Is refinancing your home a good idea?
What if you had to make no mortgage payments whatsoever? Rather than getting a home loan and making payments to the lender, the lender makes payments to you. Whether you pay back in a monthly or one-time payment, you’re not required to repay the loan until you pass on or move out of the house.
Millions of seniors have wondered whether these mortgage types are worth the risks. Most of them have their wealth tied up to their most valuable asset, their home. The problem is the lack of liquidity. And reverse mortgages give you the chance to use that equity.
Think about it: it could make a difference in your retirement plan. Payments become more flexible, and you keep owning your home.
This idea has attracted countless seniors for two main reasons:
- It reduces your mortgage rates
- Your property can increase its valuation, so you get a passive income return.
Of course, reverse mortgages are not for everyone. Only a small group of people will benefit while being barely affected by the cons. For everyone else, the idea offers more risk than reward.
What Is A Reverse Mortgage?
When you first hear of it, it does feel like you get free money. But these mortgages are still what they are: loans. Those payments are going to come, which may be a problem when having a poor financial strategy.
Although it makes it easier to pay every month, it proves more expensive than traditional mortgages. You have to add mortgage insurance, service fees, and interest.
With this method, however, you could pay off your mortgage and still have equity left. For that financial goal, you can limit how much you pull out of your property to the estimated value increase.
Pros And Cons Of A Reverse Mortgage
There is no doubt these have their advantages. But because of the risks, people keep perceiving them as controversial. Let’s look at the reasons:
Why a reverse mortgage may be better than a traditional plan?
Traditionally, you must pay your mortgage every month. Failing a few months of payment may result in the foreclosure/ loss of your home.
A reverse mortgage lets you pay whoever you choose, either a lump sum or a monthly payment. Since you need to pay monthly, you neither take the risk of losing your property.
When choosing the traditional way, your debt decreases because your mortgage depends on the loan amount. As you pay off the sum, you also receive equity.
Reverse mortgages let you start with little or no debt at first. The closing cost depends on the appraised value of the home, which could be a benefit in case its valuation grows in the future (they all do in general).
Theoretically, you could get “free cash” from these market increases, knowing it is tax-free money.
You retain 100% of the ownership as long as you keep paying those monthly amounts. If you choose reverse instead, you can still keep it and live in the property as long as you comply with the loan terms.
For example, lenders place a lien in your home in case you don’t pay this type of loan, but you still own the property.
By loan terms, we include insurance, home maintenance, and taxes.
Reverse mortgages prove useful, especially when you own an expensive home. The Federal Housing Administration insures the HECM(Home Equity Conversion Mortgage), which offers the most cash for these properties.
Even if the value declines, you will not owe more than the home value (closing cost). With an excellent credit score, you may as well get the lowest possible interest rates, which leaves you a quite comfortable retirement plan.
The downsides of a reverse mortgage
It could be a convenient option for a person who can manage well their personal finances. But if that is the case, you probably wouldn’t be planning for a reverse mortgage, knowing the other better solutions out there.
But what makes it such a bad idea?
- Property Lien
Lenders need to make sure you do pay them back, and liens can motivate people to do it. You pay when:
- You “permanently” move to another property (didn’t live there for over a year)
- You sell the property
- The last borrower passes on
There’s generally no problem in these situations. But if you miss other payments, such as property taxes or insurance, they may ask to pay the loan back. If you weren’t ready, you could lose your home.
- Social Benefits
Although this loan doesn’t affect most programs (Social Security and Medicare), it will affect Medicaid and Supplemental Security Income.
You can lose eligibility when your liquid assets make more than $2000 a month ($3K for a couple). Only when you keep the loan advance past the end of the calendar month, it counts as a liquid asset.
If you’re considering a reverse mortgage because you’re short in cash, losing your benefits may not improve the situation.
- Higher Cost
According to Experian, “the initial mortgage insurance premium for is 2% of the loan amount. On top of that, you’ll pay an annual mortgage premium of 0.5%. You’ll also pay an origination fee of $2,500 or 2% of the first $200,000 of your home value (whichever is greater), plus 1% of the amount exceeding $200,000; origination fees cannot exceed $6,000.”
You shouldn’t be surprised if your reverse mortgage ended up costing $30,000 to $40,000 more than a traditional plan long term. Of course, you can hope that the market valuation increases, but things may not happen the way you expected.
Interest rates can change every month, which aren’t tax-deductible until you pay off the loan in full. It only adds complexity to the payment.
- Lack of flexibility
If you sign a reverse mortgage contract, you’d better be ready to stay in this property for a long time. As we’ve seen, this loan isn’t the most cost-effective plan when compared to traditional mortgages, but you can get better value the longer you stay.
Your payment will be due after you leave your house for twelve months or more, which makes reverse mortgages useless if you plan to move or sell.
Likewise, we hope you don’t plan to earn equity in the process, because you almost always end up losing it (did we mention you need to have accumulated equity before you can use it?). Some people prefer increasing their equity instead of a traditional mortgage, even with the risk of monthly payments.
If you’re looking for a low-cost method to tap into your home equity, consider HELOCs first (Home Equity Line Of Credit). You will become eligible based on your income and credit, and it will require a monthly payment, however.
Why is refinancing your home a bad idea?
Do you believe you can follow up on your payments? When getting a reverse mortgage, your debt increases while your equity declines, plus the possibility of a rise in property valuation. If you’re already in your sixties, does it make sense to risk getting into debt?
- Inconvenient interest rates
Although it works, refinancing your home sounds too good to be true. When you first start paying those monthly rates, you’re mostly covering interest rates in the early years. If you choose to refinance after that period, it becomes inefficient, having to pay the same fees again, if not higher.
How does it sound to raise your interest when you’re already having problems keeping up with your payments? If you’re considering refinancing, it’s safe to assume your credit score is less than ideal. If you can’t access the lowest rates because of it, refinancing makes little sense.
If you’re already struggling with the current situation, what makes you think you will do better with an even harder debt situation? If the valuation declines, debt may increase. Failing payments after refinancing could lead to losing your home.
- Penalty fees
When you refinance, your original lender may request a penalty fee of several thousand if you paid part of the outstanding balance (20%). Refinancing is as expensive as getting a second loan to cover the first loan. Not only it doesn’t solve the problem (it delays it) but makes it bigger. If you can’t afford to pay 2% to 5% of your home’s purchase price for refinancing, consider other options instead.
Lastly, banks may not allow you to refinance unless you have a lot of equity built up already. If you just bought the property and want to refinance, it’s unlikely to happen.
Despite the many drawbacks, you will still find situations where it is beneficial to get a reverse mortgage or refinance your home. However, these exceptions rarely match the general recommendations.
It may be better to get a traditional mortgage to lower your debt and increase equity. Over time, your property may increase its valuation and improve your finances.
You can always put your home in the line as long as you have prepared for the long term costs.