What Is A Reverse Mortgage And How Does A Reverse Mortgage Work?
|What Is A Reverse Mortgage?|
If you want money to pay off your mortgage, supplement your income, or pay for healthcare expenses – you may consider a reverse mortgage. It allows you to convert part of the equity in your home into cash without having to sell your home or pay additional monthly bills. But take your time: a reverse mortgage can be complicated and might not be right for you. A reverse mortgage can use up the equity in your home, which means fewer assets for you and your heirs. If you do decide to look for one, review the different types of reverse mortgages, and comparison shops before you decide on a particular company.
Read on to learn more about how reverse mortgages work, qualifying for a reverse mortgage, getting the best deal for you, and how to report any fraud you might see.
What is a reverse mortgage?
Think of a reverse mortgage like a conventional mortgage where the roles are switched. In a conventional mortgage, a person takes out a loan in order to buy a home and then repays the lender over time. In a reverse mortgage, the person already owns the home, and they borrow against it, getting a loan from a lender that they may not necessarily ever repay.
In the end, most reverse mortgage loans are not repaid by the borrower. Instead, when the borrower moves or dies, the borrower’s heirs sell the property in order to pay off the loan. The borrower (or their estate) gets any excess proceeds from the sale.
Most reverse mortgages are issued through government-insured programs that have strict rules and lending standards. There are also private, or proprietary, reverse mortgages, which are issued by private non-bank lenders, but those are less regulated and have an increased likelihood of being scams.
What are the 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:
- 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.
- 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.
- Term payments: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years.
- 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.
- 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.
- 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.4 Also called a Federal Housing Administration (FHA) reverse mortgage, this type of mortgage is only available through an FHA-approved lender.5
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.
Who owns the house in a reverse mortgage?
Just like any other type of mortgage, you own the home in a reverse mortgage situation.
When the borrower dies or moves, however, the mortgage is payable in full. If you can’t, or won’t, pay off the debt, the lender can sell the home to recoup the money it’s owed, explains Michael Sullivan, a personal financial consultant with nonprofit credit counseling and debt management agency Take Charge America.
“Typically, the homeowner or beneficiaries are not responsible for any costs if the house is sold for less than the amount owed,” adds Sullivan.
What can a reverse mortgage be used for?
Supplementing retirement income, covering the cost of needed home repairs, or paying out-of-pocket medical expenses are common and acceptable uses of reverse mortgage proceeds, according to Bruce McClary, spokesperson for the National Foundation for Credit Counseling.
“In each situation where regular income or available savings are insufficient to cover expenses, a reverse mortgage can keep seniors from turning to high-interest lines of credit or other more costly loans,” McClary says.
How do reverse mortgages work?
When you have a regular mortgage, you pay the lender every month to buy your home over time. In a reverse mortgage, you get a loan in which the lender pays you. Reverse mortgages take part of the equity in your home and convert it into payments to you – a kind of advance payment on your home equity. The money you get usually is tax-free. Generally, you don’t have to pay back the money for as long as you live in your home. When you die, sell your home, or move out, you, your spouse, or your estate would repay the loan. Sometimes that means selling the home to get money to repay the loan.
There are three kinds of reverse mortgages: single-purpose reverse mortgages – offered by some state and local government agencies, as well as non-profits; proprietary reverse mortgages – private loans; and federally-insured reverse mortgages, also known as Home Equity Conversion Mortgages (HECMs).
If you get a reverse mortgage of any kind, you get a loan in which you borrow against the equity in your home. You keep the title to your home. Instead of paying monthly mortgage payments, though, you get an advance on part of your home equity. The money you get usually is not taxable, and it generally won’t affect your Social Security or Medicare benefits. When the last surviving borrower dies, sells the home, or no longer lives in the home as a principal residence, the loan has to be repaid. In certain situations, a non-borrowing spouse may be able to remain in the home.
Here are some things to consider about reverse mortgages:
- There are fees and other costs. Reverse mortgage lenders generally charge an origination fee and other closing costs, as well as servicing fees over the life of the mortgage. Some also charge mortgage insurance premiums (for federally-insured HECMs).
- You owe more over time. As you get money through your reverse mortgage, interest is added onto the balance you owe each month. That means the amount you owe grows as the interest on your loan adds up over time.
- Interest rates may change over time. Most reverse mortgages have variable rates, which are tied to a financial index and change with the market. Variable-rate loans tend to give you more options on how you get your money through the reverse mortgage. Some reverse mortgages – mostly HECMs – offer fixed rates, but they tend to require you to take your loan as a lump sum at closing. Often, the total amount you can borrow is less than you could get with a variable rate loan.
- Interest is not tax-deductible each year. Interest on reverse mortgages is not deductible on income tax returns – until the loan is paid off, either partially or in full.
