Are you wondering when reverse mortgages are a bad idea?
We mention quite a bit on this website that a reverse mortgage is often the best way to access funds when you are house-rich but cash poor.
However, a reverse mortgage is not always a good solution for everybody.
The truth is, there are many times you’ll be asked to consider a reverse mortgage when they are not that great of an idea.
Here are 5 of the worst uses for a reverse mortgage:
1. Beware the grandkids, they will bankrupt you….
Just about every senior has that budding entrepreneur grandchild who believes they are destined to be the next Donald Trump or Bill Gates.
They have what they consider to be a “sure bet” idea and if they only had the startup money they know they can be rich.
But, where can they raise money?
I can see “little Johnny” asking himself the question right now…
“Let’s see, who do I know that:
- has plenty of equity in their home to tap
- believes strongly in my potential greatness
- can’t say no to any request I’ve ever made?”
In other words, “who can I exploit by playing the family card?”
“I know, Grandma!”
During the real estate crash many foreclosures involved seniors who mortgaged their home so they could help their grandson start his real estate empire.
The plan was simple:
- borrow a chuck of money against the house
- give it to little Johnny to use for a down payment on a property
A year later he’ll sell the house, pay off the grandparent loan and roll his profits into the next property.
Unfortunately that last part almost never happened.
Many reverse mortgages are originated by grandparents for this reason.
Reverse mortgages are safer than a traditional mortgage since there is no payment to risk foreclosure. However, it is very dangerous when they withdraw solid and safe equity to use for a “high risk” purpose.
If you plan to use your home to fund your grandchild’s pipe dream that’s up to you.
Be warned however, to assume it’s a form of “pre-inheritance” because you’ll often never see the money again.
2. Using a Reverse Mortgage to Buy an Annuity is a Bad Idea
There is never any reason to use the proceeds from a reverse mortgage to invest in an annuity.
Most notably is the fact that you don’t need to.
One method of getting cash from a reverse mortgage is tenure which is an annuitized monthly payment.
Since it’s already built in to the loan, paying an additional commission to buy an annuity is not necessary.
As a matter of fact, it’s not only unnecessary it’s also illegal. If a “financial planner” suggests that you can make more income by using the proceeds from your reverse mortgage to buy their high yield annuity they are breaking the law.
You should report them to the authorities immediately.
3. Never Use a Reverse Mortgage to Buy Investments (Such as Stocks and Bonds)
It seems like a good idea form some to take “dead equity” from your current home and invest it in a stock paying a dividend or a bond with an interest payment.
Unfortunately the numbers just don’t make sense.
The interest rate on the reverse mortgage is usually either equal to or greater than the percentage of income received from the investment.
At the very most all you’re doing is taking money from one pocket and putting it in the other.
At the very worst (as is the case with the certificate above) your stock could become completely worthless.
4. Reverse Mortgage Line of Credit (When You Don’t Need One)
I’ve seen some advertisements suggesting that you take out the reverse mortgage line-of-credit.
Hucksters suggest that even if you don’t need the money now, you need a backup plan just in case you need the money down the road.
After all, if you don’t pull from the line you don’t start paying interest until you do and at least the money will be there if you need it.
The problem is that first part isn’t exactly true.
No matter when you take the proceeds there are fees associated with a reverse mortgage for originating it.
These fees are rolled into the loan so although you haven’t taken a draw yet you still have a loan consisting of the fees. That loan is generating interest which is also increasing the balance on the loan.
There is however one big exception to this rule.
Once the line of credit is originated they can’t take it away from you and the bank must pay out the entire principle amount when you want it.
If you expect a dramatic change to your life’s circumstances that would materially change either your financial situation or property value it might be a good idea to originate a line of credit now.
5. Leaving the House to Your Heirs
If your goal is to leave your home to your heirs you won’t want to take out a reverse mortgage.
Obviously, equity will be reduced when you draw on the loan proceeds.
You will most likely also be giving up any future appreciation in the home’s value since the loan will be growing at an equal or greater rate.
Most importantly, the loan cannot be assumed by your heirs and must be paid off in full within a year of you and your spouse leaving the home.
That means the home either needs to be sold or your heir will have to take out a new loan to eliminate the reverse mortgage loan in order to gain title.
While the idea of your heirs taking out a new loan at the time for them to take title to the house might sound doable, keep in mind the loan has been growing every day that you held it.
In my mom’s case it meant that the $225,000 original loan was $325,000 by the time she left the home and the loan was due and payable.
In our case my siblings and I had our own homes and didn’t want to move in to moms.
The only question was, should we sell it or keep it as a rental?
Before the loan it would have made a good income property. However, with a $325,000 debt to service it made better business sense to sell the house and reinvest the left over equity rather than relying on rental income.
In our case there was never any expectation that we would receive the home so it wasn’t a problem.
Having said that, I’ve met quite a few families where there is an expectation that the “family home” is exactly that:
It belongs to the entire family and the heirs expect it to be passed down when the time comes.
If that sounds like your family a reverse mortgage is not the right product for you.
So is there any scenario where an investment should be funded with a reverse mortgage?
Yes and in the next installment I’ll tell you what and why.
Hint, have you dreamed of spending those cold winters in a warmer climate?