What You Should Know About Repaying a Reverse Mortgage
Originally published at Forbes
Repayment of a home equity loan balance may be deferred until the last borrower or non-borrowing spouse has died, moved, or sold the home. Prior to that time, repayments can be made voluntarily at any point to help reduce future interest due and to allow for a larger line of credit to grow for subsequent use. There is no penalty for early repayment.
When the final repayment is due, the title for the home remains with the family or heir. Should heirs wish to keep the home, the loan balance can be repaid with other funds. Heirs could also refinance the home with a traditional mortgage should they wish to keep it. Should heirs decide to sell the home, they keep any amount the home sells for in excess of the outstanding loan balance. Should the loan balance exceed what the home can reasonably be sold for, heirs can simply hand over the keys to the home to the lender through a deed in lieu of foreclosure and not have to worry about working through the process of selling it themselves.
A deed in lieu of foreclosure is sufficient to extinguish the debt on the reverse mortgage, and the mortgage insurance from the government will compensate the lender for the difference. Generally, up to 360 days will be provided to sell the home or refinance when the loan comes due, but this requires a few extensions from the lender and it is important to maintain regular contact and provide updates to the lender to use the full 360 days.
With the non-recourse aspect of reverse mortgages, the borrowers or their estate do not have to pay back more than the value of the home, even if the loan balance is higher. In these circumstances, the borrower (or estate) can grant a “deed in lieu” and walk away from the obligation of selling the home. Any difference between the loan balance and homeowner is covered by the mortgage insurance premiums which have accumulated over time as part of the loan balance. Alternatively, if the borrower (or estate) can sell the home for more than the loan balance, then they keep the difference.
A tax professional should be consulted on the specifics of each individual case, but to provide general guidelines, distributions from the reverse mortgage are loans and do not reflect taxable income. They are not included in Adjusted Gross Income, and do not impact Medicare premiums or the taxation of Social Security benefits. In this regard, proceeds from a reverse mortgage behave in the same way as Roth IRA distributions. They can provide a way to increase income without creeping into a higher tax bracket.
Eligibility for Medicaid and other welfare benefits may be impacted by a reverse mortgage, however, for cases where this becomes a relevant matter. Spending any proceeds within a month might stop any impact for Medicaid or Supplemental Security Income benefits.
Taxes can become more complicated when the loan balance is repaid. As this matter requires delving into complicated and uncommon areas of the tax code, it is important to consult with a tax professional for personalized advice on these matters. The accumulated interest in the loan balance may be deductible, which could provide a large tax deduction for heirs. This deduction would apply to interest accumulated through the variable LIBOR rate and lender’s margin components of the effective rate, but not the mortgage insurance premiums.
The interest deduction may be capped at $100,000 unless proceeds from the reverse mortgage were used to acquire, build, or substantially improve the primary residence. Either the HECM for Purchase program or using an HECM to pay off an existing mortgage may provide exceptions which could allow the full interest due to be deducted. There may also be some special cases in which mortgage insurance premiums could also be deductible at the time of loan repayment.
One other taxable event could relate to when the non-recourse aspect of the reverse mortgage applies. If spending generated by the home exceeds the repayment value on the loan, then the additional windfall could be treated as taxable income.
The non-recourse aspect of the loan applies only to the loan, but there may be other taxes due on the windfall. Those taxes will likely be calculated in terms of the amount received from the loan and the cost-basis of the home. This issue also requires consideration of the $250,000 allowance for individuals and $500,000 for couples on capital gains from a home for which taxes do not need to be paid.
However, this aspect of tax policy is still relatively new and untested, and the knowledge base for this subject will likely grow in the future.
HELOC vs. HECM
Both a traditional home equity line of credit (HELOC) and an HECM can serve as a source for contingency funds in retirement. However, there are important differences to consider between the two options. As well, both options cannot be combined on a given home.
With a HELOC, repayments are required sooner. Users of an HECM can voluntarily repay sooner, but are not obliged to make any repayment until leaving the home.
In addition, retirees may not qualify for a HELOC if they do not have regular income. Though HECMs have new safeguards in 2015 to make sure they are not used only as a last resort option for those who have otherwise depleted their resources, the qualification requirements are less stringent than with a HELOC. An HECM may still be available with set asides included to cover tax, insurance, and maintenance obligations.
In addition, initial start-up costs may differ for the two options. Costs may differ dramatically between lenders and comparison shopping is important.
Another important point is that unlike with a HELOC, an HECM line of credit cannot be cancelled, frozen, or reduced. This was a problem with HELOCs during the 2008 financial crisis that motivated a research team at Texas Tech University to begin studying HECMs as an alternative to HELOCs. With an HECM, borrowers are protected from lenders modifying their obligations to lend remaining funds in the line of credit. No such protections are available with HELOCs. The principal limit for an HECM will also grow throughout retirement, unlike the fixed amount available with a HELOC.
In contrast to a HELOC, the HECM is non-cancellable, the borrower controls if and when it is used, has flexible payback control, and the line of credit grows over time independent of home value. There are a number of important differences to consider between HECMs and HELOCs if the goal is to set up a liquid contingency fund.