Will a reverse mortgage be your friend or foe?

Your nest egg is small. Your retirement income is limited. And you're sitting on a highly appreciated asset—your home. A reverse mortgage, which lets you convert some of that equity into cash, might just solve the problem.

Depending on your health and financial stability, however, it could also create new ones.

Alberto Pomares | E+ | Getty Images

"Reverse mortgages can be an effective tool for retirees, but the problem is that the interest rates tend to be higher than for other home loans," said Grafton "Cap" Willey, managing director at CBIZ MHM tax accounting and consulting firm. "I've also seen people outlive their ability to take any more equity out of their home and then they're forced to make tough decisions."

Indeed, cash-strapped seniors who spend all their available equity and later fall behind on property taxes and homeowner's insurance, he said, must sell their home and downsize, go back to work if they're able, or face foreclosure.

A reverse mortgage—the federally insured version is called a Home Equity Conversion Mortgage, or HECM—is a loan that enables homeowners age 62 and older to cash out a portion of the equity in their home.

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The amount homeowners can borrow varies by lender but generally is based on age, home value and the interest rate at the time they close.

The National Reverse Mortgage Lenders Association offers an online calculator that gives borrowers a better idea of how much they might be eligible to take out.

As the name implies, the mortgage payment stream under such loans is reversed.

Instead of making monthly payments to a lender, as with a traditional mortgage, the lender pays the borrower, who may receive the proceeds as a lump sum, monthly payment or line of credit.

Your loan balance accumulates over the life of the loan.

Protecting your retirement income
Protecting your retirement income   

There are no restrictions on how the funds may be used, and many seniors opt to pay off unexpected medical bills or renovate their home so they can age in place, Willey said.

Borrowers aren't required to repay their reverse mortgage loan as long as they live in their home. But the balance must be repaid when the last surviving borrower dies, sells the home or moves out.

Thus, if the borrower becomes sick and moves to a nursing home, he or she is required to notify the lender within six months. Most allow for an additional six-month extension, but the loan becomes payable in full after the home has been vacant for 12 months.

"We often tell people that if they are not well and there's a chance they may end up moving to a nursing home in the near future, that a reverse mortgage could be a very expensive way to borrow money for a short-term need," said Lori Trawinski, a certified financial planner and director of the AARP Public Policy Institute.

Added expense

Interest rates on a reverse mortgage vary by lender, but start at about 4.25 percent for a fixed-rate loan, 2.4 percent for a monthly adjustable and 2.9 percent for an annual adjustable.

Borrowers must also pay an annual mortgage insurance premium, which protects their estate in the event that the future value of their home when they sell is not enough to pay back the reverse mortgage. That adds another 1.25 percent.

As such, the Consumer Financial Protection Bureau advises homeowners to take out only as much money as they need so they don't pay more in interest and mortgage insurance than necessary.

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On top of interest and mortgage insurance premiums, borrowers who assume a reverse mortgage loan will also pay several thousand dollars in closing costs; an appraisal fee, which averages about $450 (appraisal, inspection, lender title policy) and an origination fee.

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The maximum origination fee for HECMs is 2 percent of the initial $200,000 of the home's value and 1 percent of the remaining value, with a cap of $6,000.

Some lenders, however, are willing to reduce or waive those fees.

All homeowners should understand both the costs and risks associated with reverse mortgage loans before putting their biggest asset on the line, Trawinski said.

"I think the most important thing to understand about reverse mortgages is that these are loans, and with any loan comes obligations," she said.

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Borrowers, for example, must remain current on their property taxes, homeowner's insurance and any annual association fees they may owe. They must also maintain their home in its current condition.

Failure to meet those terms could result in foreclosure.

For that reason, HUD requires homeowners to meet with a HECM counselor before they are approved for a reverse mortgage.

To curb the rising incidence of reverse mortgage foreclosures and restrict seniors from burning through their equity on day one, HUD also implemented a cap in 2013 on the amount borrowers can take out in the first year as a lump sum. Generally, that's 60 percent of their initial principal limit.

Financial assessments

An exception is made if you owe an existing mortgage or have other required payments, allowing borrowers to take out enough to pay off their mortgage or other payments (including upfront loan fees), plus cash of up to 10 percent of the initial principal limit.

As of March 2, 2015, HUD required new borrowers to complete a financial assessment to gauge their ability to comply with the mortgage requirements.

HUD examines borrowers' income sources and expenses and also looks at payment histories for property taxes and other financial obligations.

"That's totally new," Trawinski said. "HUD is trying to make sure that people have the ability to sustain ownership, and if they don't have money for property taxes and homeowner's insurance available, they'll require a set-aside of loan proceeds."

"We encourage homeowners to ask as many questions as possible. ... Get the advice of a financial advisor, elder attorney or independent expert." -Lori Trawinski, director of the AARP Public Policy Institute

The CFPB advises that, before they apply for a reverse mortgage, homeowners with minimal retirement income first determine whether they qualify for state and local programs, including subsidized housing and utility discounts, that would help lower their bills.

They should also consider whether downsizing to a more affordable home might make more sense.

Trawinski said reverse mortgages are best suited for homeowners who are healthy, intend to stay in their home for the long haul and are financially stable but may need extra cash to supplement Social Security or pay off medical bills.

Read MoreDon't crack your nest egg

Before you pull the trigger, she said, be sure to consider alternatives and make sure you're in a position to comply with the debt obligations.

"We encourage homeowners to ask as many questions as possible and learn what they can," Trawinski said. "If there's something they don't understand, get the advice of a financial advisor, elder attorney or independent expert."

—By Shelly Schwartz, special to CNBC.com