Choice is reverse vs. regular mortgage

Question: I’ve been hearing a lot about reverse mortgages and I would like to know who to contact to find out more information. We live in Arlington and are both retired but want to stay in our home as long as possible with out added expenses. Can the money be used for anything? If taken as a lump sum, do we have to pay income tax on this money?

W.R., Arlington

Answer: First, let me give a quick explanation of how a reverse mortgage works. It is a special loan program that allows older homeowners to pull cash out of their home without making payments. As its name implies, a reverse mortgage is the opposite of a regular mortgage.

Instead of borrowing a sum of money and paying it back over time to reduce the debt, with a reverse mortgage, a sum of money is given to the borrower but no payments are made and debt grows larger and larger each year. The equity can be pulled out of the home either in a lump sum or paid out gradually in guaranteed monthly payments for life. The unpaid interest is added to the loan balance each month. The total loan balance, with accumulated interest, is eventually paid off when the home is sold, typically after the owner’s death.

To make sure the homeowners don’t outlive their equity, the loan-to-value ratio on reverse mortgages is determined by several factors including the borrower’s age, interest rate, local lending limit and the home’s appraised value. To qualify for a reverse mortgage the borrower must be at least 62 years old, and the older the borrower, the larger the allowable loan amount because their expected life span is shorter.

Loan proceeds are not taxable income because the money must be repaid. As I said above, reverse mortgages are typically repaid through the sale of the home after the owner dies. But if the borrower chose to sell their home after taking out a reverse mortgage, they would pay off the outstanding balance on the reverse mortgage and can keep any proceeds that remain. As long as the profit on the home sale was $250,000 or less ($500,000 for a married couple) all of the sale profits could be kept tax-free.

Another unique tax consequence of reverse mortgages is the accrual of the mortgage interest deduction. With a regular mortgage, the interest paid each year is tax deductible and you subtract it from your income on your annual tax return. But what happens when you don’t pay your mortgage interest each year, as is the case with a reverse mortgage? You don’t lose the interest deduction, you merely have to wait until the interest is actually paid before you can claim it.

For example, if homeowners or the estate had accumulated $20,000 worth of unpaid interest on their reverse mortgage and decided to sell the house, they could claim a $20,000 mortgage interest deduction for the tax year in which the home sale closed.

The money received from a reverse mortgage, whether monthly payments or a lump sum payment, can be used for any purpose you want. There are no limitations or restrictions. You can use the money to pay your bills, make investments, or spend it any way you choose. If you want to go to Las Vegas and blow it all, that’s your choice. Of course, that would be a very poor use of your home-equity funds.

Personally, I consider a reverse mortgage to be a loan of last resort for people who have lots of equity in their home and little or no income to qualify for a standard mortgage. That’s because the fees for a reverse mortgage can be quite high. If you can qualify for a conventional mortgage, you will get better rates and fees. But if you don’t have the income to qualify for a loan, a reverse mortgage is a great way to obtain extra money to live on without having to sell and move out of your home.

There are several different reverse loan programs available. You should to talk to a reverse mortgage specialist to determine which program is best for you. Most banks and FHA-approved mortgage companies have a reverse mortgage specialist on staff. Interview a couple of them until you find someone with whom you feel comfortable. Ask how many reverse mortgages they have closed in the last year. This is a specialized program and it requires specialized knowledge. So make sure you are working with somebody who really understands the program.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.

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