What are the pros and cons of a reverse mortgage?
As a homeowner, there are lots of ways to access your home equity. You can take out a home equity loan or HELOC, apply for a cash-out refinance, or — if you're a senior — get a reverse mortgage.
Reverse mortgages are a unique option because they require no monthly payments. Instead, you receive payments from the reverse mortgage lender.
This can make them an innovative tool for retirees needing extra cash or those looking to cut monthly costs when income is limited. Still, reverse mortgages aren't the right move for everyone, and they have some pretty steep risks. Here are the pros and cons you'll want to consider before taking out a reverse mortgage.
In this article:
What's a reverse mortgage?
Reverse mortgage pros
Reverse mortgage cons
FAQs
A reverse mortgage is a type of loan that lets you borrow from your home equity — only in 'reverse.' Instead of borrowing the cash and paying it back with monthly payments over many years, the balance (plus interest) only gets repaid when you move out of the home, sell the house, or pass away.
In the meantime, the lender pays you — either through a regular monthly payment, a single lump sum, or a line of credit that lets you withdraw money as needed.
Only older homeowners are eligible for reverse mortgages. For Home Equity Conversion Mortgages (HECMs) — the most common type of reverse mortgage insured by the Federal Housing Administration (FHA) — you must be at least 62. Some lenders offer proprietary reverse mortgages, allowing borrowers as young as 55 to qualify.
Reverse mortgages offer several benefits for older homeowners. For one, they can provide much-needed income at a time when earnings may be scarce. Even better? That money isn't taxable. (The IRS considers it loan proceeds, not taxable income.)
They also allow you to age in place while eliminating your monthly housing payment, which can help you stretch your retirement dollars even further. And as long as you use a HECM, you'll never owe more than your home is worth. That means if your home loses value over the years, you'll only owe the lender up to its fair market value — nothing more, regardless of how much you borrowed.
While reverse mortgages have advantages, they also come with some significant risks. First, just like other home loans, they are secured loans that use your home as collateral. So, if you fail to comply with the terms of your loan (such as staying current on property taxes, home insurance, and maintenance), you could lose your house to foreclosure.
This type of loan may also affect what you leave behind for your heirs. It can deplete your equity and task your loved ones with paying off your reverse mortgage loan balance — either through selling the home or out of pocket.
Reverse mortgages have up-front costs too. These include origination fees, charges for third-party service providers, mortgage insurance premiums, and other closing costs. If you don't want to pay closing costs up front, you can request to have the expenses taken out of your loan proceeds.
Unlike traditional mortgages, reverse mortgages won't qualify you for the mortgage interest tax deduction until you repay the loan. (Even though interest accumulates, you aren't making interest payments to the lender, so you can't deduct it on your tax returns.) If you don't spend all the funds each month, they can also hinder your ability to qualify for Medicare or even Social Security benefits. Speak with a financial advisor about these potential issues before taking out a reverse mortgage.
There are many potential drawbacks to reverse mortgages. They put your home at risk of foreclosure, come with closing costs, and impact what you leave behind for your heirs. They can also affect your eligibility for benefit programs such as Social Security or Medicare.
Suze Orman discussed reverse mortgage loans on a 2021 episode of her podcast, Women & Money. She suggested that selling a home may be a better option for seniors needing cash — particularly those needing to use the proceeds to pay off an existing mortgage.
Many consumers worry about losing their house when taking out a reverse mortgage, as well as its ability to quickly deplete their home equity, leaving little behind for any beneficiaries. In some cases, reverse mortgages can also impact Medicare and Social Security benefits.
This article was edited by Laura Grace Tarpley.
