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How Does a Reverse Mortgage Work?
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A reverse mortgage works very differently from a traditional mortgage: Instead of making payments to your lender, your lender makes payments to you. A reverse mortgage gives homeowners age 62 or older a flexible way to access their home’s equity as their living needs change.
What is a reverse mortgage?
A reverse mortgage is a specialized home loan that allows homeowners who are 62 or older to convert their home equity into cash. The term “reverse” mortgage means it does the opposite of what a regular, or “forward,” mortgage does, because your lender pays you instead of the other way around.
Over time, your loan balance grows and your equity shrinks. With a traditional mortgage, though, you reduce your balance with each payment and your equity increases over the years.
The most common type of reverse mortgage is a Home Equity Conversion Mortgage (HECM) backed by the Federal Housing Administration (FHA). While private lenders offer their own reverse loan products, HECMs are the only reverse mortgages that are insured by the FHA. For the purposes of this article, we’ll focus on HECMs.
How does a reverse mortgage work?
A reverse mortgage gives you access to your home’s equity as you age. Reverse mortgage requirements are also different from those of a forward mortgage. Here’s a rundown of how a reverse mortgage works:
- You’ll qualify based on your age and home equity amount. The older you are when you take out your reverse mortgage, the more equity you have access to. However, all reverse mortgage borrowers must be at least 62 to qualify, and typically need at least 50% equity in their homes.
- You won’t make a monthly mortgage payment. Older borrowers on fixed incomes eliminate the expense of a monthly mortgage payment.
- You need to prove you can pay ongoing home expenses. You won’t be subject to the debt-to-income (DTI) ratio or credit score requirements of regular mortgages. However, you must pay ongoing expenses like property taxes, homeowners insurance and maintenance, or you could risk losing your home to foreclosure.
- You won’t pay taxes on the money you receive. Even if you receive a monthly payment disbursement for your reverse loan, the IRS doesn’t consider it taxable income. However, the interest isn’t tax-deductible until you sell the home or pay off the reverse mortgage.
- You must live in the home as your primary residence. Reverse mortgages were created to allow seniors to “age in place.” If you don’t live there full time or need to move into an assisted living facility, the lender could foreclose.
- You must get financial counseling before taking out a reverse mortgage. The FHA requires that you meet with a HUD-certified counselor to ensure you understand all of the benefits and downsides of reverse mortgages. There is an upfront counseling fee, in most cases.
- Your heirs won’t be burdened with a reverse mortgage balance. Reverse mortgage rules limit how much equity you can borrow, so it’s unlikely you’ll end up underwater. However, if you do, mortgage insurance will cover any loan balance higher than the home’s value.
- You’ll pay mortgage insurance and higher closing costs. Some of the disadvantages of reverse mortgages are pricey fees. Reverse mortgage lenders can charge up to $6,000 for origination fees, and the upfront mortgage insurance premiums of 2% of the home’s value are higher than most forward mortgages.
- You’ll have a variety of choices for reverse loan disbursements. One of the biggest benefits of a reverse mortgage is the number of different ways you can tap your equity, including a lump sum, line of credit or as monthly income.
Six ways to get cash from your reverse mortgage
You can choose from one or a combination of many payment options to access home equity with a reverse mortgage. Reverse mortgage interest rates are typically adjustable rates, which means they may rise or fall over time, which can deplete your equity faster in a rising-rate environment.
- Single lump sum. This option involves one large payment after your reverse loan closes. This is the only option that comes with a fixed interest rate.
- Tenure. Also called the “tenure” option, you can choose regular monthly payments for as long as you or a co-borrower lives in the home as your primary residence
- Term. If you just need extra income for a few years, this option allows you to select how many months you’ll receive regular monthly payments.
- Line of credit. A reverse mortgage line of credit is similar to having a credit card or home equity line of credit (HELOC). You can access the line as needed until you’ve used up the available balance.
- Modified tenure. You can choose a combination of monthly payments and a line of credit while you or a co-borrowing spouse are still living in your home.
- Modified term. A combination of the line of credit, which can be added for extra funds in case you need more cash, and term payments.
Different types of reverse mortgages
There are three types of reverse mortgages to choose from.
- Home equity conversion mortgages (HECMs). HECMs are insured by the FHA. There are no limits on what HECM funds can be used for.
- Single-purpose reverse mortgages. Some state and local government agencies may offer these types of reverse mortgages, but the funds can only be used to meet specific needs such as repairing a home or paying past-due property taxes. They aren’t available in all areas.
- Proprietary reverse mortgages. Private companies may offer their own reverse mortgages at loan amounts higher than HECM loan limits. You may also be able to get a bigger initial advance from a proprietary reverse mortgage, but these loans also won’t have the federal backing from the FHA and could be more costly.
Reverse mortgage pros and cons
You’ll have more choices to use your home equity as your needs change
You can supplement a portion of your retirement income
You can use the reverse mortgage funds as you want
You won’t leave a financial burden to your heirs
Your eligible non-borrowing spouse can remain in the home after you die or move out
You might reduce your monthly housing expenses
Your loan could be foreclosed if you don’t live in the home full time
Your loan balance rises over time
Your equity drops over time
You might reduce the amount you’re eligible to receive for other benefits
You’re reducing the inheritance value of your home
You’ll pay more for reverse mortgage closing costs
How to avoid reverse mortgage scams
Financial abuse of seniors has become a multibillion-dollar problem in the United States. Here are a few tips to avoid becoming a victim of a potential reverse mortgage scam:
- Look out for unsolicited reverse loan offers. If you didn’t request information about a reverse mortgage, don’t give out personal information to someone who calls or visits you about it. Same goes for email messages.
- Avoid reverse mortgages offered by estate planners or planning “specialists.” Always contact a HUD-approved reverse mortgage counseling agency to verify the credentials of any salesperson who recommends a reverse mortgage.
- Don’t sign anything you don’t understand. Reverse mortgages are more complicated than regular mortgages. Don’t sign any paperwork until it’s been fully explained to you, or you can ask a trusted relative, friend or financial advisor to look over the loan documents.
- Be wary of reverse mortgage sales that recommend against HUD counseling. HUD counselors are certified by the federal government to be a safeguard for seniors. No reputable reverse mortgage company should steer you away from this protective measure.