Copyright © 2010 PJ Wade. Excerpt from “Chapter 2: What is a Reverse Mortgage?” reprinted from “Reverse Mortgages: Best Friend, Worst Enemy...Your Choice!” with permission from the author. All reprint rights reserved. CatapultPublishing.com
“Give me a lever long enough and a fulcrum on which to place it,
and I shall move the world.”—Archimedes of Syracuse
IS REVERSE THE RIGHT GEAR?
A reverse mortgage is a financial, lifestyle, and wealth management tool, which enables a property owner to convert home equity into cash without selling the real estate or repaying the debt until a preset time in the future.
Reverse mortgages contradict the old saying "You can’t have your cake and eat it too." With equity conversion, homeowners can have the "cake"—the home—and they can "eat it too"—that is, take out equity as cash. If the reverse mortgage is a good fit—best friend—and satisfies the homeowner’s needs, the cake analogy is complete. Although the reverse mortgage is "consuming" the equity, the property is still available to the homeowner.
Yes, the equity is being eroded and, as we will see, may even be completely exhausted as interest accumulates. However, if the homeowner has taken this possibility into account when arranging a reverse mortgage, then the homeowner has decided that having "the cake" and eating it too is worth the reduction in equity. And that is precisely when home equity conversion using a reverse mortgage is ideal—when the homeowner believes there is no other acceptable way to have the home and the money at the same time.
Most people do not understand enough about real estate and traditional mortgages to make learning about reverse mortgages a "no brainer," so don’t expect to make your best choice in the midst of a crisis. Shop years, if not decades, ahead of actually signing up and you will also be able to apply what you learn to save on real estate and on traditional mortgages in the meantime.
A reverse mortgage may usually be used for any purpose the homeowner wishes, however, the following scenarios outline main applications for this approach to home equity conversion:
- House Rich, Cash Poor
Traditionally, homeowners concentrated on paying off the mortgage as quickly as possible, usually doing without lavish holidays and controlling discretionary spending to save thousands, if not tens of thousands, on the overall cost of the mortgage. Savvy property owners still follow this plan and eventually hold the full value of their property as unencumbered equity.
This is the problem. Often, the wealth of homeowners is locked in their real estate, particularly when home is the main asset. Furthermore, the increasing cost of property maintenance, insurance and real estate taxes continuously devours income and erodes savings. Ironically, while the home is a powerful symbol of independence and freedom, this valuable asset can also become a bittersweet financial burden for some homeowners. The resulting "house rich, cash poor" lifestyle can be restrictive and frustrating for those who want to stay in this home, but need a financial infusion to maintain or raise their standard of living.
- Mortgage Relief
There has been an increase in the number of homeowners who do not pay off their mortgages before their incomes drop. Business failures or late-career job loss can force homeowners into financing just as illness or accident-related medical expenses can. In some cases, poor money management skills turn the convenience of a line of credit into sizeable debt against the property. More parents and grandparents take on a mortgage to finance university education or business ventures for their children or grandchildren. Those on diminished or fixed incomes find mortgage payments a financial drain.
- Leveraging Home Equity
The federal Income Tax Act allows one residential property or home to be designated as the principal residence. This designation indicates that any profit or capital gain may be exempt from income tax. Using home equity conversion to gain access to this money means the homeowner has tax-free dollars to spend or invest without having to move. Owners of multiple residences and other real estate, particularly high-end properties, can leverage or borrow against equity to invest and deduct the cost of borrowing. In this way, the cost of a reverse mortgage could become a tax deduction.
HOME EQUITY SOLUTIONS
Conventional approaches to “cash-poor, house-rich” dilemmas and to leveraging home equity have been either to convert equity by arranging a traditional mortgage or by selling the property.
Homeowners, determined to stay in the home they know and love, may consider arranging a traditional mortgage. (These mortgages are also known as forward, standard, or straight mortgages, or, simply, mortgages. Lines of credit are a variation of this type of mortgage.) However, homeowners must have sufficient income to satisfy a mortgage lender that they can afford to repay the mortgage debt. The size of the traditional mortgage is generally based on the homeowner’s gross income. Therefore, if the borrower’s income is low, the allowable traditional mortgage may be too small to be considered useful by the borrower.
In traditional retirement, an individual’s income usually dropped drastically—often by 40 percent or more—therefore, many did not satisfy income requirements for a mortgage of any useful size. This may also be the case in unretirement, particularly for those depended on government pensions and benefits. Increasingly, many will continue at least some income-earning activity for pleasure or out of necessity, but the same problem may still be true for traditional mortgages or lines of credit.
Greater lender flexibility over the years now allows some homeowners, particularly those with a good credit rating and mortgage-free real estate, to arrange a line of credit secured by their home if their income does not qualify.
Selling the home may be an acceptable solution for homeowners who feel their houses are too big for them, or who have found an attractive housing alternative. Yet, surveys show that most people would prefer to age in place, that is, stay in their own home. Furthermore, in many rural communities, housing alternatives are often limited, forcing individuals to move out of the area if they sell their home, especially if they want more supportive or lifestyle-oriented housing.
Selling the home may offer a remedy for financial stress, but the full impact of the sale can be far-reaching, even traumatic. The decision to sell involves not only financial, but also complex personal and social considerations. In selling the home, homeowners are disconnected from neighbourhood friends, community connections, and every aspect of life that defined them and their lives.
Reverse mortgages offer a third equity conversion choice for homeowners who cannot, or will not, arrange a traditional mortgage and who wish to stay where they are. Homeowners on low- or fixed-incomes can improve their financial well-being by using a reverse mortgage to unlock the equity in their home. At the same time, they retain ownership and possession of the property. The homeowner will be free of repayment responsibilities until a predetermined time in the future. A reverse mortgage can also be used to pay off an existing mortgage and end monthly repayments, thereby, liberating income.
Homeowners with other assets to call on can liberate the tax-free equity in their homes to invest or to spend and enjoy under the same terms.
Reverse Mortgages: Best Friend, Worst Enemy...Your Choice! was not written to convince you to sign up for a reverse mortgage or any other type of home equity conversion or management option. This book offers a clear, in-depth picture of this wealth management option to help with your financial and lifestyle strategizing—now and in the future. This chapter explains how mortgages—traditional and reverse—work, how these two types differ, and why you should be interested. The discussion then focuses on the relatively-unknown and much-misunderstood reverse mortgage by examining the advantages and disadvantages of this home equity management tool:
- Chapter 3 explores the various types of reverse mortgages.
- Chapter 4 continues with an in-depth look at home equity conversion that will help you decide whether a reverse mortgage is right for you, now or in the future.
- Chapter 5 is an insider-view of how to shop for a reverse mortgage.
- Chapter 6 explains how to find the best professional advisors.
- Chapter 7 dissects a reverse mortgage contract, so you will understand what you are signing.
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