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The NPV of the best realistic alternative is thus the present value of the PCT payer's expected returns as a hypothetical licensee, as determined using either the comparable profits method or the CUT method. In effect, the income method forces the PCT payer to hand the expected NPV excess associated with CSA participation back to the participant responsible for the nonroutine platform contribution. This leaves the PCT payer with an expected return on the cash it invests in the CSA equal to the cost-sharing alternative discount rate, which represents the return that a market investor could expect to earn on an investment with the same risk profile as the CSA activity. If the PCT payer makes nonroutine contributions specific to its own territory, the income method requires that the payer's best realistic alternative be adjusted to reflect a return on its contributions. 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As reg. section 1.482-7(g)(2)(ii) explains: 'The relative reliability of an application of a method also depends on the degree of consistency of the analysis with the assumption that, as of the date of the PCT, each controlled participant's aggregate net investment in the CSA Activity (including platform contributions, operating contributions . . . and cost contributions) is reasonably anticipated to earn a rate of return (which might be reflected in a discount rate used in applying a method) appropriate to the riskiness of the controlled participant's CSA Activity over the entire period of such CSA Activity.' The method's logic is sound. The income method is appropriate only when the PCT payer makes no nonroutine platform contributions, so the payer's principal contribution to the CSA will be the cash it invests through the PCT payment and cost contributions. The arm's-length return for a cash contribution is the expected return available to market investors for bearing the risk associated with the CSA activity, and this is what the CSA discount rate represents. Unless the PCT payer makes nonroutine contributions of its own, any excess in its expected returns over the CSA discount rate must be attributable to the PCT payee's platform contribution. One could reasonably suggest that the discount rate for developing sophisticated and potentially extraordinarily valuable technologies, which Pugh found to be 17.7 percent in Facebook, overcompensates PCT payers that don't functionally contribute to cost-shared intangible development. But it prevents the far more egregious results made possible under the 1995 regulations by the residual business assets exclusion, the use of decay curves and finite useful lives, and the general judicial aversion to income-based valuation methods. The income method generates an aggregate PCT value that reflects the full NPV difference between alternatives, and it provides no basis for carving out value attributable to excluded assets. If the income method didn't establish a meaningful limit on profit shifting, a taxpayer like Facebook wouldn't make such a determined effort to invalidate it. Facebook upheld the general validity of a method that aggregates the value of all platform contributions, and in doing so, it implicitly rejected the notion that a residual business asset exclusion survives hidden somewhere in the 2009 and 2011 regulations. Pugh expressly rejected that notion as well, and in short order: 'Petitioner also spends a couple of pages in its opening brief on an argument that Facebook Ireland should not be required to compensate Facebook US for residual business assets. It is true that the definition of intangible property in the second sentence of section 482 in 2010 was limited to the intangible property listed under section 936(h)(3)(B). But the first sentence of section 482 has no such limits; the statute does not constrain the contributions to a CSA that might be compensable through a PCT Payment.' Facebook's more intricate methodological objections, including its 'zero NPV' critique, fared no better. During briefing, Facebook's zero NPV argument seized on the arithmetic relationship between the PCT value and the NPVs of the two alternatives. Because the PCT value is equal to the NPV of the cost-sharing alternative minus the NPV of the licensing alternative, the post-PCT NPV difference between the two alternatives is, by definition, zero. In other words, the income method requires that the PCT payer transfer all of the incremental value associated with entering the CSA back to the PCT payee. According to Facebook, the arm's-length standard entitles cost-sharing participants to retain some of the NPV excess associated with CSA participation. However, as Pugh rightly observed in her opinion, claiming that a PCT payer's cost contributions have an expected rate of return in excess of the discount rate would discredit every PCT method based on the investor model. This claim, the opinion explains, implies that PCT payers should receive a preferential rate of return in excess of what a market investor would receive on the same investment: 'Petitioner's objection that a generic investor would seek a return that is greater than its cost of capital proves too much. It necessarily assumes that this investment should be more attractive than another similar investment. The arm's-length standard does not require a preferred return (a positive NPV); it requires a return comparable to returns on other similar investments. Moreover, petitioner does not explain why in a controlled transaction, such as this, a positive NPV for Facebook Ireland would not result in a negative NPV for Facebook US.' Another way in which the income method allegedly shortchanges PCT payers is by denying them a return for the entrepreneurial risks and functions associated with exploiting the cost-shared intangibles in their territory. Echoing reg. section 1.482-7(g)(4)(vi)(E), Pugh explained that any such contributions can be accounted for by properly valuing the licensing alternative: 'To the extent petitioner's objection is that Facebook Ireland receives no return for its entrepreneurial contributions, that is addressed by proper comparables for the licensing alternative. . . . It is incorrect therefore to conclude that the income method denies an economic profit for any entrepreneurial efforts of the PCT Payor. Petitioner's objections are addressed through selection of the proper inputs into the income method.' Consistently applying this reasoning also led Pugh to reject the way in which the IRS applied the income method in Facebook. The regulations generally assume that the PCT payer's best realistic alternative transaction