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Reverse mortgages can help older homeowners free up cash in retirement by borrowing against the value of their home.
It can help retirees age in place while producing a stream of income for everyday expenses.
But reverse mortgages are complex and controversial. Strict rules must be followed to avoid foreclosure, and the costs can outweigh the benefits.
If you’re considering a reverse mortgage for yourself or someone you know, it’s important to understand the advantages and disadvantages involved.
In this guide, we break down everything you need to know about how reverse mortgages work and who can benefit from this type of loan.
What Is a Reverse Mortgage?
A reverse mortgage is a type of loan that allows property owners ages 62 and older to convert home equity into cash.
Unlike a regular mortgage, you don’t need to make monthly loan payments. Instead, your lender pays you, and your debt increases over time.
The loan is settled or repaid when you sell the home, move out or die.
According to The Brookings Institute, the average maximum claim amount on reverse mortgages is about $275,000, and the average borrower age is 73.
Types of Reverse Mortgages
There are three types of reverse mortgages.
Home Equity Conversion Mortgages
These are the most common type of reverse mortgage loan and are only available to homeowners ages 62 and older.
HECM loans are backed by the Federal Housing Administration (FHA), and must meet strict rules and lending standards.
HECM loans are non-recourse loans. This means you’ll never owe more than what your house is worth — even if its market value drops.
Private (Proprietary) Reverse Mortgages
These reverse mortgages are much riskier because they are not insured by the federal government. They’re typically designed for borrowers with higher home values.
Single-Purpose Reverse Mortgages
These loans are offered by some state and local governments and nonprofit agencies to help homeowners fund a specific need, such as home improvements or property taxes.
These loans aren’t available in all areas and only homeowners with low to moderate incomes may qualify.
Reverse Mortgage Process: How Does It Work?
If you’ve built considerable equity in your primary residence (usually at least 50% of the property’s value), you can work with a reverse mortgage counselor to find a lender and a program that meets your needs.
Find a list of local reverse mortgage counselors in your area with this database from the U.S. Department of Housing and Urban Development.
Remember: You must attend a HUD counseling session administered by an approved counseling agency to qualify for a HECM loan.
Next, the counselor would tell you how to apply for a loan through a specific program.
The lender will perform a credit check and review your property (including the title and appraised value).
Your home needs to be in good shape to qualify for a reverse mortgage. If it doesn’t meet certain property standards, the mortgage lender may require that certain repairs be made before approving a reverse mortgage loan.
If everything checks out and you’re approved, the lender funds the loan.
Like a regular mortgage, a reverse mortgage can have either a fixed rate or an adjustable interest rate.
Reverse mortgages tend to have higher interest rates than traditional mortgages.
Reverse Mortgage Cost and Fees
Reverse mortgage fees can be substantial.
These costs include:
Mortgage insurance premium
Origination fee
Servicing fee
Interest on the loan
Third-party charges
Interest and fees are added to the loan balance each month. Unlike a regular mortgage, the amount you owe on a reverse mortgage increases over time.
This means you’ll get charged interest and fees on top of the interest and fees that were added to your previous month’s loan balance.
But remember: You don’t need to repay the loan until you move out, sell the home or pass away.
Receiving Reverse Mortgage Proceeds
How much money you receive from a reverse mortgage depends on your age, the interest rate on your loan and the value of your home.
Loan proceeds can pay out in one of the following ways:
A lump sum.
A line of credit.
Yearly, quarterly or monthly payments.
You choose how funds are paid out. Most reverse mortgages are processed within 30 to 60 days.
If your home isn’t fully paid off, reverse mortgage funds must be used to pay off the existing mortgage.
Repaying a Reverse Mortgage
You can choose to make payments on the loan to reduce your debt — but it’s not required. You don’t need to make monthly mortgage payments like you would with a traditional mortgage.
You’re still required to pay homeowners insurance, property taxes and HOA fees. Otherwise, you can face default or even foreclosure.
Many reverse mortgage loans aren’t repaid by the borrower. Instead, when the borrower dies, the borrower’s heirs repay the loan or sell the home to satisfy the debt.
The borrower (or their estate) gets any leftover money from the sale after the loan is paid.
Reverse Mortgage Pros and Cons
Taking out a reverse mortgage can help older people age at home. But it comes with costs and risks.
It’s important to understand both the benefits and disadvantages of a reverse mortgage before you sign on the dotted line.
You should consider all of your borrowing and housing options — including a home equity loan, refinancing or downsizing — before you get a reverse mortgage.
An elder law attorney or financial advisor can also help you explore these options.
Reverse Mortgage Pros
Here are some advantages to getting a reverse mortgage.
You Get To Stay In Your Home
You get to keep the title to your property, and stay in a familiar place. You can use proceeds from the loan to pay for home improvements and other needs.
The home loan balance isn’t due until you move out, sell the property or pass away.
The Money You Receive Isn’t Taxable
The Internal Revenue Service (IRS) doesn’t consider money from a reverse mortgage income. Instead, it’s categorized as a loan advance, which means you receive the money tax-free.
This is unlike other retirement income, such as distributions from a 401(k) or IRA.
It Can Help Fund Your Retirement
Unexpected financial shocks are common in retirement. Reverse mortgages were originally designed for older homeowners on a fixed income who struggle to cover living expenses but who have a lot of wealth built up in their homes.
These seniors are often referred to as “house-rich and cash-poor.”
If an unexpected job loss, health issues or death of a spouse leaves you with limited savings, monthly payments from a reverse mortgage can help supplement your retirement income.