- You have to pay other costs related to your home. In a reverse mortgage, you keep the title to your home. That means you are responsible for property taxes, insurance, utilities, fuel, maintenance, and other expenses. And, if you don’t pay your property taxes, keep homeowner’s insurance, or maintain your home, the lender might require you to repay your loan. A financial assessment is required when you apply for a mortgage. As a result, your lender may require a “set-aside” amount to pay your taxes and insurance during the loan. The “set-aside” reduces the number of funds you can get in payments. You are still responsible for maintaining your home.
- What happens to your spouse? With HECM loans, if you signed the loan paperwork and your spouse didn’t, in certain situations, your spouse may continue to live in the home even after you die if he or she pays taxes and insurance, and continues to maintain the property. But your spouse will stop getting money from the HECM since he or she wasn’t part of the loan agreement.
- What can you leave to your heirs? Reverse mortgages can use up the equity in your home, which means fewer assets for you and your heirs. Most reverse mortgages have something called a “non-recourse” clause. This means that you, or your estate, can’t owe more than the value of your home when the loan becomes due and the home is sold. With a HECM, generally, if you or your heirs want to pay off the loan and keep the home rather than sell it, you would not have to pay more than the appraised value of the home.
Who a reverse mortgage is right for?
Reverse mortgages aren’t good for everyone. Only certain borrowers qualify, but their structure also only makes them appropriate for certain borrowers. A reverse mortgage may make sense for:
- Seniors who are encountering significant costs late in life
- People who have depleted most of their savings and have considerable equity in their primary residences
- People who don’t have heirs who care to inherit their home
What are reverse mortgage pros?
If you’re struggling to meet your financial obligations, a reverse mortgage may help you stay afloat. Here are a few benefits to opting for a reverse mortgage.
1. Helps Secure Your Retirement
Reverse mortgages are ideal for retirees who don’t have a lot of cash savings or investments but do have a lot of wealth built up in their homes. A reverse mortgage allows you to turn an otherwise illiquid asset into cash that you can use to cover expenses in retirement.
2. You Can Stay in Your Home
Instead of having to sell your home in order to liquify your asset, you can keep the property and still get cash out of it. This means you don’t have to worry about potentially downsizing or getting priced out of your neighborhood if you had to move.
3. You’ll Pay Off Your Existing Home Loan
Your home doesn’t have to be paid off in order to take out a reverse mortgage. In fact, you can use the proceeds of a reverse mortgage to pay off an existing home loan. This frees up money to put toward other expenses.
4. You Won’t Have Tax Liability
According to the IRS, the money you get from a reverse mortgage is considered to be a loan advance rather than income. That means the funds aren’t taxed, unlike other retirement income such as distributions from a 401(k) or IRA.
5. You’re Protected If the Balance Exceeds Your Home’s Value
In some cases, the value of your home could end up being less than the total amount owed on the reverse mortgage. This can happen if home prices fall, for example. If this occurs, your heirs don’t have to worry about paying the balance.
What are reverse mortgage cons?
So what is the downside of a reverse mortgage? Though it might seem like there are many benefits, there are also some serious risks to consider.
1. You Could Lose Your Home to Foreclosure
In order to qualify for a reverse mortgage, you have to be able to afford your property taxes, homeowners insurance, HOA fees and other costs associated with owning your home. You’re also required to live inside the home as your principal residence for most of the year.
If at any point during the loan period you become delinquent on these expenses or spend the majority of the year living outside the property, you could default on the reverse mortgage and lose your home to foreclosure.
2. Your Heirs Could Inherit Less
Homeownership is a key path to building generational wealth. However, a reverse mortgage usually requires the home to be sold to repay the debt. When you die, heirs will be required to pay the full loan balance or 95% of the home’s appraised value, whichever is less. Usually, that means selling the home or turning the property over to the lender to satisfy the debt.
Not to mention, a reverse mortgage eats away at your home’s equity. By the time it needs to be paid off, there may not even be any equity to be left to your heirs.
3. It’s Not Free
You might not have to make payments with a reverse mortgage, but there are still plenty of expenses associated with one. Not only do you have to keep up on your taxes, insurance, and HOA fees, but you also have to pay an upfront insurance premium. Usually, this is 2% of your home’s appraised value. You’ll also pay origination fees at closing. You do have the option of rolling these costs into your loan balance, but that means you receive less money.
4. It Could Impact Your Other Retirement Benefits
A reverse mortgage may not be considered income for tax purposes, but it could impact your ability to qualify for other need-based government programs such as Medicaid or Supplemental Security Income (SSI). It’s a good idea to discuss this with a benefits specialist to make sure your eligibility won’t be compromised.
5. Reverse Mortgages Are Complicated
There are a lot of rules and caveats to reverse mortgages. These loans come with many risks that may not be worth the extra cash. You should be wary of any reverse mortgage offer unless you understand the terms really well.
Who should avoid a reverse mortgage?
While there are some cases where reverse mortgages can be helpful, there are lots of reasons to avoid them. A reverse mortgage isn’t a good option if:
You can’t find a trustworthy lender or a reputable loan program
You have outside savings or life insurance that you can tap to cover expenses
You have heirs who want to inherit your property or family members who live with you and who need to stay in the property after the term of a reverse mortgage
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