James Sullivan

Can a Reverse Mortgage Solve an Older Client’s Debt Problem?

How you can help an older client pay off credit card debt.

June 13, 2011
by James Sullivan, CPA, PFS

Anna is a 66-year-old retired single woman. Her only source of income is a $4,000 a month teacher’s pension. She owes credit card debt of $52,000. Concerned about his mother’s situation, her son hired his CPA to analyze her situation. He became concerned when she told him about taking out a reverse mortgage on her home. Before that, he had no idea she had such tremendous debt.

Anna had a modest amount of savings that she drew on each month to make ends meet and pay her credit card bills. The savings recently ran out and she is afraid that she will not be able to pay her minimum credit card bill and her other expenses. While she is current on her credit card debt, Anna fears that she will fall behind soon. She owns her own home valued at $200,000. The remaining mortgage is $65,000.

She is considering taking out a reverse mortgage. Since her ability to obtain a reverse mortgage does not depend on her credit score (which is low) or her monthly income, a reverse mortgage is a viable option (the bank refused to provide her with a home equity loan). But is it the best option?

The Reverse Mortgage

Four plans had been provided to Anna. The only one that would provide enough of a draw to pay off her credit card debt was the HECM (Home Equity Conversion Mortgages) Standard Fixed. Under the plan she would qualify for a principal limit of $127,400. Of this, $65,000 would be used to pay the existing mortgage and $8,350 would be applied to fees leaving $54,050 allowing Anna to pay off her $52,000 in credit card debt with a little left over.

The initial growth rate on the reverse mortgage is 6.31 percent. This is much lower than the interest rate she is paying on her credit cards — all of which are 20 percent or higher. In addition to her adult son, Anna has two grown adult daughters. None of the children depend on Anna financially or expect an inheritance.

Does a Reverse Mortgage Make Sense?

The CPA’s first concern is whether using a reverse mortgage for debt relief makes sense. Here are some arguments against using a reverse mortgage to pay off credit card debt:

  • Credit card debt is unsecured while the reverse mortgage is secured through the value of the house. Anna may be able to obtain debt relief using another technique, such as, a debt settlement or bankruptcy.
  • A reverse mortgage is expensive. The fees for Anna’s reverse mortgage would be $8,350 or approximately 6.5 percent of the lump sum received ($8,300 divided by $127,300 equals slightly over 6.5 percent).
  • Anna does not itemize deductions on her income-tax return so there is no tax benefit to her existing mortgage. However, she refinanced her mortgage a few years ago at a very attractive rate — a rate that is lower than the initial growth rate on the reverse mortgage. If Anna decides to take out the reverse mortgage, the existing mortgage will have to be paid off, even though the interest rate is favorable.
  • Once the credit card debt is paid off will Anna learn her lesson or will she begin using credit cards to reboot her bad spending habits? In that case, the reverse mortgage will not solve her problem. In fact, it will only make it worse!

Alternative Debt Relief Solutions

Absent the reverse mortgage, Anna will struggle to meet her monthly living expenses and pay the monthly minimum on her credit card bills. She could, of course, sell her home and use much of the net proceeds to pay off her credit card debt. She does not, however, want to move from her home nor does she want to move in with any of her children (she laughs when she tells the CPA that none of the children have offered to take her in). Her current housing costs are relatively low. Moving into a rental unit would save her little, if any money.

The CPA reviews some alternative debt relief programs:

  • A Debt Management Plan (DMP) may help. A DMP does not reduce what is owed – the interest rate is, however, substantially reduced (in Anna’s case, to 6%) and any late fees are typically waived. Under the DMP Anna’s monthly credit card payment would not be reduced very much (in fact, it may go up) but more of her monthly payment will go to reducing the debt, not towards paying interest. Anna’s debt would be paid off in five years or less under the plan. Working with a local credit counseling agency, the CPA learns that Anna’s monthly credit card payment under the DMP will be $1,100 including agency fees — a savings over her current monthly minimum credit card payments.
  • If Anna declared bankruptcy, she would be “judgment proof” meaning her creditors cannot reach her assets or income to satisfy their claims. First, under Federal law, her creditors cannot garnish her monthly pension. Second, depending on the state in which she lives, her home equity of $135,000 (or $200,000 minus the existing mortgage of $65,000) may also be partially or totally beyond the reach of her creditors. Anna will want to check with a local bankruptcy attorney to understand the full implications of declaring bankruptcy in her state.
  • Under a debt settlement plan, Anna could make an offer to the credit card companies to settle her debt for much less than she owes. For example, after taking out the reverse mortgage she will have approximately $54,050 in cash. Rather than paying $52,000 to the credit card companies to pay off her debt in full, she may be able to reach a settlement for much less. Of course, any debt forgiveness would result in taxable income to her reported on a Form 1099.

All the alternatives under consideration (except paying off the debt in full) will adversely impact Anna’s credit score. But given her age, the impact on her credit score is less important than improving her finances.

Anna’s Decision

When discussing the alternatives with Anna, the CPA encourages her to think long term. Both of Anna’s parents lived well into their 80s. She may spend another 20 or more years in retirement. While her teacher’s pension is adjusted annually for inflation, she has very little financial “cushion” other than her home equity. The CPA encourages her to speak with an attorney to learn more about bankruptcy. He also mentions that opting for the DMP is not irreversible. If her circumstances change, she can take a second look at a debt settlement plan or bankruptcy.
After giving it some thought, Anna decides to enroll in the DMP.

“I wasn’t raised to walk away from what I owe,” Anna told her CPA. “I’m not comfortable with bankruptcy or the debt settlement. I’ll try the DMP, if things change; we can always give the other alternatives a try.” With a DMP Anna did not need to tap into her home equity with a reverse mortgage. At some future date, she might take out a reverse mortgage if a financial need arose. Besides, Anna agrees with the CPA that the fees on the reverse mortgage are “pretty high.”
The CPA put Anna in touch with a local nonprofit credit counseling agency.

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James Sullivan, CPA, PFS, MAS, works with his wife, Janet, who is an elder law attorney in Naperville, IL.

* PFP Section members, including PFS credential holders will benefit from additional Eldercare resources in Forefield Advisor on the AICPA’s PFP website at aicpa.org/pfp. Non-members can click here to join the section.