Implications of a reverse mortgage lump sum
Many people who enter into a reverse mortgage want to collect as much as possible right away. Sometimes this is done to pay a major expense, such as the balance on the original mortgage, home improvement projects, or accrued debt. Others just want the peace of mind of having cash on hand when the need arises.
Taking a large lump sum at the beginning of your reverse mortgage loan means you won’t have those funds available later. It should be viewed in much the same way as taking a large withdrawal from your retirement account; it may be necessary, but it will have an impact later on.
Because of the risks of stripping out too much equity too soon, the federal government has placed a limit on how much a borrower can access in the first year of a federally insured Home Equity Conversion Mortgage (HECM). Borrowers who owe nothing on their current mortgage can access 60 percent of their principal limit in the first year. Those who have a mortgage balance can access enough to pay off their current loan and in some instances an additional 10 percent.
Keep in mind that, depending on your age, you can typically access 50 percent to 65 of your home’s equity at the time you obtain the reverse mortgage. If you then access 60 percent of that amount right away, you’re left with a small fraction for however long you have the reverse mortgage.
For example, assume a 62-year-old owns a $350,000 with no mortgage. The homeowner takes a reverse mortgage and, after fees and costs, has a principal limit of about $173,000. During the first year, the homeowner takes the full 60 percent allotted, which is just short of $104,000. That leaves just $69,000 the homeowner can access.
If the homeowner chooses a line of credit, that $69,000 may increase about 5 percent a year. In five years, that means the line of credit could be as much as $88,000.
Those who remove a large percentage of their reverse mortgage principal right away discover they have fewer options later.
Many homeowners have expressed frustration over the inability to refinance their existing reverse mortgage. The reason this becomes difficult is that the original reverse mortgage has stripped a large chunk of the home’s equity, leaving insufficient equity to fund a second reverse mortgage. After all, when refinancing a reverse mortgage, proceeds from the second loan have to repay the loan balance on the first loan.
This most likely happens if the borrower took out a large lump sum from the reverse mortgage principal limit. This would be exacerbated if the home itself hasn’t appreciated in value much since obtaining the original reverse mortgage.
On the other hand, if the borrower established a line of credit and has not accessed much of that credit line, or opted for monthly payments, then there is likely sufficient equity in the home to fund a reverse mortgage refinance.
Those who do want to take a lump sum can take advantage of having a fixed interest rate. To help borrowers, reverse mortgage regulations began allowing fixed rate loans in 2007. A fixed interest rate loan remains constant through the life of the loan.
This appeals to many potential borrowers. But it’s important to understand that choosing between a fixed rate and a variable rate loan for a reverse mortgage is not the same as it is for a standard mortgage. Changes in the interest rate do not affect monthly benefits because borrowers are not making monthly payments.
The main downside to a fixed interest rate is that reverse mortgage borrowers can only receive the proceeds in a lump sum. No other payment options are available with a fixed rate loan.
Also, reverse mortgage rules state that borrowers can only claim 60 percent of the loan’s principal amount in the first year, unless they are using it to pay off the existing mortgage balance. So a borrower may forfeit 40 percent of the loaned amount just to get a fixed interest rate.
Therefore, experts typically advise that borrowers use a fixed rate reverse mortgage only in circumstances where a large lump sum is needed, such as paying off the existing mortgage or other debt, or making major repairs to the home.