If you own a home, chances are you've heard of a reverse mortgage. Despite increased attention and regulation, many homeowners still struggle to understand what reverse mortgages are and who should consider one. This guide will provide an in-depth understanding of exactly what a reverse mortgage is and the pros and cons of this complex financial product.
What is a reverse mortgage?
Most homeowners are familiar with a regular mortgage: You borrow money from a lender to purchase a home, then repay the loan in monthly installments over the course of several decades.
With a reverse mortgage, the lender pays you by taking some of your home's equity and converting it into monthly payments to you. As long as you live, remain in your home, and continue to meet other obligations of the mortgage (discussed in more detail later), you do not have to pay the money back.
When you die, sell the home, or move out, you or your spouse or estate will have to repay the loan. If you signed the loan paperwork but your spouse didn't, your spouse may be able to continue living in the home after you die, as long as they continue to pay property taxes, insurance, and maintenance costs. However, your spouse will cease to receive monthly payments from the reverse mortgage, since he or she wasn't a part of the loan agreement. Once your spouse passes away or moves out of the home, your family or heirs may need to sell the home to repay the loan.
Example of how a reverse mortgage works
James and Mary, ages 73 and 72, are a retired couple who own their home outright. They want to stay in their home but need to supplement their monthly income from Social Security and James's pension. They would also like to remodel their kitchen. James and Mary's home is valued at $250,000, and they do not have a mortgage.
The total amount that James and Mary can borrow using a reverse mortgage is limited by the Federal Department of Housing and Urban Development (HUD) and is based on the age of the youngest spouse, current mortgage rates, and the value of the home.
Let's run a hypothetical scenario through the National Reverse Mortgage Lenders Association's reverse mortgage calculator.
|Value of the home||$250,000|
|Loan principal limit||$150,000|
|Net principal limit||$142,200|
|Lump sum cash for kitchen remodel||-$20,000|
|Remaining for monthly advance||$122,200|
James and Mary have been mortgage-free for a year. The current value of their home is $250,000, and they are applying for a $150,000 reverse mortgage. After accounting for closing costs of approximately $7,800, the remaining available principal is $142,200. James and Mary would like to have $20,000 of that up front for the kitchen remodel, leaving $122,200 available for monthly installments. Based on this scenario, the amount James and Mary would receive monthly is approximately $750.
Reverse mortgage requirements
To qualify for a reverse mortgage, you must:
- Be age 62 or older
- Own your home outright or have a small mortgage (meaning the amount you owe on the mortgage is less than the amount you qualify for under the reverse mortgage program)
- Use the home as your primary residence
- Not be delinquent on any federal debt, such as back taxes, federally backed student loans, SBA loans, or HUD-insured loans.
- Have the financial resources to continue to meet obligations such as property taxes, homeowners insurance, association dues, and repairs
- Participate in an information session with a HUD-approved Home Equity Conversion Mortgages counselor
Meeting these basic requirements doesn't necessarily mean a reverse mortgage is right for you.
3 questions to ask yourself when considering a reverse mortgage
- Do you want or need to move? This question should help you understand whether or not your home will continue to meet your needs for the foreseeable future. If your home is physically difficult for you to navigate and maintain, you may be better off selling the home and downsizing to a home that is better suited to your retirement years. A reverse mortgage requires you to continue to reside in and maintain the home. If you are physically or financially unable to do that, you may have to sell the home to pay off the loan balance.
- Can you afford to continue paying real estate taxes, homeowners insurance, association dues, and maintenance? While a reverse mortgage will boost your monthly income, consider whether that additional cash flow will be enough to continue covering real estate taxes, insurance, association dues, and home maintenance. Keeping up with these obligations is a requirement of a reverse mortgage. If you cannot afford to keep up with these expenses and your other bills, including health care, utilities, and other living expenses, a reverse mortgage may not make sense.
- Are you planning on leaving your home to your children, grandchildren, or other heirs? When you pass, your heirs may have to sell the home to pay off the reverse mortgage. Other assets, such as investments or life insurance, may be available to pay off the loan balance. If your sole motivation for staying in the home is to pass it on to heirs, consider whether they'll be able to hold on to it after you are gone.
