity lines of credit less costly.) And by dipping into their home equity, reverse mortgage borrowers may be less likely to bequeath their property when they die. As a result, the loan might not be such a great idea for homeowners whose properties have been in their family for generations, says Christopher Fanney, the president and CEO of Seniors First Mortgage Company, which specializes in reverse mortgages. "A reverse mortgage is more of a last-resort kind of option," says David Certner, the legislative policy director for AARP. "It's generally for somebody who is older [and] plans on staying in their home for a longer period of time; they have a lot of equity tied up in the home but not much, if anything, in the way of other resources."

To get the most out of counseling, potential borrowers should do their homework; HUD and AARP have plenty of information about reverse mortgages on their websites. And although 90 percent of such counseling sessions are conducted over the phone, it's worthwhile to arrange a face-to-face meeting, says Peter Bell, the president of the National Reverse Mortgage Lenders Association. Don't just go through the motions—come to the session with questions, and don't leave until you've got reverse mortgages down cold. If you are unsatisfied or uncomfortable with your counselor, find another one.

2. Inappropriate investments: Borrowers will need one of the FHA-approved lenders, a list of which can be found on HUD's website, to handle their reverse mortgage. Finding a competent, honest lender is essential, as incidents of abuse have been reported. By allowing property owners to extract equity from their homes, reverse mortgages can give borrowers access to a great deal of cash. But along with the funds come risks, as unscrupulous lenders may pressure borrowers to purchase unsuitable financial products—such as annuities—with the proceeds of the loan. Eight states reported at least one case of such inappropriate selling of insurance products from 2005 through January 2009.

Reverse mortgage proceeds should be managed with extreme prudence because in many cases, the cash represents the bulk of the borrower's net worth. "The thing that people should not be doing with a reverse mortgage is trying to create wealth," says Lewis of Generation Mortgage. "Don't tap your house and go out and buy equity-indexed annuities or invest in your uncle's dry-cleaning store."

To find the right lender, get recommendations from others you know who have obtained reverse mortgages. And since the fees associated with the loan can vary from bank to bank, "I would recommend that a borrower talk to a couple of lenders that they feel comfortable with and compare what kind of deal they might get," says Bell of the NRMLA. In addition, Bell suggests checking with the Better Business Bureau or the state banking authority before settling on a lender. Aside from lenders trying to sell you other products, beware of those that pressure you to withdraw more money than you need, Bell says. (The exception is if you get a fixed-rate reverse mortgage, in which case you will most likely be required to take your proceeds in a lump sum.) Again, if you feel unsettled by your reverse mortgage lender in any way, find someone else.

3. Misleading marketing: In its investigation, the GAO found that certain reverse mortgage marketing materials contained potentially misleading statements. One of these claims was that the product allows borrowers to "never lose [their] home." That's not exactly true: While a reverse mortgage relieves a borrower of monthly mortgage bills, the borrower is still responsible for other costs. "Failure to [pay] the property taxes or insurance can result in foreclosure," says John Snyder, the manager of foreclosure programs for NeighborWorks America.

Unlike other mortgage products, reverse mortgages do not have a requirement for associated taxes and insurance costs to be escrowed—or set aside in a separate account—to ensure payment. That means reverse mortgage borrowers must budget enough cash to cover these costs. In his speech in June, Comptroller Dugan called on HUD to address this issue. Escrows for reverse mortgages "seem to make good sense from both the consumer's and the lender's perspective because of the significant home-loss risk that flows from nonpayment of taxes and insurance," he said.

A reverse mortgage borrower can also lose his or her home for not maintaining the property itself. As a result, a would-be borrower should be sure to have enough money set aside to mow the lawn, trim the hedges, and take care of any home repairs that may become necessary. Putting additional cash into a tax-preferred retirement savings account—such as a Roth IRA—can help ensure that seniors have sufficient funds to cover these and other expenses when they leave the workforce.

Finally, consumers should obtain information on reverse mortgages only from credible sources like HUD or AARP.