will be to license the cost-shared intangibles from the developer. This assumption shifts all development risk to the developer, but it leaves the risks associated with exploiting the cost-shared intangibles with the PCT payer. As the final cost-sharing regulations provide (in reg. section 1.482-7(g)(4)(i)): 'In general, the best realistic alternative of the PCT Payor to entering into the CSA would be to license intangibles to be developed by an uncontrolled licensor that undertakes the commitment to bear the entire risk of intangible development that would otherwise have been shared under the CSA. [Emphasis added.] But the IRS valuation expert instead used a 'services alternative' as the best realistic alternative, which treated Facebook Ireland as though it were a low-risk marketing services provider. Under the services alternative, Facebook Ireland received a cost-plus markup of 8 percent, which was nominally based on a set of marketing services companies that bore none of the exploitation risk typically associated with the licensing alternative. Although the 8 percent markup was within the interquartile range (6.8 to 14.2 percent) for the comparables set, it was well below the median value (13.9 percent). Whether it's necessary or appropriate to reward PCT payers with an expected return consistent with the returns of real risk-bearing licensees is open for debate. But the reason that Facebook's theoretical criticism of the income method failed is also the reason that, at least under the regulations, the IRS's services alternative approach was inappropriate. Calculating the PCT value by reference to alternatives with drastically different risk profiles also raises major practical problems, including those associated with a wide discount rate differential that cannot be attributed to a specific risk. Unlike a services alternative, the licensing alternative can differ from the cost-sharing alternative in narrow and predefined ways that relate only to development risk. It's unclear why the IRS opted to use a novel and more aggressive variation of the income method when the method's overall validity was at stake. But it was logically consistent for Pugh to uphold the income method in general while rejecting the method's application in Facebook, and the trade-off for the IRS was a favorable one. By confirming the income method's general validity, Facebook tentatively vindicates the foundations of the current cost-sharing regulations. Pugh rejected Facebook's attempts to create a new residual business asset exclusion and invalidate the investor model, both of which were critical for the regulatory scheme to function. But Pugh's endorsement of the income method's arm's-length bona fides in Facebook followed from her interpretation of the arm's-length standard in general, which could have implications that extend far beyond cost sharing. For Facebook, the income method's zero-NPV effect is invalidating because it creates a conflict between reg. section 1.482-7(g)(4) and the arm's-length standard. This assumes that Treasury and the IRS had an obligation to conform reg. section 1.482-7(g)(4) to the arm's-length standard. It also assumes that the arm's-length standard is a transactional and comparables-based concept, regardless of what the regulations say on the matter. As noted in Facebook, this interpretation implies that any transactional evidence at all takes priority over the methodological reliability standards specified by regulation: 'Where there are no uncontrolled comparables, petitioner maintains, the arm's-length standard requires a 'method that is expected to most closely approximate the way in which unrelated parties price transactions.' Petitioner submits that this approximation can be accomplished through sources such as peer-reviewed academic literature and broad industry standards.' The two assumptions underlying Facebook's argument are related, and the distinction between the two is often blurred. But they are distinct. Whether Treasury and the IRS have a statutory obligation to adhere to something that falls within the ambit of the arm's-length standard is one question, and whether they have to interpret the arm's-length standard in a narrow and archaic way is another. On the first question, Pugh emphasized that the applicable statutory standard established by the first sentence of section 482 is a clear reflection of income. Her opinion observes that 'neither sentence of section 482 expressly adopts the arm's-length standard,' which 'originated in the regulations promulgated under the Revenue Act of 1934.' Only the sentence added by the Tax Reform Act of 1986 directly addresses controlled intangible transfers, Pugh said, and it does not support Facebook's contention: 'The only statutory touchstone relating to intangibles in section 482 is the 'commensurate with the income' requirement. That addition seems to move the statute away from, not toward, an 'arm's length' standard, at least as petitioner defines it; it requires compensation commensurate with the income earned in the transaction. [Emphasis added.] The Facebook opinion doesn't directly say whether Treasury and the IRS could issue regulations that openly repudiate the arm's-length standard. But if the statute doesn't bind Treasury and the IRS to the arm's-length standard, then any obligation to apply it would be a self-imposed regulatory restraint on their broader statutory authority. It would follow that Treasury and the IRS have the right to specify the terms of that self-imposed restraint. However, in Facebook and other best method cases, the authority to openly abandon the arm's-length standard is less important than the discretion to interpret it. On the second question, Pugh was unequivocal. Drawing heavily on the Ninth Circuit majority's reasoning in Altera Corp. v. 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This is critical because manufacturing such conflicts has become the basis for taxpayer attacks on all income-based methods, including the CPM in Medtronic Inc. v. Commissioner, T.C. Memo. 2022-84. If legitimized by courts, those conflicts would twist the section 482 regulations into an ineffectual knot. The significance of upholding one of the centerpieces of the 2009 cost-sharing regulations, and by extension the regulatory scheme itself, in Facebook can't be understated. But the Tax Court's broader acceptance of Altera, and the corresponding rejection of an inappropriately narrow interpretation of the arm's-length standard, is arguably even more important. For the IRS, these victories on the law far outweigh its loss on the facts in Facebook.
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