When it comes to household wealth, the value of the typical American "nest" far exceeds the value of the nest egg. According to 2000 census data, home equity (the value of the home minus mortgages) constitutes by far the largest share of household net worth for homeowners of all ages. The average single-family home has increased in size from 1,100 sq. ft. in the '40s and '50s to 2,340 in 2002. In short, we've super-size our homes with funds that might otherwise have been available for savings.

Unfortunately, being house rich and nest-egg poor usually means a significant cut in the standard of living at retirement. A look at net-worth and home-equity data for seniors by quintile suggests that tapping into home equity might offer value to all households and could provide essential financial support for the less affluent.

The traditional way to convert some home equity into savings has been to downsize from the larger houses of our child rearing years to cozy retirement cottages and condos. In reality, this approach often proves disappointing because homeowners tend to overestimate the amount of equity they can recover and to underestimate the costs of selling, moving, and adjusting the new home to suit their tastes. But in recent decades the reverse mortgage has become an increasingly popular alternative that allows you to keep your nest and supplement your nest egg.

Reverse Mortgages and How They Work

A reverse mortgage, as the name implies, reverses the traditional relationship between borrower and lender, at least with regard to the exchange of funds during the life of the loan. You receive cash from the lender but make no mortgage payments for as long as you live in your home. The cash is available in several ways: a single lump sum, a monthly cash advance, a line-of-credit account, or as a combination of these methods. The loan is repaid when you sell your home, permanently move, or die.

By far the most common type of reverse mortgage, accounting for over 90% of all such loans, is the HECM (Home Equity Conversion Mortgage) designed by the U.S. Department of Housing and Urban Development (HUD) and insured by the Federal Housing Administration (FHA). Fannie Mae also offers their trademarked "Home Keeper Mortgage". In addition there are other private mortgages that primarily serve owners of expensive homes seeking larger mortgages than HECM and FannieMae can offer.

Qualifying for a Loan

To qualify for most reverse mortgages, the homeowner(s) must be 62 and live in the home. There are no income or health requirements to qualify. A reverse mortgage must be the primary loan, so if a home has an existing mortgage, it would need to be paid off with a lump-sum advance from the reverse mortgage lender. Up-front costs for a reverse mortgage are higher than those of traditional mortgages to cover the additional risks assumed by the lender (e.g., the house declines in value or an owner lives significantly longer than the actuarial tables predict). But these costs are typically built into the loan amount. The HECM mortgage application process also requires that you first meet with a counselor from an independent government-approved housing counseling agency. The counselor must explain loan costs, financial implications, and alternatives.

The amount available from a reverse mortgage is based on a combination of the appraised value of the house and the age of the owners -- the older the owners, the larger the potential loan. Once the mortgage is in place, the amount owed generally grows over time as interest accrues on the loan. The pattern of growth depends on the interest rate and the method selected for receiving the funds. Thus, the balance on a loan initiated with a large lump-sum payout would grow faster than a series of monthly payments or occasional funds received from a line of credit. However, even if the loan balance should exceed the value of the house, the debt is capped at the actual value of the property by a "non-recourse" clause that prohibits a lender from seeking repayment from any other source.

The Bottom Line

Reverse mortgages offer a flexible means of tapping home equity for home owners age 62 and older. Because of the many variables involved -- owners' age, type of mortgage, and payout options -- a first step in exploring the potential would be to use a good reverse mortgage calculator to gauge the potential value (see the NRMLA link below). Given the demographics of the aging baby boomers with their preference for large homes, their meager savings habits, and their shrinking pension plans -- reverse mortgages could be an attractive option for many retirees.

Useful Reverse Mortgage Links

http://www.ftc.gov/bcp/conline/pubs/homes/rms.htm Uncle Sam's brief overview -- clear and concise.

http://www.aarp.org/money/revmort AARP has been a major force in shaping the industry.

http://assets.aarp.org/www.aarp.org_/articles/revmort/homeMadeMoney.pdf This brochure is "must" reading for anyone seriously considering a reverse mortgage.

http://www.reversemortgage.org The NRMLA (National Reverse Mortgage Lenders Association) website -- check out the calculator!

http://www.fanniemae.com/global/pdf/homebuyers/moneyfromhome.pdf This detailed overview covers both the HECM and the Fannie Mae Home Keeper.

Note: A condensed version of this article appeared in the March 2006 Motley Fool Rule Your Retirement newsletter.