The Pitfalls of Reverse Mortgages

For years, reverse mortgages have been sold as a way for cash-strapped seniors to get some extra cash. But falling home prices, lending rules and growing instances of fraud could make these loans an incredibly risky proposition for some borrowers.

With a reverse mortgage, homeowners 62 years of age or older can convert the equity in their home into a loan that they won't have to pay back until they either die or move out. If they move out, the borrower either has to cough up the cash or sell the home, a move so difficult in today's housing market that they could end up facing foreclosure.

Last year, lenders made more than 115,000 of these federally-insured loans, known as HECMs, compared with just 8,127 in 2001, according to the National Reverse Mortgage Lenders Association, or NRMLA, an industry trade group.

Now, even more seniors may be tempted to take the leap. The Economic Stimulus bill lifted the maximum amount that seniors can borrow to $625,500 in 2009. (Previously, the borrowing limits were tied to the home’s location and were as low as $217,000.) In January and February alone, reverse mortgage lenders originated nearly 46,600 loans — on pace to far exceed last year’s numbers.

But as the industry grows, so do concerns among financial planners like Rockville, Md.-based Karen Schaeffer. “When I hear someone talking about a reverse mortgage, I want to back up to see the bigger picture,” she says. “If you can’t afford the house you’re in, a reverse mortgage won’t solve that problem.”

When used the right way – and for the right reasons – reverse mortgages can be an effective way to supplement one’s income. But they’re also laden with potential traps like expensive fees and growing occurrences of fraud.

Here’s what you or your parents should consider before getting a reverse mortgage.

Once you take a reverse mortgage, the bank expects you to maintain the house, says Leslie Linfield, executive director of the Institute for Financial Literacy, a nonprofit that provides prebankruptcy counseling. That may not only become difficult physically, but financially as well.

“We’ve had homeowners who’ve received a reverse mortgage and in a couple of years have fallen behind on their [real estate] taxes,” says Tawnya Walters, director of housing counseling at Consumer Credit Counseling Service of Greater Dallas.

The problem is that if you can't afford to maintain the house, then you probably can't afford to move either — unless you’re sure that your home will be sold before the bank moves to foreclose. (If you move to a nursing home, you have up to a year to return to your home.)

Even though the Housing and Economic Recovery Act of 2008 capped origination fees at $6,000 per loan (from an uncapped 2% of the home’s value previously), other fees remain as high as ever. You’ll pay standard closing costs and a mortgage insurance premium fee, which is another 2% of the home’s value. On top of that, you’ll pay a $30 to $35 monthly servicing fee for mortgage insurance, and a $125 fee for mandatory credit counseling, regardless of whether you decide to take a reverse mortgage or not. (The Department of Housing and Urban Development, or HUD, requires that the charge is waived for consumers in financial hardship.)

“If the person remains in the home a long time, [the fees] make sense,” says Barry Zigas, director of housing policy for Consumer Federation of America, an advocacy group. “But if you die or leave the home fairly early in the reverse mortgage’s life, it can seem like a very expensive proposition.”

When considering a reverse mortgage to pay off debt or another one-time expense, look for cheaper alternatives first. Credit-counseling agencies may know of programs or grants to help seniors with home repairs at low or no cost, says Richard Shram, special projects director at Consumer Credit Counseling Service of Greater Atlanta.

As demand for reverse mortgages has spiked, so has fraud. The most common scenario: an insurance agent convinces a senior who just took a reverse mortgage to invest the money in an annuity that won’t begin payments for years, or to buy a long-term-care-insurance policy that may not be appropriate for them, says Bronwyn Belling, a reverse-mortgage specialist with AARP.

NRMLA President Peter Bell says this is a “seriously overblown issue,” adding that the Housing and Economic Recovery Act restricts lenders from selling insurance, annuities or other financial products to the same borrower.

But there’s nothing to stop annuity salesmen from buying potential customer lists from companies who sell those same lists to reverse mortgage brokers.