Robin Faison is a licensed mortgage loan officer specializing in reverse mortgages with Open Mortgage in Scottsdale, Az. Faison also teaches a Reverse Mortgage for Purchase class accredited through the Arizona Department of Real Estate.
Faison says reverse mortgage borrowers typically fall on a spectrum, from those who are facing foreclosure and need a reverse mortgage to keep their homes, to those who are not in any financial difficulty and use a reverse mortgage line of credit strategically as a part of their overall retirement plan.
Reverse mortgage risks
A reverse mortgage is a financial product, and all financial products come with risks. Make sure you understand those risks before signing any paperwork. Those risks may include the following.
Fewer assets for heirs
Some homeowners dream of holding on to the family home and passing it down to their children or grandchildren. If this is part of your estate plan, consider whether your heirs will need to sell the home to pay off the reverse mortgage.
Even if you have life insurance proceeds or other assets that can be tapped to pay off the reverse mortgage after your death, those assets may be depleted, leaving less for your family members. Work with your financial adviser and a reputable reverse mortgage specialist to make sure that a reverse mortgage works with your overall estate plan.
Fees and other costs
Just like with a conventional mortgage, you will pay closing costs, mortgage insurance premiums, origination fees, and other costs to close on a reverse mortgage. According to the Consumer Financial Protection Bureau (CFPB), the fees and other costs of a reverse mortgage vary based "on the type of loan you choose, how much money you take out up front, and the lender you choose."
Faison says lenders also receive a premium for servicing your loan (typically from Fannie Mae or Freddie Mac), which can be used to offset closing costs. However, regulations have made it more difficult for banks to offset costs on a fixed rate loan. Your lender will have more leeway for offsetting closing costs with that premium on an adjustable rate mortgage, but then the borrower bears the risk of rising interest rates.
Will owe more over time
As you receive money from the reverse mortgage, interest is added to the balance you owe each month. The amount you owe grows as interest on the loan balance adds up over time. Faison says many borrowers choose to make some payments on their reverse mortgage in order to keep the loan balance down.
Most reverse mortgages have variable rates. While these loans have more flexibility than fixed rate mortgages, your rate can rise quickly and dramatically.
HUD publishes statistics on all federally backed reverse mortgages each month. For October 2016 (the most recent month for which information is available at the time of this writing), interest rates on adjustable rate reverse mortgages range from 2.507% to 6.045%.
Interest is not tax deductible
Unlike a traditional mortgage, the interest you'll pay on a reverse mortgage is not tax deductible until the loan is paid partially or in full.
Need to continue paying other obligations
You will still be responsible for paying property taxes, insurance, utilities, fuel, maintenance, and other standard costs of keeping up the home, just as you would with a conventional or no mortgage. If you cannot or do not continue to pay real estate taxes or insurance or to maintain the home, the lender may require repayment of the reverse mortgage.
May require "set-aside" amounts
Lenders are required to conduct a financial assessment to ensure borrowers have the financial capacity to continue paying obligations such as property taxes, homeowners insurance, and maintenance. If the lender determines that the borrower may not be able to keep up with such payments, they may require "set-aside" amounts to cover future obligations.
The set-aside amount is based on a formula that takes into account your current property taxes and homeowners insurance premiums, projected increases to taxes and insurance rates, monthly interest rates, and the life expectancy of the youngest borrower. While set-aside amounts help ensure borrowers can continue to meet loan obligations, those amounts will reduce your payment amounts.
Some unscrupulous advisers try to pressure borrowers into using proceeds from a reverse mortgage to purchase other financial investments. The Financial Industry Regulatory Authority (FINRA) warns consumers to be skeptical of such advice. If those other investments lose value, you or your heirs may not have the means to pay off the reverse mortgage balance and may have to sell the home.
Primary residence requirement
Faison says she also reminds all of her clients about the obligation to continue using the home as your primary residence. You only need to live in the home for six months and one day out of the year for the home to qualify as a primary residence.
Annually, the lender will mail an affidavit that the borrower needs to complete, sign, and send back to confirm they are still there. Make sure to respond to those notices. Otherwise, the lender may believe you are no longer living in the home and take steps to collect on the loan balance.
