Reverse Mortgage

What Is a Reverse Mortgage?

In a word, a reverse mortgage is a loan. A homeowner who is 62 or older and has considerable home equity can borrow against the value of their home and receive funds as a lump sum, fixed monthly payment, or line of credit. Unlike a forward mortgage—the type used to buy a home—a reverse mortgage doesn’t require the homeowner to make any loan payments.

Instead, the entire loan balance becomes due and payable when the borrower dies, moves away permanently, or sells the home. Federal regulations require lenders to structure the transaction so that the loan amount doesn’t exceed the home’s value and that the borrower or borrower’s estate won’t be held responsible for paying the difference if the loan balance does become larger than the home’s value. One way that this could happen is through a drop in the home’s market value; another is if the borrower lives for a long time.

KEY TAKEAWAYS

• A reverse mortgage is a type of loan for seniors ages 62 and older.¹
• Reverse mortgage loans allow homeowners to convert their home equity into cash income with no monthly mortgage payments.
• Most reverse mortgages are federally insured,² but beware of a spate of reverse mortgage scams that target seniors.
• Reverse mortgages can be a great financial decision for some seniors but a poor financial decision for others. Be sure to understand how reverse mortgages work and what they mean for you and your family before deciding.

How does a reverse mortgage work?

Cash in Equity

Reverse mortgages can provide much-needed cash for seniors whose net worth is mostly tied up in the value of their home. On the other hand, these loans can be costly and complex, as well as subject to scams. This article will teach you how reverse mortgages work and how to protect yourself from the pitfalls, so you can make an informed decision about whether such a loan might be right for you or your parents.

How a Reverse Mortgage Works

With a reverse mortgage, instead of the homeowner making payments to the lender, the lender makes payments to the homeowner. The homeowner gets to choose how to receive these payments (we’ll explain the choices in the next section) and only pays interest on the proceeds received. The interest is rolled into the loan balance so that the homeowner doesn’t pay anything up front. The homeowner also keeps the title to the home. Over the loan’s life, the homeowner’s debt increases and home equity decreases.

As with a forward mortgage, the home is the collateral for a reverse mortgage. When the homeowner moves or dies, the proceeds from the home’s sale go to the lender to repay the reverse mortgage’s principal, interest, mortgage insurance, and fees. Any sale proceeds beyond what was borrowed go to the homeowner (if still living) or the homeowner’s estate (if the homeowner has died). In some cases, the heirs may choose to pay off the mortgage so that they can keep the home.

Reverse mortgage proceeds are not taxable. While they might feel like income to the homeowner, the Internal Revenue Service (IRS) considers the money to be a loan advance.¹

Types of Reverse Mortgages

There are three types of reverse mortgages. The most common is the home equity conversion mortgage (HECM). The HECM represents almost all of the reverse mortgages that lenders offer on home values below $765,600 and is the type that you’re most likely to get, so that’s the type that this article will discuss. If your home is worth more, however, you can look into a jumbo reverse mortgage, also called a proprietary reverse mortgage.

When you take out a reverse mortgage, you can choose to receive the proceeds in one of six ways:

1. Lump sum: Get all the proceeds at once when your loan closes. This is the only option that comes with a fixed interest rate. The other five have adjustable interest rates.
2. Equal monthly payments (annuity): For as long as at least one borrower lives in the home as a principal residence, the lender will make steady payments to the borrower. This is also known as a tenure plan.
3. Term payments: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years.
4. Line of credit: Money is available for the homeowner to borrow as needed. The homeowner only pays interest on the amounts actually borrowed from the credit line.
5. Equal monthly payments plus a line of credit: The lender provides steady monthly payments for as long as at least one borrower occupies the home as a principal residence. If the borrower needs more money at any point, they can access the line of credit.
6. Term payments plus a line of credit: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years. If the borrower needs more money during or after that term, they can access the line of credit.¹

It’s also possible to use a reverse mortgage called a “HECM for purchase” to buy a different home than the one in which you currently live.⁵ Also called a Federal Housing Administration (FHA) reverse mortgage, this type of mortgage is only available through an FHA-approved lender.⁶

In any case, you will typically need at least 50% equity—based on your home’s current value, not what you paid for it—to qualify for a reverse mortgage. Standards vary by lender.

Pros and Cons of a Reverse Mortgage

Once you’re 62 or older, a reverse mortgage can be a good way to get cash when your home equity is your biggest asset and you don’t have another way to get enough money to meet your basic living expenses. A reverse mortgage allows you to keep living in your home as long as you keep up with property taxes, maintenance, and insurance and don’t need to move into a nursing home or assisted living facility for more than a year.

However, taking out a reverse mortgage means spending a significant amount of the equity that you’ve accumulated on interest and loan fees, which we will discuss below. It also means that you likely won’t be able to pass down your home to your heirs. If a reverse mortgage provides a short-term solution to your financial problems rather than a long-term one, then it may not be worth the sacrifice.

What if someone else, such as a friend, relative or roommate, lives with you? If you get a reverse mortgage, that person won’t have any right to keep living in the home after you pass away.⁹

Another problem that some borrowers run into with reverse mortgages is outliving the mortgage proceeds. If you pick a payment plan that doesn’t provide a lifetime income, such as a lump sum or a term plan, or if you take out a line of credit and use it all up, you might not have any money left when you need it.

What Are the Requirements for a Reverse Mortgage?

If you own a house, condominium, or townhouse, or a manufactured home built on or after June 15, 1976, then you may be eligible for a reverse mortgage. Under FHA rules, cooperative housing owners cannot obtain reverse mortgages since they do not technically own the real estate in which they live but rather own shares of a corporation. In New York, where co-ops are common, state law further prohibits reverse mortgages in co-ops, allowing them only in one- to four-family residences and condos.

While reverse mortgages don’t have income or credit score requirements, they still have rules about who qualifies. You must be at least 62 years old, and you must either own your home free and clear or have a substantial amount of equity (at least 50%). Borrowers must pay an origination fee, an up-front mortgage insurance premium, ongoing mortgage insurance premiums (MIPs), loan servicing fees, and interest. The federal government limits how much lenders can charge for these items.¹⁰

Lenders can’t go after borrowers or their heirs if the home turns out to be underwater when it’s time to sell. They also must either allow any heirs several months to decide whether they want to repay the reverse mortgage or allow the lender to sell the home to pay off the loan.⁹

The U.S. Department of Housing and Urban Development (HUD) requires all prospective reverse mortgage borrowers to complete a HUD-approved counseling session. This counseling session, which usually costs around $125, should take at least 90 minutes and cover the pros and cons of taking out a reverse mortgage given your unique financial and personal circumstances.¹¹ It should explain how a reverse mortgage could affect your eligibility for Medicaid and Supplemental Security Income (SSI). The counselor should also go over the different ways that you can receive the proceeds.

Your responsibilities under the reverse mortgage rules are to stay current on property taxes and homeowners insurance and keep the home in good repair. And if you stop living in the house for longer than one year—even if it’s because you’re living in a long-term care facility for medical reasons—then you’ll have to repay the loan, which is usually accomplished by selling the house.