How Does a Reverse Mortgage Work?

A reverse mortgage loan is the same as a regular mortgage except for the fact it has no regular monthly payments and doesn’t have to be paid back until you sell the house, move out of the house, or die. Reverse mortgages are designed for people who own their homes outright or have substantial equity in them. Because of this, reverse mortgages are often used by retirees to supplement their retirement income. 

A reverse mortgage is not free money — it’s a loan and it has to be paid back, either by you or by your family. There are potential disadvantages you should consider before taking out a reverse mortgage, especially if you intend to leave your home to your heirs. 

What Is a Reverse Mortgage?

A traditional mortgage involves borrowing money to purchase a home and building equity with regular payments. In a reverse mortgage, you receive a lump sum, a monthly payment, or a line of credit, and the loan doesn’t have to be paid back until the house is sold, you move out, or you die. 

There are three types of reverse mortgages. One comes from a private lender, the other two involve government agencies or nonprofits: 

  • A Proprietary Reverse Mortgage is provided by a private lender. Because it is a private product there are fewer regulations and restrictions than on other types of reverse mortgages. Proprietary Reverse Mortgages are often used by owners of higher-value properties who want more flexibility than a government-insured loan can offer. 
  • A Single-Purpose Reverse Mortgage is offered for a single lender-approved expense, often home repair or improvement or payment of property taxes. These mortgages usually tap a relatively small portion of the borrower’s home equity and are often used by lower-income homeowners. They are usually offered by state or local governments, nonprofits, or credit unions. 
  • The Home Equity Conversion Mortgage (HECM) is by far the most popular form of reverse mortgage, accounting for over 90% of reverse mortgage originations in most years. These reverse mortgages are insured by the Federal Housing Administration (FHA) and are governed by FHA rules. Because the HECM is so popular, discussions of reverse mortgages usually focus on this type. 

All of these types work on the same principle. You tap your home equity, you receive money, and you don’t pay it back until the loan term expires or when you sell the home, move out, or die. If you have an existing mortgage, that will be paid off by the reverse mortgage and the rest of the equity covered by the reverse mortgage will be available to you. 

If the reverse mortgage comes due upon your death or that of your spouse, your heirs can pay off the loan and retain the house or sell the house, pay the loan, and retain any proceeds left after the loan is paid. 

Reverse mortgages usually have upfront costs, including an origination fee, a mortgage insurance premium, and other fees. You will pay interest on a reverse mortgage. The money received in a reverse mortgage is usually tax-free and it will not affect Social Security or Medicare benefits. 

Who Can Get a Reverse Mortgage?

Proprietary and Single-Purpose reverse mortgages may be governed by different policies or regulations, depending on the private lender, government agency, or nonprofit involved. You will have to discuss requirements and eligibility with the lender, agency, or nonprofit providing the loan. 

Home Equity Conversion Mortgages (HECM) are made by private lenders but are insured by the Federal Housing Administration and must follow FHA rules. The FHA has a number of Eligibility requirements before you can get a HECM: 

  • You must be 62 or older. 
  • You must own your home and it must be your primary residence. 
  • Single-family homes, multi-family homes up to 4 units, and manufactured homes or condominiums that meet FHA standards are eligible for reverse mortgages. 
  • Your mortgage must be fully or almost fully paid off. 
  • Your home must be in good enough condition to pass an inspection and must not be in a flood risk area. 
  • You must not have any tax deficiencies or other debts to the government. 

A HUD-certified counselor will confirm that you meet these conditions and assess your finances. The counselor must be satisfied that you can meet several conditions: 

  • You must be able to pay for property taxes and homeowner’s insurance. 
  • You must have the financial capacity to maintain the home. 
  • You must be able to pay for admittance into a homeowner’s association or other necessary fees. 

A spouse under age 62 cannot be a borrower on a HECM. A spouse who is not on the loan paperwork may be able to stay in the house after the primary borrower’s death but will not be eligible to receive further proceeds from the loan. You may be able to refinance the loan when the younger spouse turns 62. This will allow the younger spouse to receive continuing payments from the loan. 