Reverse mortgages can also help pay off debts. For example, you can use funds to pay off an existing mortgage if the balance is low.
Reverse mortgages aren’t a perfect solution for retirement money problems, though. It’s possible to default on the loan and lose your home to foreclosure if you don’t meet certain requirements.
Different Payout Options
You can receive money from a reverse mortgage in a single lump sum, periodic payments or as a line of credit. The last option lets you tap reverse mortgage funds when you need them.
A Single-Purpose Reverse Mortgage Could Serve Your Needs
A single-purpose reverse mortgage is a special type of home loan generally offered by state agencies and nonprofit organizations.
This kind of reverse mortgage tends to offer lower fees and interest rates. Unlike HCEM loans — which can be used for any reason — a single-purpose reverse mortgage restricts how the funds are spent. For example, you may only be able to tap funds for home improvements or to pay property taxes.
Cons of Reverse Mortgages
Violating the terms of your reverse mortgage agreement can result in foreclosure — and leave you on the street.
It’s critical to understand the disadvantages of reverse mortgages before you enter into an agreement with a lender.
A Reverse Mortgage Isn’t Free — Or Cheap
You’ll need to maintain homeowners insurance, taxes and HOA fees.
You also need to pay an upfront mortgage insurance premium at closing which can equal 2% of your home’s appraised value.
According to the Consumer Financial Protection Bureau, other closing costs can include an appraisal, title search, surveys, inspections, recording fees, mortgage taxes and credit checks.
You’ll also face origination fees when you sign up for a reverse mortgage. Origination fees are capped at $6,000 and vary based on your loan amount.
You can pay these closing costs and fees in cash or by using the money from your loan.
While you have the option of rolling these costs into your loan balance, you’ll end up receiving less money as a result.
Aside from these upfront costs, there are also ongoing expenses added to your loan balance each month.
This includes yearly mortgage insurance premiums equal to 0.5% of the outstanding mortgage balance. These insurance premiums are charged by the lender and are paid to the Federal Housing Administration.
Mortgage insurance premiums are paid in addition to your homeowners insurance.
You Could Lose Your Home to Foreclosure
Reverse mortgage lenders can foreclose on your home for several reasons.
The most common are:
You fail to pay property taxes, homeowners insurance, HOA fees and other costs associated with owning your home.
The home is no longer your primary residence (you don’t live there for at least six months out of the year).
You don’t keep up with repairs or maintain your home as required by your lender.
If you fall into one of these situations, you could default on the reverse mortgage and lose your home to foreclosure.
Your Heirs Probably Won’t Get The House
If you leave the house to your heirs, they will need to repay the total reverse mortgage balance or 95% of the home’s appraised value — whichever is less — to keep the property.
This leaves your heirs with the following options:
Pay out of pocket to cover the loan.
Get financing to pay off the loan.
Sell the home.
Turn the home over to the lenders to satisfy the debt.
Once the debt is satisfied, there may not be any equity left for your heirs.
Roommates and Family Could End Up On The Street
Any friends, non-spouse relatives or roommates who live with you will likely need to vacate the home after you die. The same applies if you leave the property for more than a year.
Non-borrowing spouses can remain in the home following the death of a reverse-mortgage holder. So can a surviving borrower listed on loan documents.
(Keep in mind no one living with you under the age of 62 can be a borrower on a reverse mortgage.)
It Could Affect Your Medicaid And Other Benefits
A reverse mortgage can impact your eligibility for government need-based programs.
The money you receive from the loan can cause you to violate asset restrictions for Medicaid and Supplemental Security Income (SSI).
This is more likely to happen to reverse mortgage borrowers who receive the loan as a lump sum and don’t spend the money down after 30 days.
If you’re currently enrolled in one of these government programs, it’s best to speak with a social worker, benefits specialist or elder law attorney before getting a reverse mortgage.
Reverse Mortgage FAQs
To qualify for a Home Equity Conversion Mortgage, you must be at least 62 years old and a homeowner.
Here are other requirements you must meet to qualify for a federally-backed reverse mortgage:
Your home must be your principal residence.
Your home must be in good condition.
You must own your home outright or have a low mortgage balance.
You need to have the financial resources to keep up with property taxes, insurance premiums and HOA fees.
You can’t be delinquent on any federal debt, including federal income taxes and federal student loans.
You must undergo counseling from a HUD-approved reverse mortgage counseling agency.
A reverse mortgage is best for older Americans who plan to age in place at their current home until they pass away.
While it can free up income for retirement, this type of loan is best for people who can afford other financial obligations, such as homeowners insurance and yearly property taxes.
It’s also suitable for people who don’t want to pass down their home to their children or other family members.
Reverse mortgages aren’t a good idea if you already struggle to afford your property taxes, insurance payments and upkeep on your home.
These expenses don’t go away when you get a reverse mortgage. You can set aside reverse mortgage funds to pay for these expenses, but that will reduce the amount of liquid cash available to pay other costs.
Reverse mortgages are also a bad idea if you plan to move anytime soon. It doesn’t make sense to throw away thousands of dollars in home equity if you plan to sell your home in the next few years.
If you decide to sell your home while you have a reverse mortgage, you must repay the entire loan you borrowed plus interest and fees.
Finally, if your spouse isn’t at least 62, getting a reverse mortgage can be a bad idea.
Federal laws protect your non-borrowing spouse from losing the home if you die first — but they can’t receive any additional mortgage proceeds after you pass away. Losing these monthly payments or line of credit could make it impossible for your spouse to make ends meet.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.