Financial Services: Investors’ use of reverse mortgages

By James J. Eccleston
Shaheen, Novoselsky, Staat, Filipowski & Eccleston

For many individuals, their largest asset is their home, and it is their most precious source of retirement security.

Unfortunately, over the years financial advisers have convinced homeowners that they should tap into their home equity to purchase investments. In 2004, the NASD (National Association of Securities Dealers), now known as FINRA (Financial Industry Regulatory Authority) issued an investor alert, ”Betting the Ranch: Risking Your Home to Buy Securities.”

That alert addressed the use of new mortgages, refinanced mortgages, and lines of credit secured by the home. The NASD expressed its concern that ”investors who must rely on investment returns to make their mortgage payments could end up defaulting on their home loans if their investments decline and they are unable to meet their monthly mortgage payments.”

More recently, homeowners (over age 60) have been the target of those who wish to sell them a ”reverse mortgage.” While reverse mortgages may be appropriate in some circumstances (such as when homeowners cannot meet their monthly mortgage payments or cannot pay bills or meet unexpected expenses), FINRA has alerted investors to stay clear of reverse mortgages to finance a lifestyle that they otherwise cannot afford or to pay for investments. FINRA warns in its recent alert, ”Reverse Mortgages: Avoiding a Reversal of Fortune,” that ”as more Americans near retirement age, some financial institutions are aggressively marketing reverse mortgages as an easy, cost-free way for retirees to finance lifestyles — or to pay for risky investments — that can jeopardize their financial futures.”

Let’s examine FINRA’s guidance.

First, what is a reverse mortgage? Like a home equity loan, a reverse mortgage allows a homeowner to convert home equity to cash. Unlike other home loans, though, homeowners pay no interest or principal payments during the life of the loan. Instead, the interest is added to the loan principal.

Normally, the loan (with interest) is due when the homeowner dies, sells the home or leaves the home for more than 12 months (for example, to enter a nursing home). Reverse mortgages are repaid typically from the sale of the home. The loan is ”non-recourse,” meaning that the lender cannot go after any other assets, even if the proceeds from the sale of the home are less than what is owed on the loan.

Second, what are the disadvantages of a reverse mortgage? FINRA observes that reverse mortgages are ”quite expensive.” The interest rates for reverse mortgages generally are higher than the interest rates for other types of loans. FINRA warns that homeowners may be ‘’surprised” to learn how much ultimately is due as a result of the compounding of interest. Additionally, the fees and costs for reverse mortgages are ”often significantly higher” than for other loans, sometimes 4 percent to even 8 percent of the total loan amount. Other concerns include the fact that homeowners continue to be responsible for property taxes, insurance, and home maintenance costs. If the homeowner cannot meet those obligations, the lender may have the right to foreclose on the home, leaving the homeowner ”in the worst possible situation - no place to live, and no more home equity to draw on.”

Third, what does FINRA recommend considering before agreeing to a reverse mortgage?

Overall, FINRA advises, ”For many borrowers, choosing a reverse mortgage is a last resort way to secure additional monthly income in retirement.” Should a financial professional suggest a reverse mortgage in order to buy an investment, FINRA cautions homeowners that all investments carry risks and costs, and that the higher the promised return, the higher the risk.

Particularly with reverse mortgages, FINRA states, ”It’s best to steer clear of investments that are risky or underdiversified — as well as those that make it expensive, if not impossible, for you to access your money if unexpected expenses arise.” In addition, FINRA issues six tips to consider.

Among other tips, FINRA advises homeowners to weigh all of their options. These include selling the house and down-sizing, taking out a line of credit or home equity loan, consolidating credit card debts, and seeking local government assistance programs to assist in paying taxes or for home maintenance. Likewise, FINRA urges homeowners to recognize the consequences of their decision, such as the fact that while reverse mortgage proceeds are tax-free, they may impact eligibility for state and federal benefits, including Medicaid.

Finally, FINRA advises homeowners to seek advice from a financial adviser who has no interest in either the reverse mortgage of any investment to be purchased with the proceeds of the reverse mortgage. Homeowners must beware of reverse mortgages because they are a last resort solution to retirement security!