How Reverse Mortgages Can Fill the Retirement Income Gap

Who qualifies, and how much can be borrowed?

Reverse mortgages make sense for retirees who wish to remain in their home, who need some additional income and who are not concerned about leaving the equity in their home to their heirs, says Wade Pfau, professor of retirement income at The American College of Financial Services in Bryn Mawr, Pennsylvania.

“It can be an effective part of a retirement income plan, but it is going to have a bigger impact for the middle class or the mass affluent because the reverse mortgage is calculated only on the first $636,150 value of the home,” Pfau says.

There are some conditions that have to be met before a person or a couple can qualify for a reverse mortgage, says Steven Klein, mortgage director at AmCap Mortgage in Greenville, South Carolina. At least one of the borrowers has to be 62 or older, and it must be their primary residence, Klein says. It needs to be a single family home, or a Federal Housing Authority-approved condominium, townhome or mobile home, Klein says.

In addition, if the borrower has an existing balance, they must use whatever amount that is from the reverse mortgage to pay it off completely, Pfau says. For example, “If I still have a $100,000 mortgage, and the reverse mortgage gives me $300,000, I would have to pay that off immediately and be left with $200,000,” he says.

Furthermore, the borrower must maintain the property in good order and keep up with their real estate taxes and insurance, notes Tim Hewitt, senior wealth advisor at Wiley Group in Conshohocken, Pennsylvania.

NEXT: How much can be borrowed

Generally speaking, the value the bank will allow a person to borrow against their home is 50% at age 62, after closing costs, Klein says. At age 62, the exact loan to value percentage is 52.4%, Klein notes. As people age, that rises: at age 72, it is 59.1%; at age 82, 67.4%; and at age 90, 75%. The reason for that is, “the older the borrower is, the lower their life expectancy.” Klein says.

So, if a 62-year-old wants to retire but wait to collect their Social Security until they are 70 in order to receive the highest possible payment, Klein says, they might turn to a reverse mortgage and rely on that money in the eight-year interim.

Increasingly, however, reverse mortgage borrowers are taking out the loans and letting them sit there as a standby line of credit before accessing the money, Pfau says. This is because the money grows with interest over time, and the interest is higher than a traditional mortgage, typically ranging from 2.5% to 4% a year, tied either to the one-month or one-year LIBOR, he says.

Klein says the reverse mortgages he has overseen have actually grown 5% to 6% a year. “So if you are awarded a $100,000 reverse mortgage, a year from now that might grow to $106,000, and with compounding growth, 10 years from now that could potentially grow to $200,000,” he says.

Essentially, Pfau says, reverse mortgages are like home equity lines of credit except their value grows over time, it is not required to be repaid until the loan becomes due (when the borrower leaves the home or passes away), and it cannot be frozen, cancelled or lowered in value, he says.

Reverse mortgages do give retirees additional sources of income in retirement and, because they are tax free, do not impact Social Security or Medicare, Hewitt says. “I have brought this up to clients when they are barely able to pay their bills, really need an additional source of income and don’t know where to go,” he says.

But Hewitt makes sure to ask his clients if they want to leave their home to their children or other heirs, in which case a reverse mortgage really isn’t an option. Also, if they are planning to live in a retirement community down the road, the reverse mortgage may not make sense, because it is costly to get into one due to origination fees that can be 1% to 2% of the value of the loan, he adds.