Reverse mortgage vs downsizing

Is downsizing my home an alternative to a reverse mortgage?

Seniors who have a large amount of equity in their homes but need cash have several options, including a reverse mortgage. Many candidates for reverse mortgages may also consider whether selling their home and moving into a smaller, less expensive home is a viable option.

Homeowners have several factors to weigh in determining whether it’s better to downsize or stay in their current homes with a reverse mortgage. The following is a hypothetical comparison to show the potential financial impact of both options.

Option 1: Get a reverse mortgage
If a couple, age 65, own a $400,000 home with nothing owed, they could qualify for a principal limit of about $206,000 after closing costs and fees of about $10,500. If they chose a tenure payment option, the reverse mortgage would provide about $1,060 a month for as long as the lived in the home. They could also take a cash advance of $50,000 upfront, then receive about $800 a month for as long as the reverse mortgage remained in force.

If they selected just the tenure option and lived in the home for 20 years with the reverse mortgage, they would have received $254,400 in payments. Assuming an average interest rate of 4.5 percent, the total in interest payments would be $158,500 for a total repayment amount of nearly $413,000.

If the home appreciated in value an average of 2 percent each year, it would be worth about $594,000. Therefore, there would be plenty of equity remaining to pay off the reverse mortgage and leave a small amount to heirs.

If the couple lived in the home for 30 years, they would have received $381,600 in payments. Assuming an average interest rate of 4.5 percent, the total in interest payments would be $426,370 for a total reverse mortgage repayment of almost $808,000.

If the home appreciated at the same 2 percent rate, it would be worth $724,000. The good news is that a reverse mortgage is a non-recourse loan, so you or your heirs won’t be forced to repay more than the market value of your home.

Option 2: Downsize
If the couple chose to downsize, they could sell their $400,000 home. After fees and closing costs, they would likely have $360,000 in proceeds from the sale. If they downsized to a home for $150,000, they could pay cash for their new home and not have a loan to repay either now or in the future. That would still leave them $210,000 in cash.

If they invested the entire $210,000 in a single premium immediate annuity (SPIA), they could receive a lifetime monthly income of about $900. If they chose to keep $50,000 in cash and placed the rest in the SPIA, their lifetime monthly income would be about $680.

At the end of 20 years, they would owe nothing and have a home worth $223,000, assuming the same 2 percent annual appreciation, they can pass to heirs.

A third option: Do both
A third option is to downsize AND obtain a reverse mortgage.

While most reverse mortgages are obtained to enable homeowners to remain in their houses, there is also a program that allows seniors to use a reverse mortgage to buy a new principal residence.

Known as an HECM for Purchase, this program allows seniors to buy a new house and obtain a reverse mortgage on it within the same transaction. Because it’s a single transaction, there is only one set of closing costs the borrower must pay.

The intent of the program is to help seniors move when the need arises and still have the option of benefiting from the reverse mortgage. You do not have to sell your existing home before applying for an HECM for Purchase loan, but the lender will assess whether you can financially handle owning two properties.

One of the main differences is that an HECM for Purchase loan requires a downpayment, whereas a standard reverse mortgage does not. A conventional reverse mortgage allows you to borrow against the equity you have already built up. But in an HECM for Purchase loan, you have no equity to borrow against because you don’t own the property.

The minimum downpayment required will be based on the sales price, the age of the borrower(s) and the expected interest rate. The typical user of this type of loan will need to pay around half of the purchase price as a downpayment.

The equity generated by the downpayment is used to calculate the reverse mortgage loan amount. The reverse mortgage funds cover the remaining cost of the home, just like with a traditional mortgage.

For example, say you want to buy a $200,000 home, and have $125,000 for a downpayment. You can then obtain a reverse mortgage for the remaining $75,000. Instead of making monthly payments on that $75,000 balance like you would with a conventional mortgage, the reverse mortgage allows you to defer payments until the loan matures. Just as with a standard reverse mortgage, this occurs when you pass away or move out of the home.