Reverse mortgages: Beware the come-ons

(MONEY Magazine) -- Last year, borrowers took out more than 132,000 reverse mortgages - 50% more than the year before and almost 10 times as many as five years ago. Such loans, as you may already know, allow you to draw down your home equity if you're 62 or older without repaying it as long as you stay in your house.

That's good news. Reverse mortgages can help cash-strapped retirees generate extra money for living expenses, pay for home improvements, lower other debts or fund the occasional splurge.

There's also a downside to reverse mortgages' growing popularity, however. Loan-origination fees that can top $7,000 on a $500,000 home are attracting aggressive salespeople intent on getting you to take out a reverse mortgage whether you need one or not. Some may try to persuade you to invest the proceeds in high-priced financial products, such as annuities, boosting their commissions even more.

No one can say how widespread such tactics are. But the Senate Special Committee on Aging was concerned enough to hold a hearing in December, while FINRA (the Financial Industry Regulatory Authority) issued an investor alert in March. Several lawsuits have also been filed, including a class-action alleging, among other things, that Financial Freedom, one of the largest reverse-mortgage lenders, encouraged brokers to steer seniors into the loans under the guise of providing financial planning services. Financial Freedom says the allegations "are baseless and without merit" and that the company "does not sell, require, promote or recommend annuities to reverse-mortgage borrowers."

So if you've been considering a reverse mortgage, how can you avoid making a misstep? Follow these three tips.

Make sure you really need it

A reverse mortgage can generate cash, but it's not the only way or necessarily the best. Up-front costs can exceed 10% of the loan, making a reverse mortgage a very expensive option if you're borrowing a small amount or you plan to move in a few years. In such cases, you might pay far less by taking out a home-equity line of credit. And hanging on to your home might not be a great idea. You may be able to generate more income by selling and moving to a less expensive place.

Look out for the product pitch

A 2006 AARP survey found that one in 10 reverse-mortgage borrowers had been pitched a financial product along with their loan, most often deferred annuities but also long-term-care policies. Buying an annuity with reverse-mortgage proceeds rarely makes sense though. As the example below shows, you're unlikely to earn more with an annuity than you are being charged in interest and fees on the reverse mortgage. Worse, you might have to pay surrender charges that are upwards of 20% to take money out in the first few years.

Using a reverse mortgage to pay for long-term-care insurance is tougher to evaluate since it depends on your assets and resources, the cost of the policy and the odds you'll end up in a nursing home for an extended period. "But as a general rule," says Donald Redfoot of AARP's Public Policy Institute, "if you've got to borrow to be able to pay for the cost of a long-term-care policy, then you're probably not a good candidate for one."

Get help from a financial planner

The federal government requires you to meet with a counselor before taking out a reverse mortgage. The quality of the counseling is uneven though. This spring, HUD will promulgate new standards for counseling and require a discussion of the implications of using loan proceeds to buy annuities. If you want a rigorous analysis of whether you're better off with a reverse mortgage or a less expensive home, however, you should consult a fee-only financial planner. (Don't let him sell you an annuity either!) After all, you want to be sure that the equity you took years to accumulate enriches your retirement rather than a salesman's wallet.

Sure loser

A salesperson might prod you to get a reverse mortgage so you can buy an annuity. But the annuity's value will never catch up to the mortgage debt.

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