A retirement plan that lenders have been pitching in the past 10 or so years is the reverse mortgage. Despite almost everyone being aware of the term, most people understand very little about this concept. Thanks to a brilliant marketer somewhere, the term “reverse mortgage”, known officially as a Home Equity Conversion Mortgage (HECM), really got people’s attention. This concept of a reverse mortgage helped most people visualize a paid off house that suddenly becomes a bank account for their retirement years. The reverse mortgage option has been packaged as a life saver for baby boomers and property owners who are reaching their golden years.
Types of Reverse Mortgage Options
I was asked by one of our mailing list subscribers to shed some light on reverse mortgages, especially when it comes to making it a strategy for real estate investing. A reverse mortgage is basically a method to borrow equity back from your home without having to “pay it back.”
There are three different types of reverse mortgage options, all with various amounts of flexibility for your situation. They are: Lump Sum, Monthly Payments, and Line of Credit. Here’s a little more detail on each one:
Lump Sum – Your money is received in one lump sum payout at the time of closing.
Line of Credit – Draw from your loan whenever you choose and you are charged interest on what you take out.
Monthly Payments – Receive a payment from your lender each month for as long as you remain living in your home and continue to meet all loan requirements.
This article does a great job at comparing all three (Should You Take Out a Line of Credit, Lump Sum, or Monthly Payment with Your Reverse Mortgage?)
What Happens to My Home When I Die?
I think you may have already read between the lines and realized that for some of these reverse mortgage options, lump sum especially, you may not be leaving your cherished family home to the kids. If you think you are going to die soon (horrible and unsettling thought), you may have a lot of that reverse mortgage money to pass on, but of course, if you didn’t do a reverse mortgage, your kids could sell your house when you die and get money that way. So before getting too far, have that discussion with your children or next of kin and make sure they understand the decision you are making to pull equity out.
Let’s go into a little more detail on how your heir(s) could buy the property back. The lender lets you pick the lesser of the two:
- Pay the outstanding balance of the mortgage off – Interest accrues on the money you are borrowing, so if you die next year, your heir would pay almost the same amount that you borrowed. If you die in 20 years, the interest rate, around 4.92% according to ReverseMortgageAlert, will really increase the amount you’ll have to pay later. If the housing market has appreciated substantially, your children or next of kin may be better off paying the mortgage balance.
- Pay 95% of the appraised value of the property – Here’s another option…if the housing market does poorly and the home decreases in value, you could pick it back up for much less than the mortgage balance. This is obviously a very good decision in this case.
So in summary, once all that interest adds up, or if the house appreciates a lot, it will cost much more to obtain the property. In that case, it’s much less likely your child will get back her old bedroom with Star Wars wallpaper and Prince posters! It’s also important to note that your age is going to make a big difference on the reverse mortgage deal you get. If you are very old, and if you are “statistically” expected to die soon, you won’t get as much cash up front. This is very similar to how a life insurance policy works because they lose money if you die sooner than the statistical average, but they make money if you live longer than this average.
Reverse Mortgage Obligations
Before considering a reverse mortgage, remember that you still have to fulfill these obligations:
- You must be at least 62 years old.
- The existing mortgage, if any, must be paid off first.
- Occupancy – The home MUST be your primary residence. As mentioned earlier, don’t try to do this with an investment property.
- Maintain property costs – Have the ability to pay your taxes, insurance, and other fees such as Homeowners Association (HOA) fees.
- Property condition – Just as you have to keep up on your required property costs, you have to keep the property in good shape. Since the lender may end up getting your house (see #5), they want that house clean and valuable. Before you get your reverse mortgage, an appraiser will come by and inspect the property. If he/she finds a significant problem with your home, you will have to hire a contractor to fix the problem. Afterwards, the appraiser will come by and check your property to ensure repairs are done.
- Rights to own the property – The lender wants rights to the property after you pass away, or, they will either take 95% of the current appraised value or the mortgage balance, whichever is lesser. Check with your lender to get more details on this requirement.