How Much Money Will I Get, and How Will I Receive It?

Proprietary and single-purpose reverse mortgages may calculate eligible amounts differently and have varying payout methods. You will have to confirm these with the lender.

A HECM will set your loan amount based on the current assessed value of your property, the prevailing interest rate, the current HECM loan limit and the age of the borrowers. 

A HECM provides several payout options:

  • You can get the full amount of the loan in a lump sum with a fixed interest rate. 
  • You can receive a monthly payment for a fixed loan term. 
  • You can elect to receive fixed monthly payments for as long as you occupy the home. 
  • You can establish a line of credit that you can tap at any time. 
  • You can combine a line of credit and monthly payments. 

Different options are suitable for different needs. It is usually possible to change the payout method during the life of the loan, though you may pay a fee. 

How Do I Pay Back A Reverse Mortgage?

You are not required to make monthly payments on a reverse mortgage. Instead, the loan and accrued interest are paid back when the loan reaches maturity. 

A HECM typically matures when you sell the house, when you move out of it, or when you die. If you move into a nursing home or other medical facility, or if you move in with one of your children, the loan will mature. If your home is not your primary residence for 12 consecutive months, the loan will mature. 

Proprietary and Single-Purpose reverse mortgages may have a set term for maturity, or they may define maturity in terms similar to those of a HECM. Check the proposed loan agreement and be sure that the repayment terms are clear. 

Failure to pay property taxes or home insurance may trigger a foreclosure on your loan. 

Most reverse mortgages are paid off when the house is sold. The reverse mortgage is paid from the proceeds of the sale and any excess is retained by the borrower or the borrower’s heirs if they are the ones selling the house. The heirs also have the option of paying the loan off and retaining the house. 

If the house declines in value or the loan accrues substantial interest and fees, the sale of the house may not cover the loan balance. If your reverse mortgage is a HECM, the borrower or the borrower’s heirs will pay the full mortgage or 95% of the home’s appraised value, whichever is less. The mortgage insurance will cover the balance. 

If you are considering a proprietary or single-purpose reverse mortgage, check your loan agreement to see what will happen if the amount due on maturity exceeds the value of the home. 

You can make payments on your reverse mortgage if you choose to do so. You can pay off the accrued interest and reduce the loan balance, which will reduce the amount you or your heirs will pay back on maturity. 

What Costs Are Associated with a Reverse Mortgage?

There are several significant upfront costs in a reverse mortgage.

  • Most lenders will charge an origination fee. This will usually be either $2,500 or 2% of the first $200,000 of your home’s appraised value plus 1% of the appraised value above $200,000, whichever is larger. HECM origination fees cannot be above $6000. 
  • You will pay a counseling fee for HUD-approved counseling services. Counseling is required for a HECM. This fee cannot be included in the mortgage and must be paid to the counseling service. 
  • Closing costs include fees for credit checks, title insurance, loan recording and more. There should be a detailed list in your lender’s loan disclosure document. 
  • An initial mortgage insurance premium of 2% of the property’s value must be paid upon closing on a HECM. Many non-HECM reverse mortgages also require insurance. 

Most of these charges are bundled into the loan. You do not have to pay them in cash, but you have already spent that much of your home’s equity at the start of the reverse mortgage. These upfront costs are a particular consideration if you may not keep your house for long. 

  • Many lenders charge ongoing loan servicing fees, which add to the total cost of your loan and also accrue interest. 
  • Annual mortgage insurance premiums can be included in the cost of the loan, but they will accrue interest over the loan’s life. 

You will also pay annual interest on the reverse mortgage. The accrued interest is added to the balance of the loan and paid off upon maturity. The accumulated interest, the accumulated fees, and the interest on the fees can add up to a significant cost by the time the loan matures. 

How Will My Credit Affect My Reverse Mortgage Application?

