How to Do a Reverse Mortgage Right

NEW YORK ( BankingMyWay) -- Switch on the TV and sooner or later you'll see an aging actor pitching reverse mortgages for retirees. Nothing wrong with that: The point is to use a reverser to tap your home equity after turning 62.

But most seniors are doing it the wrong way, taking a lump sum in cash instead of a more flexible, potentially more valuable credit line, monthly income for life or combination of the two.

In fact, the most widely used reverse-mortgage program, the government-backed Home Equity Conversion Mortgage, offers flexibility that can be valuable for retirees who don't really need a big lump sum right away, says Jack M. Guttentag, professor of finance emeritus at the University of Pennsylvania's Wharton School.

"Most seniors are not aware of how HECMs could enhance their retirement, and they don't hear about it in HECM advertisements," Guttentag writes on his website, The Mortgage Professor. "The industry is focused on the all-cash option, because it is easier to explain, easier to sell and much more profitable. "

All reverse mortgages share basic features. The homeowner aged 62 and older borrows against the equity in the home, or difference between the property's value and any remaining mortgage or home-equity debt. The borrower needs no income to qualify because there are no monthly payments. Instead, the debt and accumulating interest build up over the years and are paid off when the homeowner moves, sells or dies. If the total owed exceeds the home's sale proceeds, it's the lender's loss; the homeowner or estate are not liable for the difference.

Because of this risk to the lender, the older homeowner -- who has less time for the debt to grow -- can borrow more on a given home than a younger one. So the ideal strategy is to hold off and use a reverse mortgage as a final income source in your 70s or 80s, rather than tapping the full amount in your 60s.

But any homeowner not desperate for lots of immediate cash should pass up the lump-sum option and instead use a mix-and-match option of taking the smallest monthly income needed while reserving the rest of the potential loan as a line of credit that can be tapped only if money runs short, Guttentag says.

That way, the unused credit line does not incur interest obligations, which can chew away at the homeowner's future borrowing limit. In fact, that limit will grow if the home continues to appreciate.

Best of all, the homeowner can modify the strategy as conditions change, taking a larger monthly payment or "tenure annuity" if necessary, or reducing or eliminating it if it's not needed. That would allow the credit line to grow even faster, leaving a bigger cushion for the future.

"A unique feature of the tenure annuity is that it can be modified at any time based on the home equity remaining at that point, for $20 paid to the servicer," Guttentag says. This can be done multiple times.

He offers an example of a 72-year-old owning a mortgage-free home worth $400,000. She could qualify for a maximum lump sum of $255,000 or take a maximum monthly income of $1,460. If she didn't need that much, she could take just $730 a month and have a $128,000 credit line.

This flexibility would be useful, for example, if the spouse with a traditional pension dies, leaving the survivor without that dependable income. Taking a minimal monthly income might also allow a homeowner to let other assets, such as stocks and mutual funds, continue to grow. And leaving a large credit line could provide a good safety net and peace of mind, even if it's never needed.