What is 'Reverse Mortgage'
A reverse mortgage is a type of mortgage in which a homeowner can borrow money against the value of his or her home, receiving funds in the form of a fixed monthly payment or a line of credit. No repayment of the mortgage (principal or interest) is required until the borrower dies, moves away permanently or sells the home. The transaction is structured so that the loan amount will not exceed the value of the home over the life of the loan.
BREAKING DOWN 'Reverse Mortgage'
Reverse mortgages have existed in one form or another since the 1960s, but the modern version has recently entered public awareness as a viable debt instrument for homeowners. Although this type of loan has been viewed with distrust by both the financial planning community and the media, demand has been increasing because it can provide a quick solution for people who are “house rich and cash poor," especially senior citizens who need to supplement their retirement income or pay for long-term care. Before jumping in, however, it’s important to understand the basics, including how reverse mortgages work, how they are obtained and the costs involved.
How Does a Reverse Mortgage Work?
Most people purchase a home with a regular (or forward) mortgage: You borrow money from a lender, make monthly payments to pay down the balance, and steadily build equity in the home. Over time, your debt decreases and your home equity increases, and when the mortgage is paid in full, you own the home outright.
A reverse mortgage works differently – in fact, as the name implies, it works the opposite way. Instead of making monthly payments to a lender, a lender makes payments to you, based on a percentage of the value in your home. You choose whether the cash is paid as a single lump sum, a regular monthly cash advance (either for as long as you live in the home or for a certain number of years), a line of credit (where you decide when and how much to borrow), or a combination of these options.
Throughout the life of the reverse mortgage, you keep title to your home, which acts as collateral for the loan. You are charged interest only on the proceeds you receive, and both fixed and variable interest rates are available. Most reverse mortgages are variable interest rate loans tied to short-term indexes, such as the 1-year Treasury Bill or the London Interbank Offered Rate (LIBOR), plus a margin that can add an extra one to three percentage points. Any interest compounds over the life of the reverse mortgage until repayment occurs.
As the loan progresses, your debt increases while your home equity decreases. When you move, sell the home or pass away, the lender sells the home to recover the money that was paid out to you. After lender fees are paid, any equity left in the home goes to you or your heirs (in some cases, the heirs have the option of repaying the mortgage without selling the home). If you receive more payments than your home is worth (if you “outlive” the loan), you will never owe more than the value of the home, according to the Federal Trade Commission.
A reverse mortgage can become due if you fail to meet the obligations of the mortgage; for example, if you fail to pay your taxes and/or insurance, or if the property falls into disrepair. You remain responsible for paying property taxes, homeowners insurance and maintaining your home. But if its value drops below the amount you've borrowed for other reasons, like a decline in the housing market, you can't be foreclosed upon.
Types of Reverse Mortgages
There are several different types of reverse mortgages. They include:
Single-purpose reverse mortgages, which are offered by some state and municipal government agencies and non-profits
Federally-insured reverse mortgages, known as HECMs (Home Equity Conversion Mortgages)
Proprietary reverse mortgages, which are private loans backed by an issuing company
Single-purpose reverse mortgages are usually for low- and moderate-income homeowners. The lender determines how this type of reverse mortgage can be used (for example, to pay property taxes or for repairs to the house).
The Home Equity Conversion Mortgage (HECM) is the most common. HECM loans are issued by private banks and insured by the Federal Housing Administration (they are the only reverse mortgage products guaranteed by the U.S. government). These loans have no income limitations or medical requirements, and there are no restrictions on how the money can be spent. The primary drawback to this type of reverse mortgage is that the maximum loan amount is limited (currently, it's the lesser of the residence's appraised value or the HECM FHA mortgage limit of $625,500).
Proprietary reverse mortgages, also available from various lending institutions, offer amounts that are higher than HECM loans; however, that potential benefit comes at a cost. Non-HECM mortgages are not federally insured and can be considerably more expensive. Homeowners with higher-value homes (in the six figures, say) can benefit the most from this type.
