What Is a Reverse Mortgage and How Do They Work? Here’s the Answer
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A reverse mortgage is a type of home loan that allows you to tap into your home’s equity. What’s more, you don’t have to repay a reverse mortgage loan until you move out. This unique financial tool could benefit homeowners seeking access to cash to supplement their income in retirement.
But before you sign for a reverse mortgage, it’s a smart idea to learn what a reverse mortgage is, how a reverse mortgage works, and what the risks are with this type of loan.
In this article
- What is a reverse mortgage?
- How reverse mortgages work
- Example of a reverse mortgage
- Types of reverse mortgages
- Reverse mortgage fees and rates
- How much you can borrow with a reverse mortgage
- Things to know before you get a reverse mortgage
- Alternatives to a reverse mortgage
- Bottom line
What is a reverse mortgage?
A reverse mortgage is a loan that allows homeowners aged 62 and older to borrow against their home’s value and, therefore, access their home’s equity as cash. Equity is the difference between what you owe on your mortgage and what the property is worth. In other words, it’s the amount of your home that you truly own.
Many seniors live on a fixed income, with the bulk of it coming from their 401(k), pension, or Social Security benefits. Too often, their income doesn’t keep pace with the rising costs of healthcare and living expenses, while their net worth is tied up in their home.
Many senior homeowners are drawn to the reverse mortgage because it provides supplemental funds to help make ends meet and make the most of their largest asset without moving out of their homes.
How reverse mortgages work
A reverse mortgage is a loan based on the equity you have in your home, and it works in two ways. First, it pays off your remaining existing mortgage balance, if you still have one. Then, the reverse mortgage lender pays you any leftover proceeds from the new loan. You can typically choose to receive your home equity as a lump-sum payment, monthly payments, or a line of credit
A reverse mortgage is unique in that you are not required to make monthly mortgage payments. That’s because the loan balance doesn’t have to be repaid until you move out or die. Though the loan may come due sooner if you fail to pay taxes or insurance, or if you stop maintaining the home.
The most common type of reverse mortgage is the Home Equity Conversion Mortgage (HECM), although there are other options. The HECM program is regulated by the U.S. Department of Housing and Urban Development and insured by the Federal Housing Administration (FHA).
To qualify for an HECM, you must meet the reverse mortgage requirements, including:
- You must be at least 62 years of age
- The home must be your principal residence.
- You must own your home outright or maintain a low mortgage balance.
- You must not be delinquent on any federal debt, including income tax or federal student loan debts (though you may use loan proceeds from the reverse mortgage to pay off federal debts).
- You must use some of the reverse mortgage funds to cover ongoing property expenses, such as taxes, insurance, and home maintenance.
- Your home must meet specific quality standards, or the lender will give you a list of necessary home repairs to perform.
- You must get counseling from a HUD-approved reverse mortgage counseling agency to discuss the financial ramifications of a reverse mortgage and explore other alternatives.
The loan amount you could receive will vary depending on a number of factors. Since HECM loans are the most popular type of reverse mortgage, let’s take a look at the factors that determine your loan amount with an HECM:
- Your age
- The home’s value
- The current interest rate
- The type of reverse mortgage
- Your financial ability to pay property taxes and homeowner’s insurance
HECMs also provide different ways to access your funds, such as:
- Lump-sum disbursement to you (with this option, you must opt for a fixed interest rate)
- “Term” option with fixed monthly payments to you for a defined period of time
- “Tenure” option with fixed monthly payments to you for as long as you live in the home
- Line of credit you can access
- Combination of monthly payments to and a line of credit you can access
You don’t have to make monthly payments to the reverse mortgage lender because the balance isn’t due until the last surviving borrower moves out, fails to pay taxes or insurance, forgoes home maintenance, or dies.
Most borrowers and their heirs repay the reverse mortgage by selling the home. The proceeds from the sale are first used for the repayment of the entire reverse mortgage balance. You or your eligible heirs would then receive any remaining equity once the reverse mortgage is repaid in full.
