What is a Reverse Mortgage, and How Does It Work?

Rising interest rates, high inflation, the return of student loan payments and the disappearance of stimulus checks are making it hard to save.

Americans’ average retirement savings in 2019 had a median of $65,000. That’s only a 2% increase from 2016. The increase in retirement savings doesn’t even cover the cost of average yearly inflation. To top it off, only 37.3% of U.S. households had an IRA (Individual Retirement Account) in mid-2020. And the median retirement savings for families of all ages are at a paltry $93,000.

Many senior citizens struggle to live on Social Security alone. A reverse mortgage could be the solution.

Reverse Mortgages: What You Need to Know

A reverse mortgage loan allows homeowners to borrow money using their home as collateral for the loan. Like a traditional mortgage, the title will remain in your name when you take out the reverse mortgage.

However, there are some key differences between a home equity loan and a reverse mortgage.

With a reverse mortgage, the amount the lender owes increases over time due to interest and fees added to the loan balance every month.

  • Your home equity will decrease as your loan balance increases.
  • Borrowers don’t make monthly payments.
  • The loan is repaid when the borrower no longer lives in the home
  • Interest and fees are added to the loan balance each month
  • Borrowers must use the property as their principal residence
  • The homeowner must keep the house in good condition
  • Like a traditional mortgage, homeowners must stay updated on property tax and insurance payments.

Types of Reverse Mortgages

There are three types of reverse mortgages. Here’s a closer look at each:

Home Equity Conversion Mortgages (HECM)

The most common is the home equity conversion mortgage (HECM). Also called a Federal Housing Administration (FHA) reverse mortgage, these loans are only available through FHA-approved lenders and are only available to borrowers who are 62 or older. The maximum claim amount for 2022 for the HECM program is $970,800 for all parts of the country.

A reverse mortgage loan is not free money. It is a loan where borrowed money + interest + fees each month = a rising loan balance. The homeowners or their heirs will eventually have to repay the loan, usually by selling the home.

Home equity conversion mortgages (HECMs) are federally insured and backed by HUD (the U.S. Department of Housing and Urban Development. It’s popular because it has no medical requirements or income limits, and there are no restrictions on how you can use the loan. However, HUD-approved loans are often more expensive than traditional home loans, and upfront costs are high.

Applicants are required to undergo counseling to ensure they know the costs, payment options, and responsibilities involved. A reverse mortgage counselor will also provide information about any nonprofit or government-issued alternatives as long as they’re eligible. There is a charge for the counseling session, but the borrower can pay it from the loan proceeds.

After the counseling session, the counselors will complete a financial assessment to help you determine how much you can borrow. Determining factors include:

  • Your age (or the age of the youngest borrower or eligible non-borrowing spouse.)
  • The appraised value of your home
  • Your home’s property value
  • Current interest rates

The Consumer Financial Protection Bureau offers a good explanation of reverse mortgages at consumerfinance.gov.

Jumbo Reverse Mortgage or Proprietary Reverse Mortgage

This program offered by private lenders allows you to borrow more than the FHA’s Home Equity Conversion Mortgage loan caps. Any reverse mortgage amount higher than the FHA HECM loan limit requires a jumbo reverse mortgage.

A Single-Purpose Reverse Mortgage

These are offered by state, local, and nonprofit agencies. It is the least expensive option because the government or nonprofits back it. It’s also the least common option because it isn’t offered in every state. Single-purpose reverse mortgage lenders restrict how your loan proceeds can be used. Homeowners can only use them for a single, lender-approved item, like property taxes.

It’s also possible to use a reverse mortgage called a “HECM for purchase” to buy a different home than where you currently live.

While home equity loans or home equity lines of credit (HELOCs) require monthly installment payments, these single-purpose reverse mortgages don’t have to be repaid until the home’s ownership changes. The borrower moves to a different primary residence, or the borrower passes away. These loans also become due if borrowers stop maintaining homeowners’ insurance on the property or if the city condemns the property.

Mortgage insurance, fees, and interest reduce the amount the homeowner can borrow in a single-purpose reverse mortgage.

How Reverse Mortgages Work

Qualified homeowners may be unable to borrow the equivalent of their home’s entire value — even if the mortgage is paid off.

Homeowners are likely to receive a higher principal limit depending on the following factors:

  • The older they are
  • The more their property is worth
  • The lower the interest rate on their loan

The amount might increase if the borrower has a variable-rate HECM.

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

  • Lump sum: This is the only option with a fixed interest rate
  • Equal monthly payments (annuity): The lender will make steady payments to the borrower as long as the borrower lives in the home
  • Term payments: The lender makes equal monthly payments to the borrower for a set timeframe
  • Line of credit: Like with a credit card, money can be borrowed as needed. The homeowner only pays interest on the total that’s borrowed
  • Equal monthly payments plus a line of credit: This provides a regular monthly payment as long as at least one borrower uses the home as a principal residence. If borrowers still need more, they can access a line of credit
  • Term payments plus a line of credit: This provides equal monthly payments for a set timeframe plus offers access to a line of credit

Reverse Mortgage Requirements

To be eligible for a reverse mortgage, the primary homeowner must be 62 or older. Other eligibility requirements include the following:

  • You must own the property outright or have paid a substantial amount of your mortgage
  • The property must be your primary residence
  • You cannot be delinquent on federal debts
  • You will have to prove you can continue to afford payments for property taxes, homeowners’ insurance, and mandatory homeowners association dues
  • You must participate in the counseling session provided by a (HUD)-approved reverse mortgage counseling agency

What are the Pros and Cons of a Reverse Mortgage?

