The Allure of Reverse Mortgages

For many elderly homeowners in the years ahead, there will be little choice other than a reverse mortgage. With increasing longevity and spiraling energy and health care costs pressuring fixed income cash flows, time is their enemy, and time will not wait.

A recent (and highly unscientific) survey, as reported by a relative who had just attended their retired teachers meeting, showed that 40 percent of this demographic group relies on reverse mortgages to make ends meet.

Of course, a sample size larger than a banquet table with a seating capacity of ten is likely required to more accurately assess this growing trend, but the results were no less shocking. Four out of ten!

These were all former co-workers and long-time friends - retirees trying to enjoy their golden years while at the same time keeping the house warm, staying current with their medication, and having a little bit left over to maybe have some fun while body and mind are still willing.

The Boom that Keeps Giving

This story from last month's Money Magazine does a pretty good job of describing what reverse mortgages are and how they are used.

It begins with that sorely missed, 2005 Money Magazine housing boom spirit, where it is learned that housing prices that have "more than doubled" are the source of "new riches" and the cause of "bloated equity" (if you're old, and something has to be bloated, your home equity is probably the best of all possible scenarios):

As real estate prices in large parts of the country have more than doubled during the past five years, homeowners have found plenty of ways to cash in on their new riches.

Many are trading up to an even bigger house or borrowing against their bloated equity to remodel the kitchen, buy a vacation home or consolidate debts.

But for one group, these paper riches are just that. If you're retired with no plans to downsize and no desire to add loan payments to your budget, how can you benefit from your real estate wealth?

Apparently, the older generation isn't comfortable with the approach adopted by so many of their children for perpetual prosperity through perpetually rising real estate values. You see, when the younger generation taps their home equity, they are sure to withdrawal sufficient cash to handle the new debt service.

This is the "home equity withdrawal as income" theory - borrow enough to cover the interest on the new debt (as if your income had risen) until housing prices rise sufficiently, or interest rates fall, and the whole thing can be refinanced to make the new debt seemingly vanish.

So What's a Senior to Do?

But many seniors see through this approach. They see it for what it is - just more debt that someone has to pay back at some point, and many seniors don't like debt.

Enter the reverse mortgage -- a loan that lets homeowners age 62 and older take money out of their home and never have to move out or worry about paying it back.

Think of a reverse mortgage as the mirror image of a traditional mortgage. When you borrow to buy a house, your monthly payments whittle away at your debt and build up your equity over time.

With a reverse mortgage, you gradually take that equity out and increase your home's debt. The bank doesn't collect the principal and interest until you or your heirs sell.

Although reverse mortgages still represent only a small fraction of home loans, demand for these once obscure financial products has grown exponentially. Last year more than 43,000 homeowners took out a reverse mortgage. In 1990 about 150 did.

Despite their high cost, in another five or ten years that 43,000 figure from last year is probably going to look a lot like that 1990 total of 150 looks today.

Two examples in the story had fees of $10,000 on a $200,000 loan and $8,000 on a $50,000 loan - the first guy probably didn't realize what a good deal he was being offered.

Reverse mortgages are not cheap, and a big part of the reason for this is that the counter party is assuming risk far beyond that of a traditional lender and they want to be rewarded for this risk. Actuarial tables are used to estimate life expectancy and both interest rate risk and future home values are factored into the mix.

In the end, the lender/insurer will profit - at the expense of the homeowner.

But to some the high expenses are justified by the convenience that reverse mortgages offer - just sign on the dotted line and instead of money flowing from the house to the bank, the direction reverses.

But, What About My Inheritance?

Instead of continuing to make payments, with the "oh so quaint" goal of owning their residence "free and clear" as they used to say, many seniors may soon look at their spendthrift offspring and reconsider the lessons they learned when they were young and times were tough.

Instead of maintaining the goal of passing on their home, unencumbered by anything other than inheritance taxes and probate lawyers, some seniors may consider spending a little more freely both on the convenience of a reverse mortgage and themselves, knowing that the kids won't find out just how expensive that reverse mortgage really was until they settle up after the funeral.

Someday your mortgage has to be paid off, either in cash or when the house is sold. Although mortgage insurance ensures that you or your heirs won't owe more than your house is worth, it's entirely possible to drain your home's equity, leaving your children with little or nothing.

One reason is that when the loan comes due, the bill is for what you borrowed plus fees and interest, and rates on reverse mortgages are not fixed. The annual rate, recently 8.3%, is the rate on a one-year Treasury bill plus 3.1 percentage points and 0.5 points for insurance. Over the life of the loan, your rate can't rise more than five points. At today's rate, a homeowner who borrows $100,000 would owe $222,000 in interest and principal in 10 years.

Part of the reason that the fees are so high is because of that pointy thing to the right.

For the lender/insurer, it's all about value, time, and risk, and while there are sure to be losers as this market heats up in the years ahead, most participants in the reverse mortgage business will sufficiently cover their risk exposure.

This coverage, however, will not be cheap - to the deceased or to the heirs.