Heirs wishing to keep the property can either pay off the home with cash savings or other funds or refinance the reverse mortgage with a traditional home loan. As the reverse mortgage borrower, if you’d rather not sell your home to repay the loan, you have the option to make payments on the mortgage at any time during the loan term.
Of course, you might be taking out the loan to increase your cash flow, in which case making monthly loan payments might not make financial sense for you. Many seniors take advantage of a reverse mortgage to cover healthcare expenses, including home care, assisted living, or nursing home care.
But homeowners need to be aware that they will have to pay for certain obligations under the loan — namely, paying the property taxes, homeowner’s insurance, and maintenance and repair of the property. Remember, lenders may tell homeowners what repairs are needed, and they will need to have the funds to make those repairs.
Example of a reverse mortgage
Fred, 70, and Ethel, 68, are house-rich but cash-poor. Their retirement and Social Security benefits barely cover the rising costs of healthcare and living expenses, so they start looking into getting a reverse mortgage. They discover they can borrow money from a reverse mortgage and receive it in one of three ways: a lump-sum payment, monthly payments, or a line of credit.
Their house, which they own outright, is appraised at $450,000, and they’re approved for a $100,000 reverse mortgage line-of-credit at a 3% interest rate. Though, as with a credit card, interest is never charged on the untapped portion of the loan. The line-of-credit will allow Fred and Ethel to tap into their equity only when they need it most and keep their interest charges low.
Over the next several years, the couple remains in their home and accumulates $75,000 on their reverse mortgage, plus interest. Sadly, Fred dies, followed by Ethel a short time later, and they leave the home for their children.
If they want to keep the home, the heirs must pay back the entire loan balance — $75,000 plus accrued interest. They might pay off the balance from savings, a life insurance policy, or another source. They could also convert the reverse mortgage into a conventional mortgage.
If the children don’t want to keep the home, they can sell it, repay the reverse mortgage debt, and keep the remaining equity for themselves. Alternatively, they could surrender the house to the lender. That is not the smartest financial solution in this example, but it might make sense if a home’s market value declines and the property ends up worth less than the outstanding reverse mortgage balance amount.
Types of reverse mortgages
While an HECM is popular among borrowers, it’s not the only kind of reverse mortgage available on the market. There are three different types of reverse mortgages, which include:
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- Single-purpose reverse mortgage: Some state and local government offices and nonprofit organizations offer single-purpose reverse mortgages. As its name suggests, this type of reverse mortgage is intended for one purpose only, such as healthcare expenses, property taxes, or home maintenance.
- Proprietary reverse mortgage: A proprietary reverse mortgage is a loan offered by a private lender that you can typically use as you wish. As a private loan, it doesn’t come with the same funding limits as HECMs but often comes with higher fees.
- Home Equity Conversion Mortgage (HECM): The FDA insures HECMs and borrowers can use them for any purpose. These reverse mortgages currently cap funding at $822,375 and come with other requirements that could disqualify many homeowners.
Reverse mortgage fees and rates
Here’s a breakdown of the fees you can expect with an HECM reverse mortgage:
- Origination fee: The origination fee is the amount a lender charges you to process your loan. The origination fee for an HECM is 2% of the first $200,000 of the home’s value and 1% of the remaining value on top of that. Regardless of your home’s value, the FHA sets a floor of $2,500 and a ceiling of $6,000 for origination fees, so the amount you pay will fall in that range.
- Mortgage insurance premium: FHA mortgage insurance works like this: At closing, you’ll pay an initial MIP of 2% of your loan amount. You’ll then be responsible for paying 0.5% of the outstanding balance each year. This MIP structure is consistent among mortgage lenders.
- Third-party costs: You’ll likely be on the hook for various fees, including fees for the credit pull, home inspection, appraisal, title search and title insurance, recording fee, and so on.
- Servicing fees: For fixed-rate loans and loans where interest rates adjust annually, lenders can charge a servicing fee of no more than $30 a month. For loans with interest rates that adjust each month, the maximum servicing fee is $35 per month.
Naturally, interest rates add to the cost of your loan. The interest rate you receive will depend on many variables, such as the lender you choose, the type of loan you get, and whether you choose an adjustable or fixed-rate mortgage.