While borrowing against your home equity can free up cash for living expenses, the mortgage insurance premium, origination, and servicing fees can add up. Here are the advantages and disadvantages of a reverse mortgage.

Pros

  • The borrower doesn’t need to make monthly payments toward their loan balance
  • For living and healthcare expenses, debt repayment, and other bills, proceeds can be used
  • Funds can help borrowers enjoy their retirement
  • Non-borrowing spouses not listed on the mortgage can remain in the home after the borrower dies.
  • Borrowers facing foreclosure can use a reverse mortgage to repay the existing mortgage, potentially stopping the foreclosure.

Cons

  • The borrower must maintain the house and pay property taxes and homeowners insurance
  • It forces you to borrow against the equity in your home, which could be a key source of retirement funds
  • Fees and other closing costs can be high and will lower the amount of cash that is available

How Much Does a Reverse Mortgage Cost?

The closing costs for a reverse mortgage aren’t cheap, but most HECM mortgages allow homeowners to roll the costs into the loan, so you don’t have to shell out the money upfront. Doing this, however, reduces the number of funds available to you through the loan.

Here’s a breakdown of HECM charges, according to HUD:

  • Mortgage insurance premiums (MIP): There is a 2% initial premium at closing and an annual premium equal to 0.5 percent of the outstanding loan balance. The borrower can finance mortgage insurance premiums into the loan
  • Origination fee: Lenders charge more than $2,500 or 2% of the first $200,000 of your home’s value plus 1% over $200,000. The cost is capped at $6,000
  • Servicing fees: Lenders can charge monthly to maintain and monitor your loan. Monthly payments can’t exceed $30 for loans with a fixed rate or a rate that adjusts annually or $35 if the rate adjusts monthly.
  • Third-party fees: Third parties may charge their fees, as well, including appraisal and home inspection fees, credit checks, title searches, and title insurance or recording fees

Remember that the interest rate for reverse mortgages tends to be higher, which can add to your costs. Rates can vary depending on the lender, credit score, and other factors.

What Percentage of Equity is Required for a Reverse Mortgage?

You will need at least 50% of equity to qualify for a reverse mortgage. That equity is based on what the value of your home currently exceeds its monthly payment.

The requirements are as follows:

  • You must be at least 62 years old.
  • While the specific percentage of equity required varies across lenders, typically, you’ll need 50%.
  • There is no credit score or income requirements for reverse mortgages.
  • The U.S. Department of Housing and Urban Development (HUD) requires all prospective reverse mortgage borrowers to complete a HUD-approved counseling session.
  • Borrowers must also pay an origination fee and an upfront mortgage insurance premium.

While not technically a requirement to get a reverse mortgage, you must pay property taxes and homeowner’s insurance once you have the mortgage.

Reverse Mortgage Scams

As with many loan products geared toward older Americans, plenty of scammers are looking to take advantage of your financial situation.

  • Contractor scams: Watch out for contractors who approach you about getting a reverse mortgage loan to pay for home repairs. Don’t be pressured into getting a reverse mortgage
  • Scams targeting veterans: The Department of Veterans Affairs (VA) does not offer reverse mortgages. If you see an ad promising special deals for veterans, implying VA approval, or offering a “no-payment” reverse loan, it is probably a scam

If you think you’ve spotted a scam, report it to the Consumer Financial Protection Bureau (CFPB) and your state attorney general’s office.

You Have a Three-Day Right to Cancel

With most reverse mortgages, you have three business days after the loan closing to cancel the deal for any reason without penalty. To cancel, you must notify the lender in writing. The decision to cancel is known as your right of “rescission.”

Want to know financial guru Dave Ramsey’s thoughts on reverse mortgages? Check out this video:

The Bottom Line

Deciding to take out a loan is always a big deal. You should continually assess why you need the loan and, most importantly, utilize this financial resource responsibly — especially when you risk losing your home.

FAQs

Can You Get a Reverse Mortgage on a Condominium?

Yes. As long as you are 62+ and own the condo, it’s your principal residence and is worth at least $150,000.

What is the HECM Initial Disbursement?

When a reverse mortgage applicant has completed the application process, they become eligible for disbursement of funds either as a line of credit, monthly installments, or a lump sum. The initial disbursement is the first portion of their reverse mortgage proceeds. There is a three-day right of rescission.

What are Some Other Ways to Refinance My Mortgage?

A home equity loan is a secured fixed-rate second mortgage that allows you to borrow the amount of equity in your property.
A home equity line of credit (HELOC) is a revolving line of credit that lets you borrow against your home’s equity and pay it down like a credit card.
Cash-out refinance is where you take out a new mortgage and get the equity in a lump sum.

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