The Risks and Rewards of Reverse Mortgages

As the worst financial crisis since the Great Depression guts real estate values, hammers 401(k)'s, and drives job losses higher, a disconcerting number of older Americans are facing a threat they never expected to encounter during their golden years: home foreclosure. In a first-of-its-kind study released last fall, AARP reported that Americans ages 50 and older accounted for more than a quarter of all home foreclosures and mortgage delinquencies in the second half of 2007. "The impact of a foreclosure is often more significant for older households, as they have less time and ability to recover the financial losses," the report concluded. "The problem is likely growing, as homeowners increasingly carry mortgage debt into their retirement years." But a unique type of loan enables seniors 62 years and older with enough equity in their home to tap a sizable chunk of cash and kiss their house payments goodbye. And for those who understand its features—as well as its risks—a reverse mortgage can be a valuable tool for reducing the financial pressures that arise in modern-day retirement.

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A reverse mortgage is a loan, secured by a house, which gives seniors access to the equity they've built up in their home. Unlike a traditional mortgage, the loan doesn't call for borrowers to make monthly payments. Instead, they receive cash—in monthly installments, a lump sum, or a line of credit—that doesn't have to be repaid for as long as they live in that home. The loan balance is due when the homeowner relocates or dies, and it's typically repaid with the proceeds from the sale of the home. "[If] you need some of your money that is stuck in your house like in a block of ice, we basically come in with a pick and dig it out for you," says Jeffrey Lewis, chairman of Generation Mortgage. "Seniors have a tendency to have lumpy demands for their money, and sometimes the only place to get it is the house."

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Since its inception in 1988, the Federal Housing Administration's program for reverse mortgages—which it calls "home equity conversion mortgages"—has expanded considerably. From 157 loans in 1990, the program grew to more than 112,000 last year, with the agency handling roughly 90 percent of all reverse mortgages today. In February, Congress raised the program's ceiling for reverse mortgages to $625,500, making even more funds available to seniors. The total amount of cash accessible depends on the borrower's age, the value of the home, and interest rates. Homeowners in their early or mid-60s can most likely borrow around 50 percent of what their home is worth, and an 80-year-old can probably borrow about 70 percent. And since lenders scrutinize the house—rather than the borrower—as the source of repayment for the loan, "it doesn't matter what your credit history is as long as you don't owe the government taxes or you are not behind on an FHA mortgage," says Josh Denney, associate vice president of public policy at the Mortgage Bankers Association.

Seniors are free to use the cash for whatever they please: to supplement a fixed income, cover rising living expenses, or take care of unexpected medical bills. "I have seen it used for people who still have a mortgage and for whatever reason they really can't afford [it]," says Ellen Bernards, a certified reverse mortgage counselor in Madison, Wis. "Sometimes people just say, 'You know, I have got a lot of money in the house. I want to spend it.'"

If handled properly, a reverse mortgage can be a nice way for seniors to reduce living costs or pay off expenses. But the product's potential risks have left some government officials unnerved. In a June speech, Comptroller of the Currency John Dugan said: "I am struck by some of the similarities to the risks of subprime mortgages: a vulnerable customer class; complex product features that can be difficult to explain and can be susceptible to deceptive marketing; nontraditional, asset-based underwriting; and the potential for skewed incentives for key distributors of the product." To help consumers better understand the product, U.S. News spoke with a number of reverse mortgage experts to pinpoint the potential pitfalls. Here's a look at three possible hazards and how to sidestep them.

1. Incomplete counseling: Before obtaining the loan, borrowers are required to speak with a reverse mortgage counselor who has been certified by the Department of Housing and Urban Development. (A list of approved counselors is available on HUD's website.) But in a report released in late June, the Government Accountability Office found deficiencies in HUD's counseling efforts. Although counselors in general provided accurate information about the main features of the product, they overlooked some key details. For example, seven of the 15 housing counselors the GAO examined failed to discuss with borrowers all of their alternatives to reverse mortgages.