While reverse mortgages are sometimes advertised as providing a secure source of income for the rest of your life – and they can, under the right conditions – running out of proceeds sooner than you expected to is one of the major risks of taking out this type of loan. There are several different ways to receive reverse mortgage proceeds, and the one you choose will affect how quickly and how easily you can use up your ability to borrow against your home. Here is a look at the circumstances under which you could run out of reverse mortgage proceeds too early – and how to avoid that scenario.
There are six ways you can receive reverse mortgage proceeds (see How to Choose a Reverse Mortgage Payment Plan for details). These payment plans pose varying levels of risk to borrowers.
♦ Fixed-Rate Lump Sum
Only one reverse mortgage payment plan, the single disbursement lump sum, has a fixed interest rate. Taking out a fixed sum with a fixed interest rate is normally a low-risk way to borrow in the sense that you know exactly how much you will have to repay. But with a reverse mortgage, this loan structure has unique risks.
Homeowners often take out reverse mortgages when their home equity is their only asset and they have no other options for getting the money they need. However, people who take out these loans but aren’t good with money – or aren’t as mentally sharp as they once were due to age-related problems – can easily mismanage a large sum. Once they’ve used up that money, they might have no other monetary sources to draw upon. In an ideal world, mandatory reverse mortgage counseling would deter risky borrowers from choosing this option, but in the real world, that doesn’t always happen. For more information on getting help before making this decision, see Find the Right Reverse Mortgage Counseling Agency.
The Consumer Financial Protection Bureau (CFPB) has identified the increasingly popular lump-sum option as potentially risky, especially for younger borrowers with longer lifespans who don’t have other retirement resources. They’re at risk of using up the equity early in retirement. A reverse mortgage makes it possible to stay in your home for life even after you’ve exhausted the proceeds. However, with no money left, the borrower will not only have trouble paying living expenses, but might end up getting foreclosed on. That’s because continuing to pay homeowners insurance and property taxes – and keeping the home in good repair – are conditions of being able to have a reverse mortgage. The CFPB has found that fixed-rate borrowers do, in fact, default on their reverse mortgages more often than adjustable-rate borrowers for not meeting these expenses.
Taking out a lump sum also puts reverse mortgage borrowers at greater risk of being scammed, since the large sum they’ve borrowed is an attractive target for thieves. (Learn how to protect yourself and your loved ones in Beware of These Reverse Mortgage Scams.)
♦ Line of Credit
Your chances of running out of money with a line of credit payment plan – whether used alone or in combination with a term plan as described in the next section – depend on how you use it. Unlike a regular home equity line of credit, a reverse mortgage line of credit is irrevocable, meaning it can’t be canceled or reduced because of changes in your finances or home value. That means you aren’t in danger of losing access to the money. In addition, your available line of credit only goes down as you draw upon it, and you only pay interest and mortgage insurance premiums on the money you borrow. What’s more, with a line of credit, you gain access to additional funds over time because the unused portion grows each year whether your home’s value increases or not. The unused part of your reverse mortgage line of credit grows at the same interest rate you’re paying on the money you’ve borrowed.
You can access up to 60% of your available principal limit in the first year you have your line of credit. Starting in the second year, you can draw on the remaining 40%, plus whatever you didn’t use in the first year. Of course, if you use up your entire available credit line early on, you’ll have little to nothing left to use in future years unless you repay some or all of what you borrowed, which will increase your principal limit. Yes, you can make payments on a reverse mortgage to reduce your loan balance during your lifetime, and there’s no prepayment penalty for doing so. Your lender is required to apply any partial repayment first to the interest you owe, then to any loan fees and last to your principal.
♦ Term and Modified Term
Of the five payment plans with adjustable interest rates, the term and modified term plans also put you at risk of outliving your reverse mortgage proceeds. Term payment plans provide equal monthly payments with a predetermined stop date. Modified term plans give you a fixed monthly payment for a predetermined number of months, plus access to a line of credit. The monthly payment will be smaller than if you choose a straight term plan, and the line of credit will be smaller than if you choose a straight line of credit plan.
With a term payment plan, you reach your loan’s principal limit – the maximum you can borrow – at the end of the term. After that, you won’t be able to receive additional proceeds from your reverse mortgage. You will be able to stay in the home, with the caveats mentioned earlier in the lump-sum section. With a modified term plan, you’ll only receive monthly payments for a predetermined period, but the line of credit will remain available until you’ve exhausted it. You can avoid running out of money with this plan if you use your line of credit carefully. You can also run out of money quickly if you exhaust the line of credit early on. A safer choice is to rely primarily on the term payments until the term ends, letting your line of credit grow, and then to rely on your line of credit later. If you never use the line of credit, you might have enough equity to give you future flexibility to sell your home, pay off the loan and move.