Although they have received increased attention in recent years, many consumers still have a hard time fully understanding what reverse mortgages are, how they work and who they benefit.
Continue reading for a thorough explanation on the above topics, plus a discussion of the advantages and disadvantages of this complex financial product.
What is a reverse mortgage?
A reverse mortgage is a loan that allows senior homeowners to borrow money against their home’s equity. Instead of making monthly payments to their mortgage lender, the homeowner receives money every month from their lender — or receives a larger amount in a lump sum. The balance owed to the lender grows over time and isn’t due until the homeowner moves out, sells the property or passes away.
Reverse mortgages are the opposite of a “forward,” or traditional, mortgage, which allows a borrower to purchase a home and repay their lender on a monthly basis. With traditional mortgages, the balance owed reduces over time until it’s completely paid off.
In both forward and reverse mortgages, the property is used as collateral for the loan. Only homeowners who are at least 62 years old can take out a reverse mortgage.
Reverse mortgage types
There are three types of reverse mortgages available to homeowners depending on their situation.
Home Equity Conversion Mortgage (HECM)
This is the most common reverse mortgage and is backed by the Federal Housing Administration (FHA). A HECM offers more flexibility in terms of how payments are disbursed to borrowers. Payment options include:
- A single, lump-sum 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 of a credit line and monthly payments.
Single-purpose reverse mortgage
As the name suggests, this type of loan is used for a single purpose, such as covering home repairs or property taxes. Loan proceeds are typically distributed in a lump sum to cover the homeowner’s financial need. Single-purpose reverse mortgages are offered by nonprofit agencies and some local and state governments.
Proprietary reverse mortgage
This loan is offered by private lenders and usually benefits borrowers with high-value homes because they may receive bigger advances.
How a reverse mortgage works
A reverse mortgage is a loan that takes a portion of your equity and converts it into payments made to you. The money you receive is typically tax-free, according to the Federal Trade Commission. Unlike a traditional home equity loan, you are not required to pay back a reverse mortgage on a set schedule.
Let’s look at an example of how a reverse mortgage works:
John is retired, has paid off his mortgage and owns his home outright. He wants to stay in his home, but needs to supplement the monthly income he receives from Social Security and his pension.
The total amount John can borrow using a reverse mortgage is based on his age and that of his spouse, current mortgage rates and the home’s value; these limits are imposed by HUD. Here’s how the numbers could possibly work out for him, based on LendingTree’s reverse mortgage calculator:
|Value of the home||$300,000|
|Title holder’s age||70|
|Lump sum estimate||$145,902|
Based on the calculator, John might qualify for as much as $145,902 if he decides to go the single disbursement route. An advantage of getting a lump-sum payment from your lender is that the interest rate will be fixed, unlike the other options which have an adjustable interest rate.
The reverse mortgage loan limit is $726,525 for 2019, which is 150% of the conforming loan limit of $484,350 for forward mortgages. Still, even if the amount of equity you have is lower than the loan limit, you won’t be allowed to borrow the full amount.
The amount you’re allowed to borrow for a reverse mortgage is determined by the age of the youngest borrower, the home’s appraised value and the anticipated interest rate. Generally, the older you are, the more you can borrow.
Costs and fees
The most common fees associated with a reverse mortgage include:
- A loan origination fee, which could cost up to 2% of the loan amount.
- An initial mortgage insurance premium, which is a flat 2% fee.
- An annual mortgage insurance premium, which is 0.5%.
- Housing counseling, which usually costs about $125.
There are also additional closing costs and interest fees.
Reverse mortgage requirements
Senior homeowners who are interested in borrowing a reverse mortgage must meet the following requirements:
- Be at least age 62 or older.
- Own your home outright or have a small remaining mortgage balance. If you still have a loan, a good rule of thumb is to have at least 50% equity in your home, because you’ll first need to use the reverse mortgage funds to pay off the outstanding balance on your forward mortgage.
- Must be seeking a loan backed by your primary residence.
- Have no federal debt delinquencies, including student loans and taxes.
- Proof of sufficient income to cover your property taxes, homeowners insurance and other housing-related expenses.
- Demonstrate your creditworthiness as a potential borrower. While there isn’t a minimum credit score requirement, it helps your case to be responsible with your credit usage by maintaining on-time payments, keeping your balances low, etc.
- Participate in an information session with a HUD-approved reverse mortgage counselor.
Most reverse mortgages have what’s called a “non-recourse feature,” which means if the lender takes legal action against you due to default, the lender can only use the home to satisfy the defaulted debt and can’t come after you for any difference between how much you owe and the home’s value. This also applies to your heirs in the event you pass away and the home is sold to repay the debt.
4 things to watch for when taking out a reverse mortgage
Just like all other financial products, a reverse mortgage comes with its share of risks, which typically include the following:
Higher financing costs
Compared with a forward mortgage, the fees associated with a reverse mortgage are more costly. As an example, a HECM lender can charge an origination fee equal to $2,500 or 2% of the first $200,000 of your home’s value, whichever is greater, plus another 1% for any home value amount above $200,000. The maximum allowable origination fee is $6,000. By contrast, the average origination fee for a traditional mortgage is just under $1,000, according to data from Value Penguin, a LendingTree company.
