Reverse Mortgages: What the Ads Don't Say

You’ve seen them on TV and heard them on the radio.

They may be yesterday’s screen stars, but they’re today’s pitchmen for one of the hottest financial products that baby boomers of a certain age and financial circumstance want: the reverse mortgage.

According to studies performed by Fidelity Investments and the Charles Schwab Corporation, 48% of the 10,000 boomers who are turning 65 every day of the week are woefully unprepared for retirement. In fact, 60% have less than $100,000 in the bank. What many of them do have, however, is a big, fat and typically underleveraged asset: their house.

Enter the reverse mortgage specialists with a seductively simple value proposition.

Your house has value today—probably a lot more than you owe against it—and barring another economic calamity, that value can be expected to increase over the years while you plan on staying put. Meanwhile, you have a life to live and bills to pay, and the three-legged stool of retirement planning (personal savings + retirement savings in the form of 401(k) or pension + Social Security) is wobbly, at best.

Why not extract and use today the money that would otherwise head to your kids tomorrow? God knows, you’ve already spent enough of that feeding, clothing and educating them. It’s about time they do for themselves what you’ve worked hard to accomplish on your own.

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Sound good? Now for the math.

What a $200,000 Home Will Get You

Reverse mortgage loans are like traditional mortgages in that the lender advances a sum of money at the start. But unlike a traditional mortgage, the borrower doesn’t remit interest and principal payments over 20 or 30 years in order to pay back the loan. Rather, it’s the collateral—the house in this instance—that pays off the mortgage when it’s ultimately sold.

The tough part is ballparking that future sale date and estimating the value of the house at that time. Both of these numbers are critically important to the lender because a wrong guess either way will make the difference between profit and loss.

For example, suppose I own my house free and clear, it’s worth $200,000 right now and houses that are similar to mine can be expected to increase in value by 3% year over year—slightly more than the projected rate of inflation. Also suppose that I’m 62 years old (the qualifying age for this type of loan) and I plan to stay in my house for another 15 years. If so, my property will be worth a little more than $300,000 in 2029, thanks to the magic of compound interest.

But that’s not what the lender will offer me upfront.

The going rate for reversible mortgages these days is about 5%. The lender will take that rate into effect as it mathematically translates tomorrow’s value into today’s cash—a process known as present value. As such, that $300,000 house in 2029 is actually worth only $140,000 in upfront loan proceeds in 2014.

How can that be? I just said that my house is worth $200,000 in today’s market. The answer is in the difference between the two interest rates: Although my property is expected to increase in value by 3% per year, the lender is charging 5% for the use of its money, hence the discrepancy.

So let’s say the lender agrees to advance all $140,000 upfront. And let’s also say that I end up staying in my house for 20 years instead of 15. If so, my property should be worth approximately $360,000 in 2034.

Good for me, bad for the lender.

That’s because its loan will have increased in value to a little less than $380,000 by then. That means a $20,000 loss, which could become even larger if the property needs fixing up or a commission is paid to sell it. Not surprising, lenders are treading more carefully these days—valuations are more conservative, fees are higher and it costs more to finance a reverse mortgage than it does a traditional one.

The Details You Shouldn’t Overlook

Valuations, rates and fees aside, prospective reverse-mortgagors have several other matters to consider before dialing that 800-number for the no-obligation DVD and free reading magnifier.

First, even if your intention is to toss the keys to your house when your time there is up, you’ll still have to maintain and insure your property, and pay the real estate taxes, too.

Second, taking an upfront, lump-sum payment can be harmful to your financial health. That’s because cash has a way of getting spent. And since, for many people, their house represents their most valuable asset, once that’s gone, there will be very little left to tap.

Third, when a reverse mortgage is set up as a line of credit, each drawdown will be deposited into an account against which the borrower can write checks. This isn’t an ordinary checking account, though—it’s a money spigot that’s attached to the remaining value in your house. Consequently, it’s imperative that you safeguard those checks—as in lock and key—because no different from any other account, if someone were to pull out a check from the middle of the book, write it to himself, sign your name at the bottom and cash it, the loss will be yours to bear. My wife’s late uncle lost nearly $10,000 of reverse-mortgage money that way to a caretaker.

Last, this method of financing also has the potential to gum up even the best-laid estate planning efforts, leaving the heirs to deal with the problems, as a recent New York Times article explains.

When all is said and done, reverse mortgages are a legitimate financial alternative for those who feel strongly about remaining in their homes but lack the cash flow to do so. Others, however, should give serious consideration to what is often a more economically favorable alternative.

If your mortgage is paid off, or, if there’s relatively little remaining, consider selling your house and investing the proceeds—even 10-year Treasury notes are yielding nearly 3% these days. The resulting income can be used to help pay the rent or upkeep on a more financially manageable property.

Frankly, I wish my mom had done that before the family was faced with a medical crisis that was triggered by an accident in a house that was beyond her ability to maintain. By the time we got it sold in order to pay for her care, I figured that she had yielded a roughly 4% compound annual rate of return for the 38 years that she’d owned the place—1% more than the average rate of inflation for the same period of time.

My mom was lucky. But many others could end up sacrificing a good deal more of their wealth under similar circumstances or if they were to prematurely cash in the equity they’ve worked so hard to create.