Reverse Mortgages: How to Avoid a Reversal of Fortune

Editor's note: This is a special alert from FINRA -- Financial Industry Regulatory Authority. It has been republished for TheStreet.com readers.

If you are in your sixties, and own your home, chances are you have heard about reverse mortgages -- or will soon. Reverse mortgages can be helpful to homeowners who want to stay in their homes but are having trouble keeping up with their mortgage payments, or who have no other source of funds to pay bills or meet unexpected expenses. But as more Americans near retirement age, some financial institutions are aggressively marketing reverse mortgages as an easy, cost-free way for retirees to finance lifestyles -- or to pay for risky investments -- that can jeopardize their financial futures.

FINRA is issuing this Alert to urge homeowners thinking about reverse mortgages to make informed decisions and carefully weigh all of their options before proceeding. And, if you do decide a reverse mortgage is right for you, be sure to make prudent use of your loan.

What is a Reverse Mortgage?

Older homeowners who want to tap the equity in their homes typically have three options. They can sell their house and downsize, take out a home equity loan, or consider a reverse mortgage. A reverse mortgage is an interest-bearing loan secured by the equity in your home. To be eligible, you and any other co-borrowers, such as your spouse, must own your home and be 62 or older--although some lenders offer reverse mortgages to individuals as young as age 60.

Like a home equity loan, a reverse mortgage allows you to convert your home equity to cash that you can use for any purpose. Unlike other home loans, however, homeowners make no interest or principal payments during the life of loan. The interest is added to the principal, which is why reverse mortgages are often called "rising debt" loans. Unless you opt for a fixed-term loan, the loan only becomes due when you die, sell your home to move, or otherwise leave your home for more than 12 months--for instance, if a health issue requires you to enter a nursing home.

If any of those events occur, you or your heirs must repay the loan, including compounded interest, in full. Normally, that means the house must be sold, and the loan will be paid back from the proceeds of the sale. Because interest will have been accruing during the life of the loan, you will likely owe more than you borrowed -- and if home values have fallen or you live longer than expected, you may even owe more than your house is worth. But since reverse mortgages are non-recourse loans, the worst that will happen is that you or your heirs will receive nothing from the sale of your house. The lenders can not go after any other assets that you or your heirs own.

So What's The Catch?

First of all, reverse mortgages may seem like "free money" but in fact, they are quite expensive. Like traditional mortgages and home equity loans, you will be charged interest, but interest rates for reverse mortgages are generally higher than these other types of loans. In addition, the fees and costs associated with reverse mortgages are often significantly higher, too -- sometimes as high as 4-8% of the total loan amount. You can usually have these costs deducted from the loan amount, instead of paying for them out of pocket, but either way, you may end up with less cash than you expected.