The Danger of Reverse Mortgages (August 2008)

Dominick Paoloni

According to Albert Einstein, compound interest is the greatest invention of mankind. This premise is based on the fact that compounded money grows exponentially. For example, the Rule of 72 shows that money earning 10% compounding interest will double every 7 years. If you invested $200,000 and received a compounded average return of 10% per year, in 14 years your money would be worth $800,000.

So if compound interest is the greatest invention of mankind, then I assume that Mr. Einstein would agree that negative compound interest is the worst invention of mankind.

Enter the Reverse Mortgage

This concept didn’t hit me until a client called me to discuss a reserve mortgage she had purchased several years prior. Her husband was developing dementia and she said that when he passed she would sell their home and move closer to her children. She understood that if she sold the home she would have to pay back the loan on the reverse mortgage.  The principal amount owed on the loan was growing every month, as would be expected, because no payments are made on a reverse mortgage. What she didn’t understand was that her outstanding loan was growing exponentially at a 10% negative compound rate. In other words, in seven years she would owe approximately $400,000, and in fourteen years she would owe $800,000 for the $200,000 she had borrowed. This leaves her only $200,000 to use for a new home. She was horrified.

Why would anybody throw away the only real asset many people have left and watch it erode exponentially?  In my client’s situation, she was talked into a reverse mortgage (that she didn’t need) by an overzealous insurance agent wanting to make a big fat annuity sale and the commission that went along with it. After tying up their liquid assets in an investment vehicle with a 14-year surrender period, he convinced her she needed the reverse mortgage to provide liquidity.

Do Reverse Mortgages Have Value?

According to AARP, the greatest fear of the elderly is outliving their income. The Home Equity Conversation Mortgage (HECM) program guarantees a lifetime income stream to the homeowner under the federally guaranteed “tenure” option. This could be the magic bullet for an elderly person’s fear of running out of money, especially if they can not keep up with the increase of daily living expenses. However, according to HECM only 5% of all borrowers take the lifetime income option, which arguably is the best feature of a reverse mortgage. The rest, a full 95%, take either a lump sum or a line of credit. Perhaps too many sales people recommend a lump sum payout on reverse mortgages to get their hands on the available cash.

The exponential negative cost of a reverse mortgage makes it, in my opinion, a “last resort” financial planning option. Under the direst of circumstances the reverse mortgage may be the only door left open. However, the problem that I have with reverse mortgages is that too many borrowers are left unaware of the pitfalls.