Reverse mortgages are secured by your home, which reduces the lender’s risk, and there is generally no minimum credit requirement for a reverse mortgage. Lenders will check your credit report to see if you have any delinquent Federal debt that could be charged against your reverse mortgage. 

If your credit report shows a pattern of financial troubles you may be required to set up a Life Expectancy Set Aside, or LESA, which will cover tax and insurance costs if you’re unable to pay them. You will have to evaluate the terms of your LESA, if one is required, and decide whether you can afford the cost. 

When to Consider a Reverse Mortgage?

Reverse mortgages have significant advantages and can be a useful tool for some homeowners. These are some signs that a reverse mortgage could be a good move for you.

  • You own a home and need money to supplement your retirement income, to make home improvements or repairs, for medical needs, or for other purposes. 
  • You’ve considered a home equity loan or a home equity line of credit, but you’re concerned with your ability to make the monthly payments. 
  • You are not planning to leave your home to your heirs or trying to maintain the value of your estate. 
  • You are planning to stay in your home for some time. 

When a Reverse Mortgage Might Not Be the Right Move

There are also some circumstances that could lead you to consider other alternatives instead of a reverse mortgage.

  • If you may not be able to keep up with the cost of taxes, insurance, and repairs on your home, be careful. If you fail to keep up with these costs you could trigger foreclosure and the loss of your home. 
  • If you may be moving out of your house soon, the upfront costs could make a reverse mortgage very expensive. 
  • If you have health issues that may force you to move out of your home, think twice about a reverse mortgage. 
  • If you have other people living with you, they may be forced out of the house if you can no longer stay in it. 
  • If you want to leave your home to your heirs, a reverse mortgage might not be your best option. Your heirs will have to come up with a substantial amount of money to pay the loan if they wish to retain the home. 

What Are Some Alternatives to a Reverse Mortgage?

If you need money but you’re not sure if a reverse mortgage is right for you, consider some possible alternatives.

  • If your property has high taxes or is expensive to insure and maintain, consider selling it and moving to a smaller home in a less expensive area, or renting. 
  • A cash-out refinance on your existing mortgage, if you still have one, can provide cash. You will have to make payments but you will rebuild your equity as you do. 
  • If you need cash on an ongoing basis, consider renting out a room or a part of your home. 
  • A home equity loan or a home equity line of credit could be an alternative if you need money for home repairs or another fixed expense. You will have to make payments. .
  • Consider selling your home to your children and having them rent it back to you. They will gain tax advantages as landlords and the home will stay in the family. 
  • An inter-family mortgage loan allows family members to make payments to you instead of a bank, gradually gaining equity in the home. 

All of these options have their own advantages and disadvantages, but a reverse mortgage is a complicated choice with serious implications for both you and your heirs, and it’s worth considering alternatives before making a commitment. 

Don’t Be Pressured Into a Reverse Mortgage

Some salespeople promote reverse mortgages as free money and may encourage you to use a reverse mortgage to pay for products and services they provide, like home improvement and repair. Some people selling investments or other financial products may suggest a lump-sum reverse mortgage as a way to pay for what they’re selling. 

Always be suspicious of any attempt to pressure you into a reverse mortgage or any financial decision. If you do decide on a reverse mortgage, do your own research and choose a lender that you feel comfortable doing business with. 

If you’re not sure you understand a reverse mortgage proposal, counselors from government-approved housing counseling services can assist you. You have the right to cancel a deal up to three business days after closing if you don’t feel right about a deal. 

Making Your Decision

Your equity in your home is probably the largest asset you have, and you may have worked much of your life to acquire it. You have the right to use that equity as you choose, but you should treat the decision carefully and be sure you understand exactly what you will gain and what you and your heirs may lose.

Your heirs are involved in the process and may be affected by a reverse mortgage. You may wish to discuss your options with them and get them involved in the decision.

A reverse mortgage is a complicated decision and if you’re not clear on any part of it, don’t hesitate to contact a qualified counselor. Understanding the process will help you to make the decision that best suits your financial goals.

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