A reverse mortgage is a loan that allows homeowners to turn part of their home equity into cash. Available to people 62 and older, a reverse mortgage can be set up and paid out as a lump sum, a monthly payment, or a line of credit, which can then be used to fund home renovations, consolidate debt, pay off medical expenses, or simply improve one’s lifestyle.
While older Americans, particularly retiring baby boomers, have increasingly drawn on this financial tool, reverse mortgages aren’t for everyone. Find out how they work, their advantages and disadvantages, and alternatives you might consider instead.
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How Does a Reverse Mortgage Work?
Usually when people refer to a reverse mortgage, they mean a federally insured home equity conversion mortgage (HECM). That being said, there are two other types of reverse mortgages (more on those below).
To qualify for an HECM, all owners of the home must be 62 or older and have paid off their home loan or have a considerable amount of equity. Borrowers must use the home as their primary residence or live in one of the units if the property is a two- to four-unit home. Certain condominium units and manufactured homes are also allowed. The borrower cannot have any delinquent federal debt. Plus, the following will be verified before approval:
• Income, assets, monthly living expenses, and credit history
• On-time payment of real estate taxes, plus hazard and flood insurance premiums, as applicable
The reverse mortgage amount you qualify for is determined based on the lesser of the appraised value or the HECM mortgage loan limit (the sales price for HECM to purchase), the age of the youngest borrower or the age of an eligible non-borrowing spouse, and current interest rates. Generally, the older you are and the more your home is worth, the higher your reverse mortgage amount could be, depending on other eligibility criteria.
The reverse mortgage loan and interest do not have to be repaid until the last surviving borrower dies, sells the house, or moves out permanently. In some cases, a non-borrowing spouse may be able to remain in the home.
An HECM loan may include several charges and fees, such as:
• Mortgage insurance premiums
◦ Upfront fee (2% of the home’s appraised value or the Federal Housing Administration (FHA) lending limit, whichever is less)
◦ Annual fee (0.5% of the outstanding loan balance)
• Third-party charges (an appraisal fee, surveys, inspections, title search, title insurance, recording fees, and credit checks)
• Origination fee (the greater of $2,500 or 2% of the first $200,000 of the home value, plus 1% of the amount over $200,000; the origination fee cap is $6,000)
• Servicing fee (up to $30 per month if the loan interest rate is fixed or adjusted; if the interest rate can adjust monthly, up to $35 per month)
Your lender can let you know which of the above fees are mandatory. Many of the costs can be paid out of the loan proceeds, meaning you wouldn’t have to pay them out of pocket. However, financing the loan costs reduces how much money will be available for your needs.
The servicing fee noted above is a cost you could incur from the lender or agent who services the loan and verifies that real estate taxes and hazard insurance premiums are kept current, sends you account statements, and disburses loan proceeds to you.
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What Is the Most Common Kind of Reverse Mortgage?
The most common type of reverse mortgage is the HECM, or home equity conversion mortgage, which can also be used later in life to help fund long-term care. HECM reverse mortgages are made by private lenders but are governed by rules set by the Department of Housing and Urban Development (HUD). The current loan limit is $1,089,300.
To qualify for this kind of reverse mortgage loan, you must meet with an HECM counselor, which you can find through the HUD site. When you meet with the counselor, they may cover eligibility requirements, potential financial ramifications of the loan and when the loan would need to be paid back, including circumstances under which the outstanding amount would become immediately due and payable. The counselor may also share alternatives.
The reverse mortgage loan generally needs to be paid back if the borrower moves to another home for a majority of the year or to a long-term care facility for more than 12 consecutive months, and if no other borrower is listed on the loan.
However, a new HUD policy offers protections to a non-borrowing spouse when a partner moves into long-term care. The non-borrowing spouse may remain in the home as long as they continue to occupy the home as a principal residence, are still married, and were married at the time the reverse mortgage was issued to the spouse listed on the reverse mortgage.
In 2021, HUD also removed the major remaining impediment to a non-borrowing spouse who wanted to stay in the home after the borrower’s death. Now they will no longer have to provide proof of “good and marketable title or a legal right to remain in the home,” which often meant a probate filing and had forced many spouses into foreclosure.
Two Other Types of Reverse Mortgages
The information provided so far answers the questions “What is a reverse mortgage?” and “How do reverse mortgages work?” for HECMs, but there are also two other kinds: the single-purpose reverse mortgage and the proprietary reverse mortgage.
Here’s more information about each of them.
Single-Purpose Reverse Mortgage
This loan is offered by state and local governments and nonprofit agencies. It’s the least expensive option, but the lender determines how the funds can be used. For example, the loan might be approved to catch up on property taxes or to make necessary home repairs.
Check with the organization giving the loan for specifics about costs, as they can vary.