How to Get a Reverse Mortgage
Because the vast majority of reverse mortgages are HECM loans, we’ll focus on them. To qualify, you must:
Be at least 62 years old
Own the home outright (or have a low mortgage balance)
Be capable of making timely and full payments for ongoing property charges (e.g. property taxes, insurance, HOA fees, etc.)
Participate in a consumer information session offered by a U.S. Department of Housing and Urban Development (HUD)-approved HECM counselor (these sessions are free)
Often, the lender will require that there can be no other liens against the home (if there are, they must be paid off with the proceeds of the reverse mortgage).
In addition, your home must be:
A single family home or a two-to-four unit home (and you occupy at least one of the units)
A HUD-approved condominium project or townhouse
A manufactured home that meets FHA requirements (built after June 1976)
You can’t get a reverse mortgage on a rental home, a vacation home or even a home that used to be your primary residence but has been unoccupied for a year (because you’ve been living in a nursing home, for example). Once you have a reverse mortgage, however, you can live elsewhere for up to 12 months before the loan becomes due.
How Much Can You Borrow?
Since you aren’t making payments on a reverse mortgage, but rather are receiving payments, you don’t necessarily need any earned income to qualify for one. However, lenders are now conducting financial assessments to ensure that borrowers are able to meet mandatory financial obligations, such as property taxes and insurance. Your income, assets, monthly living expenses, and credit history will be verified during the loan process (though your credit score isn’t a significant factor). if you don’t have enough income or liquid assets, the lender might set aside part of your reverse-mortgage proceeds to cover taxes and insurance.
The amount of money you receive depends on a number of factors, including the age of the youngest borrower (couples can borrow, not just individuals), the current interest rate, the value of the home and – in the case of a HECM loan – the lending limit. In general, the older you are, the more valuable your home and the more equity you have it, the more money you can get for a reverse mortgage.
Here's an example of how it can work for two houses in the same area, both worth $300,000: John was born on January 1, 1942, and may be able to get a home equity loan of $174,900 (before fees, insurance and closing costs). John’s neighbor, Jim, born on January 1, 1952, will likely be able to borrow only $154,200 because of his younger age.
The Costs of Reverse Mortgages
Reverse mortgages involve a number of costs. The fees and charges include:
Mortgage Insurance Premium (MIP). Mortgage insurance guarantees that you will receive your loan advances if the company managing your account (the loan servicer) goes out of business. You will typically be charged an upfront MIP of 0.5% of the home’s appraised value (or 2.5% if you take more than 60% of available funds). You will also be charged MIP on an annual basis, equal to 1.25% of the outstanding loan balance. This amount accrues over time and is paid when the loan becomes payable.
Loan origination fee. If your home is valued at less than $125,000, your lender can charge an origination fee up to $2,500. If your home is valued at more than that amount, the lender can charge up to 2% of the first $200,000 of your home’s value, plus up to 1% of any amount greater than $200,000. Origination fees for HECM loans are capped at $6,000.
Servicing fees. Lenders can charge you a monthly servicing fee of $30 if the loan has an annually adjusting interest rate, or $35 if the interest rate adjusts on a monthly basis. The fee covers things like sending your checks and account statements, plus any other customer service.
You can roll these into the loan if you don’t want (or can’t afford) to pay for them up front and out-of-pocket. If you do, they will accrue interest as part of the overall balance.
The Counseling Requirement
Before you can get a reverse mortgage, you’re required by the federal government to go through mortgage counseling.
Reverse mortgage counselors work for independent, government-approved housing counseling agencies, and their job is to explain the costs and consequences of taking out an HECM and the various ways you can receive the proceeds. They will also help you explore other options for making ends meet, such as getting public assistance to pay for your food, utilities and medications. The Federal Trade Commission says you can expect to pay around $125 for mortgage counseling. If you can’t afford it, that doesn’t mean you can’t get a reverse mortgage, but you will need to find a reverse mortgage counselor who waives the fee.
Mortgage counseling is designed to protect those who aren’t financially savvy and need extra help understanding what they’re getting into. If you already fully comprehend how reverse mortgages work, this step is probably going to feel like a waste of time and money; just find the least expensive, most convenient option – phone consultations are available in most states – and get it over with. Because reverse mortgages can be complicated and expensive, it never hurts to run through the details one more time or pose some last-minute questions.
