A reverse mortgage may sound like a good deal for cash strapped seniors.  You can turn some of your home equity into cash without having to sell your house.  The money you borrow is tax-free income, and you don’t need to make regular payments on the loan.

Some financial experts advise seniors to avoid getting a reverse mortgage and instead explore other options for retirement income.  Before you consider a reverse mortgage it’s important to understand how they work, what fees are involved, and some of the pitfalls to avoid.

What is a reverse mortgage?

A reverse mortgage is a loan designed for homeowners 55 years of age and older.  Unlike a traditional mortgage, you don’t make any regular or lump-sum payments on a reverse mortgage.

Instead, the interest on your reverse mortgage accumulates, and the equity that you have in your home decreases over time.  If you sell your home or it’s no longer considered your principal residence, you must repay the loan plus any interest that has accumulated.

The loan amount on a reverse mortgage can be up to half the current value of your home.  However, you must pay off any outstanding loans that are secured by your home with the funds you receive from your reverse mortgage.

You can decide how you want to receive the money.  You can choose to receive a lump sum payment or a loan that provides you with a regular stream of income (or a combination of the two).

Related: Consider A Life Annuity

Drawbacks of a reverse mortgage

The biggest disadvantage of a reverse mortgage is that it’s subject to higher interest rates than most other types of mortgages.  HomEquity Bank, the only national provider of reverse mortgages to Canadian seniors, currently charges 5.95% for a 5-year fixed term, and 4.95% on a variable rate term.

Another drawback is the equity you hold in your home will decrease as the interest on your reverse mortgage accumulates.

When you die, your estate will have to repay the loan plus interest in full within a limited time frame.  The time required to settle an estate can often exceed the time allowed to repay a reverse mortgage.

Since the principal and interest will be repaid to the lender when you die, there will be less money in your estate to leave to your children or other beneficiaries.

Costs associated with a reverse mortgage can be quite high. They can include:

  • higher interest rates than with a traditional mortgage or line of credit
  • a home appraisal fee, application fee or closing fees
  • repayment penalties for selling your home or moving within three years of obtaining a reverse mortgage
  • fees for independent legal advice

Related: Shopping For Mortgage Rates: Fixed Vs. Variable

Qualifying for a reverse mortgage

To see if you qualify for a reverse mortgage, a lender will look at the equity you have available in your home.  Lenders also look at your age, the location and market value of your home, and current interest rates.  Typically, the older you are, the larger the loan you will be able to get.

Final Thoughts

A reverse mortgage may seem like an attractive option for many aging baby boomers who lack the savings needed for a comfortable retirement.  However, before choosing to obtain a reverse mortgage you should consider cheaper alternatives.

Using your home equity to secure a different type of loan, like a home equity line of credit, can be a cheaper way to borrow while giving you more flexibility than a reverse mortgage.

Other options include selling your home and buying a smaller one, renting, or moving into assisted living or other alternative housing.

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