Increase in debt
You receive income from a reverse mortgage, but it’s still a loan that you or your estate will be responsible for repaying. Since you’re borrowing from your home’s available equity, your loan balance increases over time, which adds to your outstanding debt load.
No tax deductibility
The IRS treats the income received from reverse mortgages as loan advances, and for that reason any interest paid on a reverse mortgage isn’t tax-deductible.
Rising interest rates
The majority of reverse mortgage products have an adjustable interest rate, which is subject to market fluctuations. Your rate will be at a high risk of increasing very quickly.
Reverse mortgage pros and cons
Consider the following benefits and drawbacks before applying for a reverse mortgage:
- Increase in your monthly income. If you opt for monthly payments from your lender, a reverse mortgage gives you additional income every month on top of any retirement income you already receive.
- Flexibility to use the funds how you see fit. If you take out a HECM or proprietary reverse mortgage, there aren’t restrictions imposed on what the money is used for.
- Ability to stay in your home. Not only do you get to keep your home, but you can keep it in your family after you pass away if your estate is able to fully repay the reverse mortgage.
- Free from underwater mortgage stress. If your loan balance becomes greater than your home’s value, you likely won’t be on the hook for the difference between the two.
- High upfront costs. There are origination fees, mortgage insurance expenses and closing costs in a reverse mortgage transaction. If you choose to cover these costs with your loan, you’ll receive a smaller payout.
- Decrease in your home equity. With a reverse mortgage, your loan balance grows and your available equity shrinks over time.
- Loan becomes due if you have a change of heart. If you decide you want to move out of or sell your home, the outstanding balance on your reverse mortgage becomes due immediately.
- Adjustable-rate mortgage. Most reverse mortgages have adjustable interest rates that will likely increase over time. As of January 2019, the latest month for which data are available, reverse mortgage rates range from 3.583% to 7.019%, according to FHA statistics.
Shopping for a reverse mortgage
The first few steps you should take when you decide you want to apply for a reverse mortgage are to educate yourself on how reverse mortgage programs work, and to determine which loan type works best for your financial situation.
Once you have those details figured out, gather multiple quotes from reverse mortgage lenders and compare the costs and fees to find the best deal available. Ask questions about any and everything that seems unclear, and don’t forget to consult a HUD-approved reverse mortgage counselor for extra help.
Consider the interest rate each lender charges, as well as the origination fee and other closing costs. Additionally, work with each lender to determine how folding the financing costs into your loan will affect the amount you ultimately receive and whether it makes sense to pay those costs out-of-pocket instead.
After you’ve closed on a reverse mortgage and — for some unforeseen reason — decide you no longer need it, you have a “right to rescission,” which means you’re allowed to cancel the deal without penalty. You have a minimum of three business days after the loan closes to notify your lender in writing, and the lender has 20 days to refund any money you’ve paid toward the financing of that loan.
FAQs about reverse mortgages
The timeline varies by lender, but the lending process could take two months or longer. Be sure to ask your loan officer for a rough idea.
No, interest paid on reverse mortgage balances is not tax-deductible.
When you pass away, your reverse mortgage becomes due and payable. If you have a surviving spouse or heirs, they will be responsible for paying back the loan, which might involve selling your house.
Reverse mortgage alternatives
A reverse mortgage isn’t the best option for every senior homeowner. If you need money to fund renovations, repairs or other expenses, here are some alternative options.
Borrow a home equity loan or line of credit
If you have a sizeable amount of equity in your home, you might qualify to take out a home equity loan or home equity line of credit (HELOC). You borrow a lump sum of cash with a home equity loan and you’re granted a line of credit, similar to a credit card, with a HELOC. Either of these products might work better if you’re still employed, as they require you to make monthly payments after borrowing the funds.
Refinance your existing mortgage
For those borrowers who still have a mortgage balance, you could refinance your loan by extending the term and lowering your monthly payment amount, which frees up some cash in your budget. You could take advantage of a cash-out refinance, which allows you to borrow a new mortgage that’s larger than what you actually need for your house and pocket the difference.
Rent out a room
Empty-nesters with more home space than they actually need might benefit from renting out one of their bedrooms either through short- or long-term rentals. This generates extra income that can be used for remodeling, traveling or other expenses.
Don’t forget your retirement accounts
As long as you’re old enough to tap your 401(k), IRA or other retirement account without any early withdrawal penalties, going this route is a less costly way to supplement your income. Generally speaking, you can withdraw from your retirement accounts without penalty starting at age 59 ½.
The bottom line
Reverse mortgages come with additional considerations that may not always be a concern for forward mortgages, but they may provide relief for some older homeowners who want to supplement their income and also age in place.
If you can comfortably manage your insurance, tax and other obligations related to homeownership, maintain your property and keep it in good condition, and are confident that your heirs will take care of your home after your passing, a reverse mortgage could work well for you.
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