The Younger Spouse Problem
Because reverse mortgage borrowers must be at least 62 years old, in the past, some married couples made only one spouse an official borrower on the reverse mortgage contract. The goal was to increase the reverse mortgage proceeds because older borrowers get more money. That decision had unintended consequences: If the borrowing spouse died first, the reverse mortgage came due, and the surviving spouse would lose the home unless he or she could repay the reverse mortgage. (HUD now has a procedure that often can avoid that problem.)
If you take out a reverse mortgage today, the lender must include both you and your spouse on the contract even if one of you isn’t yet 62 years old, thanks to 2014 HUD rules following a 2013 court ruling. If one spouse is not yet 62, he or she still will not be a borrower. However, these new rules set up a deferral period that prevents a widow or widower from potentially losing the home. Unfortunately, the new rules also mean that loan proceeds now have to be based on the younger spouse’s age.
In August 2014, the Department of Housing and Urban Development further revised their policies to allow for the transferring of the reverse mortgage benefits to a surviving non-borrowing spouse after the borrowing spouse passes away.
What Happens Afterwards
Once the remaining borrower and spouse has died or moved from the property, the heirs have several options, depending on how much equity is in the property.
The heirs can keep the property, which would entail paying off the balance owed, or at least 95% of the current appraised value of the home, either from their own funds or by refinancing the existing mortgage.
The heirs can sell the property, and they would be able to keep any proceeds from the sale after the reverse mortgage is paid off.
The heirs can walk away if the property has little to no equity or the mortgage is underwater, which means the balance owed is greater than the value of the home, the heirs can simply give the keys to the lender. In fact, they may have to: Most reverse loan documents stipulate that upon the homeowner's death or cessation of the homeowner's residence in the house, homes with mortgage balances greater than the home's value will be repossessed. Most reverse mortgages have a ‘nonrecourse’ clause, which prevents you or your estate from owing more than the value of the home when the loan becomes due; but in this situation, the only alternative may be for the heirs to produce the balance in cash.
Reverse Mortgages for Home Buying
A special type of FHA-insured reverse mortgage called the HECM for Purchase lets seniors use a reverse mortgage to buy a home. This option can work if your current home doesn’t meet your needs (too large, too many stairs, etc.), you don’t have significant retirement assets or enough monthly cash flow to support a mortgage payment on top of your other expenses, and your long-term plan is to age in place in a home that you own.
In general, conditions, costs and other qualifications for this HECM parallel that of regular HECM. As with a regular HECM, an HECM for Purchase requires you to either own the home outright or have a substantial amount of equity in it. You’ll need to pay somewhere between 50% and 100% of the purchase price at closing. The older you are, the smaller your required down payment and the more you can borrow, all else being equal. You can’t use a reverse for purchase to buy a home that hasn’t been constructed yet. But you can use it to buy a brand-new home, as long as it’s finished and has been issued a certificate of occupancy.
Reverse Mortgages Pros and Cons
For people who are planning to stay in their homes, a reverse mortgage can be a good, ready source of needed cash flow. It’s generally easier to qualify for a reverse mortgage than to qualify for a regular, forward mortgage. Your credit score isn’t a factor, and you only need enough income or assets to continue paying for homeowners insurance, property taxes and home maintenance.
Seniors don’t have to pay taxes on the money they receive from a reverse mortgage: They are not considered income and therefore, not taxable. On the flip side, the interest generated by the loan is not tax-deductible over its term; it can be deducted only when the loan is paid off in full – unless the borrower actually makes interest payments as he goes along (which somewhat defeats the rationale for getting a reverse mortgage in the first place).
Most of all, it’s important to understand that, because they use up equity in your home, reverse mortgages will leave you and your heirs with fewer assets. That could be desirable if you're seeking to reduce the size of a taxable estate, but it means you won’t be able to give or sell your home to a child during your lifetime without repaying the mortgage.
As with any loan, it always pays to shop around for rates and terms. And homeowners of a certain age with good credit who are considering reverse mortgages should carefully analyze the options of other home-secured financings, such as a home-equity loan or home equity line of credit.