How to shop for a reverse mortgage
Reverse mortgages are not one-size-fits-all products. Here are a few things to keep in mind when selecting a reverse mortgage.
Types of reverse mortgages
- Single-purpose reverse mortgages. These are offered by some state and federal agencies and nonprofit organizations. As the name implies, the loans can be used for only one purpose, such as home repairs or improvements or property taxes.
- Proprietary reverse mortgages. These are private loans without federal backing. Owners of higher-valued homes may receive bigger advances from a proprietary reverse mortgage.
- Home Equity Conversion Mortgages (HECMs). HECMs are federally insured and backed by HUD. Proceeds can be used for any purpose. An HECM may be more expensive than a traditional home loan, but they offer more flexibility. Borrowers can choose several payment options, including:
- Single disbursement
- Fixed monthly advances over a specified period of time
- Fixed monthly advances as long as you live in your home
- A line of credit
- A combination line of credit and monthly payments
Other considerations for choosing a reverse mortgage
Faison recommends working with a local licensed loan officer who specializes in reverse mortgages or HECMs. "It's fine to work with companies you hear about on TV," Faison says, "but I often work with people who heard about reverse mortgages on the television but then decide they want to work with someone local."
No matter who you work with, make sure you understand all costs involved. Loan expenses, including origination fees, interest rates, closing costs, and servicing fees, can vary among lenders. Make sure you fully understand the total cost of the loan.
How long do reverse mortgages take?
Depending on where you live and how busy appraisers are in your area, it could take two months or more just to get an appraisal on your home, which is only the first step in the process.
Faison also recommends asking your loan consultant how long the reverse mortgage process will take. If you are facing foreclosure or need money right away, a reverse mortgage may take more time than you have. Faison says some lenders may take 60 days or more, depending on the appraisal. “The appraisal industry has undergone a lot of change recently, and there are fewer appraisers available,” Faison says.
Alternatives to a reverse mortgage
A reverse mortgage isn't right for everyone. Faison speaks with many people who ultimately are not good candidates. Credit issues may stand in the way of passing a financial assessment. In other cases, homes haven't been maintained and are unable to pass the appraisal process. These problems can be resolved. However, if they are impossible to overcome, alternatives to a reverse mortgage include the following.
Refinance existing mortgage
If you have an existing home loan, you may be able to refinance your mortgage to reduce your monthly payments and free up some cash.
Take out a home equity loan or line of credit
If you own your home outright, you may be able to take out a home equity loan or line of credit. You will still be responsible for monthly payments, but the interest on the loan is usually tax deductible up to $100,000.
Sell your home and downsize or rent
If you are willing and able to move, selling your home to downsize or rent will free up the equity in your home, giving you extra cash to save, invest, or spend. You could also sell the home to your kids or another family member. Often, people who sell the home to a family member use a sale leaseback agreement where they rent back the home using proceeds from the sale.
A REX agreement is an alternative to a home equity line of credit. It allows you to access the equity in your home, giving you a cash payment of a percentage of your home's market value (typically 12% to 17%) in exchange for 50% of the increase in your home's value when it is sold. For example, if the home is worth $100,000 when the REX agreement is signed, the homeowner may receive a cash payment of $12,000 to $17,000. If the home increases in value by $50,000 over the next 10 years, when the home is sold, the company receives $25,000 (50% of the $50,000 increase).
Rent out part of your home
If you want to stay in your home but need some additional income, you may be able to rent out a part of your home to a roommate. Be sure to screen candidates carefully.
The bottom line
If you are considering a reverse mortgage of any kind, make sure you understand the pros and cons of this complex financial product before you sign. The television commercials may make it look easy, but a reverse mortgage is a serious financial commitment that comes at a cost and may impact potential heirs.
If you do not have the money to continue living in your current home at your current lifestyle, borrowing money against your home equity may not be the best option. Discuss your situation with a trusted adviser and a reputable, licensed loan officer with experience in reverse mortgages and HECMs. If you do decide that a reverse mortgage is right for you, review the different types of reverse mortgages and shop around for the best terms and rates. Do some research to find a counselor or company who will take the time to help you understand the costs and obligations before making any decisions.