What about Using a Reverse Mortgage for Real Estate Investing?
Wait a minute…you wanted to do a reverse mortgage for real estate investing. You wanted to borrow “HECM style” against a paid off investment property and that’s why you are reading this article. Nice try, but sorry…you can’t! The property used as collateral for your reverse mortgage has to be owner occupied…
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Now that we have that covered, let’s assume you want to take a reverse mortgage out on your primary residence to invest in real estate. Should you do that or not? This really is going to be a numbers game with the cost of borrowing money. Just as you would run the numbers on bank financing for a potential rental, you need to think of reverse mortgages as the same.
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One concern with reverse mortgages is that the closing costs are high. Check out this Reverse Mortgage Calculator to run a hypothetical (or actual) scenario on a property. This calculator gives you an estimate of how much money you would get in lump sum or a line of credit, depending on the option you choose. How much money you get is dependent upon your age, the interest rate of the loan, and the value of your home. This dollar amount is known as the initial principal limit.
The initial principal limit is the amount of funds that you’re able to receive from a reverse mortgage before closing costs. The rule of thumb is that you can take out up to 60% of this “initial principal limit” in the first year of the loan, according to consumerfinance.gov. Make sure to talk with a lender to get exact details, depending on your situation.
As with any investment you make, run the numbers (you can use our free tool), do your due diligence, and see if your financial situation is really going to improve or not. The closing costs and equity you lose in your home may really knock your net worth down compared to the benefit you’ll get out of the rental property.
[bctt tweet=”Before you should even consider a reverse mortgage, look at the rest of your options!!”]
Do You Need ALL of Your Equity?
Reverse mortgages are typically are for people who want all the equity out and don’t care about passing the house on to their kids or next of kin. If you just want “some” of the money for an investment, consider a Home Equity Line of Credit (HELOC) or even a standard Home Equity Loan. Want to know the difference? Check the video and blog from BankRate below.
Are You Truly Out of Options?
One interesting fact that most people don’t know about reverse mortgages is that they’ve actually been around for quite a while. Back in the 70s and 80s, however, they were used as a last resort option. It definitely wasn’t meant for vacationing on fancy cruise ships, buying luxury cars, or paying for country club memberships. But, you stopped by AssetRover because you want to do something smart with your money! You are going to invest that money into real estate to get passive income, tax benefits, and a physical investment that you can pass to your children when you leave this world.
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You might have already tried the bank route via a traditional mortgage, HELOC, and Home Equity Loan and things just didn’t work out. They see your financial situation or credit situation and don’t see how you are going to pay that monthly fee. Reverse mortgages have fairly minimum requirements since they get your home if things go sour.
There Are Many Ways to Pull Equity Out of Your Property
One thing to remember here is that no matter which alternative you look at, you have a physical piece of real estate that’s either paid off or has a lot of equity in it. Your home is likely worth a substantial amount of money. The bank gave you money 30 years ago to buy this home when you hardly had any equity. Usually, they’d be happy to put a lien on your property again! A lien does need to be paid off though, and you now have a house payment again.
Sometimes a solution to an immediate problem is attractive, but in the long run, it may be detrimental to your financial success. A reverse mortgage could be a great way to get extra money to help you enjoy your life and still keep your house; however, if you’re still looking to ride the wave of real estate investing a little longer, you may be better off looking at more traditional methods instead of using a reverse mortgage for investment cash. Whatever you do, look at the long term consequences of your decisions–whether you’ll be around to see the end results or not!
WARNING: Reverse mortgages, lines of credit, and other financing can be complex. Decisions like these, usually life changing MAJOR decisions should never be made based on reading one blog post on the internet. PLEASE consult with your financial advisor, lender, attorney, and other trusted members of your network to make sure your decisions really meet your financial and life goals! You can also talk to a reverse mortgage counselor. HUD-approved housing counselors can be found at HUD’s counselor search page or calling HUD’s housing counselor referral line (1-800-569-4287).