How much you can borrow with a reverse mortgage
The amount of money you’ll receive from a reverse mortgage will depend on a number of factors, including:
- Age of the youngest borrower
- Type of reverse mortgage
- Appraised value of your home, the HECM mortgage limit, or sale price of your home
For more details on how to get a loan and a more accurate estimate of how much you might be able to borrow, it’s best to consult with a reverse mortgage specialist.
Things to know before you get a reverse mortgage
As with any financial product, it’s wise to do your due diligence and learn how a reverse mortgage might affect you and your loved ones.
For HECMs taken out August 4, 2014, or later, an eligible non-borrowing spouse may continue to live in their primary residence after the death of the last surviving HECM borrower. However, the non-borrowing spouse must meet some eligibility requirements. For example, they must have been married to the borrowing spouse when the loan originated, and they must be designated on the loan as a “non-borrowing spouse.”
In some cases, a reverse mortgage could impact your heirs’ ability to inherit your house. Say your home depreciates and is now worth less than the mortgage balance. If your heirs cannot pay the difference to satisfy the loan, they might need to foreclose or allow the lender to take back ownership of the home.
Another element to be aware of is mortgage scams that can financially harm their victims. These scams include false claims of free homes, investment opportunities, and assistance foreclosing or refinancing your property.
The Federal Bureau of Investigations (FBI) offers these tips to avoid becoming a victim of reverse mortgage scams:
- Never respond to unsolicited ads
- Never sign anything you don’t understand
- Never accept payment from anyone for a home you didn’t purchase
- Be wary of anyone who says you can own a home without a down payment
- Find a reverse mortgage counselor to discuss your concerns
Alternatives to a reverse mortgage
For those under age 62, a home equity loan or a HELOC may be more advantageous for you than a reverse mortgage. Both of these financial products allow you access to 80% to 85% of your home’s value, and their closing costs and fees are significantly less than with a reverse mortgage. Unlike a reverse mortgage, you’ll need to make monthly payments with a home equity loan or HELOC.
Here are some other options to consider:
- Downsizing: By moving into a less expensive home, you may be able to use proceeds from the sale of your home to pay cash for another home or to pay off debt.
- Refinancing: A cash-out refinance of your current mortgage could lower your monthly payments and create some extra room in your budget. There is even an FHA cash-out refinance program.
- Sale-leaseback: With this type of agreement, you sell your house to a new owner (many people simply sell to their children) and then rent the home from them using proceeds from the sale.
Review your resources: Perhaps you can sell stock or cash out an unneeded life insurance policy. Explore the financial options at your disposal that don’t involve risking your home.
Who owns the house in a reverse mortgage?
If you take out a reverse mortgage, your name remains on the title, so you still own the home. Like a traditional mortgage, a reverse mortgage is a loan that places a lien on your property. In other words, your home acts as collateral to secure the loan. Your name should remain on the title so long as you fulfill your obligations under the loan terms.
Are heirs responsible for reverse mortgage debt?
If you have a reverse mortgage and you die, your heirs can inherit the house, but not before they satisfy the debt on the mortgage. In other words, if you leave your home for your heirs after receiving $100,000 of reverse mortgage funds, your heirs must repay the $100,000 debt and any fees and interest that have accrued before they can take ownership of the home.
When should you not get a reverse mortgage?
You probably shouldn’t get a reverse mortgage if you cannot cover the costs, including property taxes, insurance premiums, and home maintenance. If you fall behind with these costs, your lender might designate the reverse mortgage to come due. If you can’t repay the reverse mortgage at that point, you could potentially lose your home.
A reverse mortgage might be a good idea if you want to live in your home for a long time and do not wish to leave your home to any heirs. Ideally, homeowners considering a reverse mortgage should have substantial and diversified retirement savings and have the financial ability to cover the ongoing costs associated with the loan.
But homeowners must thoroughly educate themselves on the risks that come with a reverse mortgage. After all, the loan is secured by your home, and that’s never something to take lightly.
If you decide a reverse mortgage isn’t for you, you might want to consider other refinancing options offered by the best mortgage lenders.
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