Reverse mortgage: What is it and how does it work?
What is a reverse mortgage?
Reverse mortgages are often considered a last-resort source of income, but they have become a great retirement planning tool for many homeowners.
The first federally-insured reverse mortgage — also known as a home equity conversion mortgage, or HECM — was introduced in 1989. These loans allow people who are 62 or older to tap a portion of their home equity without having to move.
Who would benefit from a reverse mortgage?
Steven Sass, research economist at the Center for Retirement Research at Boston College, says a reverse mortgage makes sense for people who:
- Don’t plan to move.
- Can afford the cost of maintaining their home.
- Want to access the equity in their home to supplement their income or have money available for a rainy day.
Some people even use a reverse mortgage to eliminate their existing mortgage and improve their monthly cash flow, says Peter Bell, president and CEO of the National Reverse Mortgage Lenders Association, or NRMLA.
“There are a lot of motivations leading into it,” Bell says. “In some cases, people may have an immediate need to pay off debt, or they may have had some unexpected expenses like a home repair or health care situation.”
The bank makes payments to the borrower throughout his or her lifetime based on a percentage of accumulated home equity. The loan balance does not have to be repaid until the borrower dies, sells the home or permanently moves out.
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Reverse mortgage basics
- How does it work? The bank makes payments to the borrower based on a percentage of accumulated home equity.
- When does it need to be repaid? When the borrower dies, sells the home or permanently moves out.
- Who is eligible? Seniors age 62 and older who own homes outright or have small mortgages.
- How can the money be used? For any reason. Retirees typically use cash to supplement income, pay for health care expenses, pay off debt or finance home improvement jobs.
Better yet, you can never owe more than the value of your home in a reverse mortgage loan, regardless of how much you borrow. And if the balance is less than the value of your home at the time of repayment, you or your heirs keep the difference.
How much can you get?
Several factors determine the amount of funds you are eligible to receive through a reverse mortgage.
Factors that influence reverse mortgage loan amount
- Age (or the age of the youngest spouse in the case of couples).
- Value of home.
- Interest rate.
- Lesser of appraised value or the Federal Housing Administration’s HECM mortgage limit of $636,150.
To be eligible for a reverse mortgage, you must either own your home outright or have a low mortgage balance that can be paid off at the closing with proceeds from the reverse loan.
You must also use the home as your primary residence.
A change in federal rules that took effect in October 2017 tightened the amounts that can be borrowed. But generally, the older you are and the more valuable your home, the more money you can get.
There are no restrictions for how the money from a reverse mortgage loan must be used.
The method of payment collection depends on the type of mortgage. Retirees with an adjustable-rate mortgage can collect their payments on a reverse mortgage as a lump sum, fixed monthly payment, line of credit or some combination.
Holders of fixed-rate mortgages receive a lump sum.
Pros and cons of a reverse mortgage
- Does not require monthly payments from the borrower.
- Proceeds can be used to pay off debt or settle unexpected expenses.
- The money can pay off the existing mortgage.
- Funds can improve monthly cash flow.
- Fees and other closing costs can be high.
- Borrower must maintain the house and pay property taxes and homeowners insurance.
- A reverse mortgage can complicate one’s wish to keep the house in the family.
Who wouldn’t benefit?
A reverse mortgage wouldn’t be the best option if you can’t keep up with maintenance and the other costs associated with the home, even without a monthly mortgage payment.
If you die or the home is no longer the primary residence for more than 12 months, the loan comes due, which means either you or the estate has the option to repay the loan or put the home up for sale to settle it.
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Homeowners interested in taking out a reverse mortgage are required to receive mandatory (free) counseling by an independent third party, including an agency approved by the Department of Housing and Urban Development or a national counseling agency such as AARP. These organizations help homeowners review alternative options.
“As you get older, it gets harder to grasp some of the terms in these kinds of transactions, so it’s not a bad idea to have someone younger who you trust, like an adult child, involved in the process,” says Phillip Cook, CFP professional in Manhattan Beach, California.
Reverse mortgage costs
If you decide to proceed with the loan, you can expect to pay higher-than-average closing costs based on the value of your home, including origination fees, upfront mortgage insurance and appraisal fees.
The interest rate you pay is also generally higher than that for a traditional mortgage.
Keep in mind that anyone who takes out a reverse mortgage remains responsible for paying property taxes, insurance and repairs on their home. If you fail to comply, you may be required to repay your reverse mortgage early.
Spending the equity in your home, of course, also diminishes the value of your estate — leaving you less to pass along to your heirs down the road.
“Always explore all other sources of income first before tapping into your home equity,” advises Cook. “Liquidate your portfolio and cut down on your living expenses. If you still don’t have enough, a reverse mortgage may make sense.”
To locate a Federal Housing Authority-approved lender or HUD-approved counseling agency, you can visit HUD’s online locator or call the department’s Housing Counseling Line at (800) 569-4287.
The National Reverse Mortgage Lenders Association also maintains a database.
Thinking of applying for a reverse mortgage? First, check your credit report at myBankrate.