A reverse mortgage offers a way for an older homeowner to tap the equity in his/her home without having to move out of the home. But these complex financial products have potential downsides that are not always immediately apparent.
Bottom Line Personal asked Michael Gilfix, a fellow of the National Academy of Elder Law Attorneys, what homeowners need to know if they’re considering reverse mortgages…
What Is a Reverse Mortgage?
A reverse mortgage is a loan secured by the borrower’s home equity. The borrower can receive a lump sum…recurring monthly income… and/or a line of credit. Unlike with most loans, the borrower isn’t required to make loan payments until he/she no longer lives in the home, at which point the entire loan—including accrued interest and fees—must be paid off. Typically, a reverse mortgage is paid off by selling the home, though that’s not required. Homeowners must be at least 62 years old to qualify for the most common type of reverse mortgage, the Home Equity Conversion Mortgage (HECM).
Is a Reverse Mortgage a Good Idea?
A reverse mortgage can be appropriate in some situations. If an older homeowner has a strong desire to continue living in his home but lacks sufficient financial resources to pay for personal care or other services, using a reverse mortgage to tap home equity might be a viable option. But there are potential downsides…
A lengthy nursing home stay might force you to sell the home. One of the main selling points of a reverse mortgage is that the borrower can remain in his home as long as he likes and the loan need not be repaid until he dies or moves out. But moving out isn’t always a choice—if a health issue forces the borrower to live in a nursing home or assisted-living facility for 12 months or longer, the loan repayment is typically required even if the borrower wants and plans to move back into his home once his health improves. Exception: The home might not have to be sold under these circumstances if an eligible spouse or “co-borrower” is still living there.
You could face a big capital gainstax bill. As noted above, a reverse mortgage typically must be paid off once the borrower no longer lives in the home, and the usual way to pay off these loans is with the proceeds from the sale of the home. But if the home has increased dramatically in value over the years since its purchase, that could trigger an otherwise avoidable tax bill. Example: An older homeowner takes out a reverse mortgage on a home she purchased decades ago for $300,000 and that now is worth $1 million. When her health deteriorates, she moves out of the home and into a nursing home, which eventually means her reverse mortgage is due and she is forced to sell the home. But since the home has increased so dramatically in value—as many homes have in recent decades—the $250,000 capital gains tax exemption for primary residences isn’t sufficient to shield her from a big capital gains tax bill on this sale. If this woman hadn’t taken out a reverse mortgage, she could have held onto the home until she died and the “step up in basis” that her heirs received upon her death could have meant that no capital gains taxes were due.
Reverse mortgages can lead to big out-of-pocket long-term-care bills. People who require long stays in nursing homes often depend on Medicaid to pay the crushingly large bills that result. Medicaid covers these costs only for people with very low income and few assets. A primary residence usually is exempted from eligibility calculations, so it often is possible to use Medicaid to pay nursing home bills and still leave the family home to heirs. But if someone with a reverse mortgage requires a long nursing home stay, the loan could come due and the home might have to be sold. If so, any money that remains from the home sale after paying off the reverse mortgage is likely to disqualify that former homeowner from Medicaid, forcing him to use the home sale proceeds to pay nursing home bills and leaving little or nothing for heirs.
Expect steep fees and potentially even scams. Reverse-mortgage fees and costs tend to be steeper than with most other types of loans—they sometimes climb into five figures. And this sector also attracts scammers.
Alternative to a Reverse Mortgage
If you’re considering a reverse mortgage, first discuss this with your adult children or other intended heirs. Many parents are loath to discuss their financial challenges with their grown children—they “don’t want to be a burden.” But if one or more of your future heirs have significant assets or income, they might come out ahead financially if they loan you the money to stay in the home rather than let you take out a reverse mortgage. If nursing home care becomes unavoidable, Medicaid may be available to cover the cost of care leaving home ownership intact.
Raise this topic with your heirs in a way that makes it clear they should not feel any pressure to provide financial assistance and that you’re perfectly happy to take out a reverse mortgage. Explain that you’re discussing this with them in case they would prefer to provide money to you now so they can inherit your home free of any reverse-mortgage debt and with the valuable stepped-up basis. If your heirs don’t understand the potential implications of a reverse mortgage, mention the potential drawbacks cited above or encourage them to discuss this with a financial planner.
Helpful: If you have multiple adult children but only one can afford to provide you with the money you need, you can provide this adult child with a promissory note and/or adjust your estate-planning documents to ensure that he recoups the money he’s given you before your estate is divided up among all of your heirs. If one of your heirs pays more than half of your living expenses, he might even be able to claim you as a dependent on his taxes, creating additional financial upside.
