There are two surprisingly similar home mortgage options that seniors can consider to tap into their home equity: the reverse mortgage and the option ARM. The option-ARM has been frequently used by seniors to take cash out of their home equity since monthly payment amounts are much less than those of the traditional mortgages for the same loan amount. Another popular solution is the reverse mortgage which is designed for a similar purpose, but requires no monthly principal or interest payments. So given these loans' similar function to access home equity, the question becomes, which loan is better the option ARM or reverse mortgages for seniors?
To start, a definition of each type of loan will be helpful. The reverse mortgage is a home loan that allows people over the age of 62 to pull out some of their home equity to use for any purpose that they want. The loan may be kept until the homeowner(s) either sells the home or permanently moves out. An aspect of this mortgage that is very appealing for many seniors is it does not require any monthly mortgage payment whatsoever for the life of the loan. A reverse mortgage is similar in many ways to a line of credit in that there is a credit limit and the ability to pull cash out and put it back in. But it is different in that the borrower does not pay the monthly interest that accrues. The lender cannot require any payments from the homeowner for as long as they live in the home, but instead the interest is added to the principal balance of the loan. At the end, the lender collects the total amount that it has lent to the borrower, which includes principal plus interest.
The option ARM is similar to the reverse mortgage in that it allows a homeowner (of any age) to pull out a lump sum of equity (no credit lines available), while only taking on a relatively small mortgage payment. The option Arm is known by any number of names, such as "pick-a-payment", "pay-option mortgage", "deferred-interest loan", or "negative amortization loan", among others. The mortgage payment is paid monthly and interest is usually between 2% and 5% annually of the loan balance (take 2% to 5% and divide by 12). However, that payment does not equal the interest rate on the loan, which may be 6% to 12%. For example, if the interest rate is 8% and the payment is 5% (a common scenario), then the interest that is not being paid is 3% (8% minus 5%). Similar to a reverse mortgage, the lender allows that 3% of unpaid interest to be added to the principal balance of the loan, to be repaid at a later date. Thus, the loan balance grows over time, even though payments are being made. But the loan balance is not allowed to grow indefinitely. Once it reaches 110% to 115% of the original loan balance (depending on the lender), a full mortgage payment must be made.
In considering each of these options, it is essential to take into account the seniors' individual situation. The option ARM would be a poor choice if the senior does not have an abundance of income and wants to stay in their home for many years to come. It would be like a ticking time bomb - it is only a matter of time before the low monthly mortgage payment would be replaced by a large monthly payment. In this particular case, the reverse mortgage if preferable because it carries the guarantee of no mortgage payments for as long as the homeowner lives in the home.
In order to qualify for the reverse mortgage, no set income, assets (other than home equity) or minimum credit score is required, making it much easier to qualify for than the option ARM. The option ARM does require those items, even if they only must be "stated" on the forms by the borrower. But be warned: despite what an eager loan officer might say, if "stating" a certain amount of income or assets means "lying", such an action can potentially carry the consequences of loan-fraud.
For most homeowners, the option ARM will cost far more than a reverse mortgage. Even though the closing costs are usually comparable, the interest rates on option ARMs are about 1% higher on average. Far more costly is the fact that you must cash out all the money at once from an option ARM rather than being able to take it out of a line of credit on an as-needed basis. The line of credit aspect of the reverse mortgage saves money by allowing you to keep the mortgage balance lower for a longer period of time, so that the interest accrues against a smaller loan balance.
Obviously, seniors should look before they leap into an option ARM. That loan is really designed for working people who are willing to trade some of their equity for the privilege of freeing up some monthly cash flow for a period of time. But for a senior, a reverse mortgage is a far better choice in most cases.
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