Proprietary Reverse Mortgage
If a home is appraised at a value that exceeds the maximum for an HECM ($1,089,300), a homeowner could pursue a proprietary reverse mortgage.
Counseling may be required before obtaining one of these loans, and a counselor can help a homeowner decide between an HECM and a proprietary loan.
Typically, proprietary reverse mortgages can only be cashed out in a lump sum. The costs can be substantial and interest rates higher. This type of reverse mortgage, unlike an HECM, is not federally insured, so lenders tend to approve a lower percentage of the home’s value than they would with an HECM.
One cost a borrower wouldn’t have to pay with a proprietary mortgage: upfront mortgage insurance or the monthly premiums. In some cases, the costs associated with this type of mortgage may cause a homeowner to decide to sell the home and buy a new one.
💡 Quick Tip: Generally, the lower your debt-to-income ratio, the better loan terms you’ll be offered. One way to improve your ratio is to increase your income (hello, side hustle!). Another way is to consolidate your debt and lower your monthly debt payments.
Pros and Cons of Reverse Mortgages
• No monthly payments
• Flexibility on how you get money
• Can pay back the loan whenever you want
• The money counts as a loan, not as income
• An HECM can be used to buy a new primary residence
• Rates can be higher than traditional mortgage rates
• Generally requires reducing your home equity
• Must keep up with property taxes, insurance, repairs and any association dues
• Interest accrued isn’t deductible until it’s actually paid
If you’re nearing retirement, it’s easy to see why reverse mortgages are appealing. Here are some of their pros:
• Unlike most loans, you don’t have to make any monthly payments. The HECM loan can be used for anything, whether that’s debt, health care, daily expenses, or buying a vacation home (although this is not true for the single-purpose variety).
• How you get the money from an HECM is flexible. You can choose whether to get a lump sum, monthly disbursement, line of credit or some combination of the three.
• You can pay back the loan whenever you want, even if that means waiting until you’re ready to sell the house. If the home is sold for less than the amount owed on the mortgage, borrowers may not have to pay back more than 95% of the home’s appraised value because the mortgage insurance paid on the loan covers the remainder.
• The money from a reverse mortgage counts as a loan, not as income. As a result, payments are not subject to income tax. Social Security and Medicare also are not affected.
• An HECM can be used to buy a new primary residence. You’d make a down payment and then finance the rest of the purchase with the reverse mortgage.
Then again, here are some cons of reverse mortgages to consider:
• Reverse mortgage interest rates can be higher than traditional mortgage rates. The added cost of mortgage insurance also applies, and, like most mortgage loans, there are origination and third-party fees you will be responsible for paying, as described above.
• Taking out a reverse mortgage generally means reducing the equity in your home. That can mean leaving less for those who might inherit your house.
• You’ll need to keep up property taxes and insurance, repairs, and any association dues. If you don’t pay insurance or taxes, or if you let your home go into disrepair, you risk defaulting on the reverse mortgage, which means the outstanding balance could be called as immediately “due and payable.”
• Interest accrued on a reverse mortgage isn’t deductible until it’s actually paid (usually when the loan is paid off). And a deduction of mortgage interest may be limited.
Alternatives to Reverse Mortgages
A reverse mortgage payout depends on the borrower’s age, the value of their home, the mortgage interest rate and loan fees, as well as whether they choose a lump sum, line of credit, monthly payment, or a combination of those options.
If the payout will not provide financial stability that allows an individual to age in place, there are other ways to tap into cash, including:
Cash-out refi: If you meet credit and income requirements, you may be able to borrow up to 80% of your home’s value with a cash-out refinance of an existing mortgage. Closing costs are involved, but this product lets you turn home equity into cash and possibly lock in a lower interest rate.
Personal loan: A personal loan could provide a lump sum without diminishing the equity in your home. This kind of loan does not use your home as collateral. It’s generally a loan for shorter-term purposes.
Home equity line of credit (HELOC): A HELOC, based in part on your home equity, provides access to cash in case you need it but requires interest payments only on the money you actually borrow. Sometimes a lender will waive or reduce closing costs if you keep the line open for at least three years. HELOCs usually have a variable interest rate.
💡 Recommended: What Are Home Equity Lines of Credit (HELOC)?
Home equity loan: A fixed-rate home equity loan allows you to borrow a lump sum based on your home’s market value, minus any existing mortgages. You make a monthly principal and interest payment each month. Again, lenders may reduce or waive closing costs if you keep the loan for, usually, at least three years.
A reverse mortgage may make sense for some older people who need to supplement their cash flow. But many factors must be considered, including the youngest homeowner’s age, home value, equity, loan rate and costs, heirs, and payout type. As homeowners are weighing the pros and cons, remember there are other options.
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