Often marketed as a solution to allow a homeowner over age 60 to remain in their home while borrowing the money needed for improvements or living expenses, reverse mortgages can present a nasty surprise for the borrower’s estate. A relatively small amount of money borrowed can become a surprisingly large debt. Because the debt is not paid until the house is sold or the borrower dies, the borrower may not suspect during their lifetime just how much they owe. This can significantly reduce the inheritance that is left to loved ones, and even in some cases bankrupt or near bankrupt an estate (even if there is enough equity in the home to cover the reverse mortgage itself). If the borrower has to sell during their lifetime to move into long term care, they may be shocked by how little money is left from the home proceeds to fund that care.
I have seen $40,000 borrowed become almost a $200,000 debt of the estate – 5 times the original amount borrowed and almost the entire value of the borrower’s condominium which was the primary asset of the estate. By the time the reverse mortgage, funeral expenses, probate fees, and basic estate administration costs were covered, there was just enough money left to cover a relatively small Visa debt and no inheritance left for the beneficiaries named in the Will.
The reason is compound interest. The nasty surprise above would come about with an interest rate of 11% compounded over 15 years. To take another example closer to today’s relatively lower interest rates, and assuming compounding only once annually:
Year 1 – $50,000 x 5% (a relatively low interest rate on a reverse mortgage) = $2,500
Year 2 – $52,500 x 5% = $2,625
Year 3 – $55,125 x 5% = $2,756.25
Year 4 – $57,881.25 x 5% = $2,894.06
By Year 5, the total interest is $13,814 (28% of the original amount borrowed), and total amount owing is $63,814.
By Year 10, the total interest is $31,445 (63% of the original amount borrowed), and total amount owing is $81,445.
By Year 15 the total interest is $53,946 (108% of the original amount borrowed), and total amount owing is $103,946. All of this assuming that the interest rate does not rise during that 15 year period.
A potential borrower can avoid nasty surprises by doing their research, considering all the options, considering all the scenarios that might occur, getting objective advice from a financial expert and doing some calculations to get a realistic idea of the cost of borrowing.
The named executor of a person who has died will want to know if there is a reverse mortgage and, if so, immediately get a full statement for the mortgage. If it looks like there might be any possibility of a bankrupt estate, the named executor will want to get full information and legal advice about the options before taking on the role of executor.
Next installment: What happens if an estate is bankrupt?