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What Is A Reverse Mortgage, How Does It Work, And What Are The Pros And Cons?

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Published on December 3, 2019
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Whether you’re already retired or are approaching retirement, you’ve likely prepared for this stage in your life ahead of time. But with rising costs of living and longer life expectancy, more and more people find themselves coming up short on funds.

What’s the solution? For some, a reverse mortgage might be just the ticket to securing a comfortable retirement.

What Is A Reverse Mortgage?

A reverse mortgage is a loan that allows homeowners over the age of 62 to convert a portion of their home equity into cash. This type of loan is especially appealing to people who want, or need, to supplement their retirement funds. If you have an existing mortgage, you must use your proceeds to pay that off first, thus eliminating the required monthly mortgage payment. With a reverse mortgage, you remain the owner of your home, so you must continue to pay your property taxes, homeowners insurance and home maintenance costs throughout the life of the loan even if you don’t have a mortgage payment.

Why Would Someone Want To Consider A Reverse Mortgage?

Whether they need financial assistance or just want access to more funds while they live their retirement and reach other financial goals, there are several reasons why someone may want to consider a reverse mortgage.

  • Eliminate or lower their monthly mortgage payments, freeing up more money each month
  • Consolidate their debts
  • Pay for in-home care
  • Make home improvements
  • Purchase a new home with a Home Equity Conversion Mortgage for Purchase
  • Supplement their income to allow other assets to grow in value
  • Create an emergency fund or increase their savings
  • Protect home equity from declining home markets
  • Have access to the net worth tied up in their home

How Does A Reverse Mortgage Work?

A reverse mortgage works by using a portion of your home equity to first pay off your existing mortgage on the home – that is, if you still have a mortgage balance. You are not required to make monthly payments on the reverse mortgage because the loan balance doesn’t come due until the final borrower moves out of the home, passes away, fails to pay taxes or insurance, or neglects to maintain the home.

While you are not required to make monthly payments, doing so could reduce your monthly interest or prevent it from accruing altogether. If you choose not to make a monthly payment on the loan, interest for that month will get added to the total loan balance.

After paying off your existing mortgage, your reverse mortgage lender will pay you any remaining proceeds from your new loan. If you own your home free and clear, you’ll receive all of the proceeds from the loan since you do not have a mortgage balance to pay off first. As the homeowner, you get to choose how you want to receive your funds.

Responsibilities Of A Reverse Mortgage

It’s important to remember that a reverse mortgage is still a loan and, as the homeowner, you still have responsibilities tied to the loan and to the home. While you don’t have to make monthly mortgage payments with a reverse mortgage, you’re still responsible for paying your property taxes and homeowners insurance. And, since the home is often used to repay the loan later, you must keep the home in good condition and complete any repairs and routine maintenance.

The home must also be your primary residence, so you must continue to live in the home for more than half of the year.

If you do not stay current on your taxes and homeowners insurance, fail to maintain the home, or live in the home for less than 6 months of the year, your loan may come due.

However, if you uphold the loan obligations listed above, your reverse mortgage will not come due until the last borrower moves out of the home or passes away. When this happens, the home is sold and the proceeds of the sale are used to pay the loan balance in full.

A reverse mortgage is a nonrecourse loan. That means, if the home sells for less than what is owed, you or your heirs will not be responsible for paying the difference. Depending on the type of reverse mortgage you get, the FHA or the lender will cover the difference and absorb the cost.

On the other hand, if the home sells for more than what is owed on the loan, the remaining money is given to you or your heirs.

Types Of Reverse Mortgage

While there are other types of reverse mortgages out there, including proprietary and single-purpose loans, the most common type of reverse mortgage is the Home Equity Conversion Mortgage. This type of reverse mortgage is a popular option because it is backed by the Federal Housing Administration and is the only federally insured reverse mortgage available. The HECM may be the best option for most people, but it has its limitations. For example, the loan has a max claim amount (or loan limit) of $726,525. If your home is worth more than $726,525, you may benefit more from a proprietary, or jumbo, reverse mortgage.

For the purpose of this article, we’ll stick to the HECM when talking about what a reverse mortgage is, how it works, and how you may benefit from one.

There are two types of HECM loan options: an adjustable rate loan and a fixed-rate loan. The adjustable rate loan has an interest rate that may increase or decrease throughout the life of the loan and offers more options on how to receive your proceeds. A fixed-rate loan has an interest rate that stays the same throughout the life of the loan and offers only one option for receiving your proceeds.

Reverse Mortgage Proceeds

Depending on the type of loan you choose, you may receive your money in one of the following ways:

Lump sum: With a lump sum payment, you’ll receive all of your money at once, in one large payment, when the loan closes. If you have a fixed-rate loan, this is the only way you can receive your money.

Monthly term payments: If you choose term payments, you can decide how long you want to receive money from your reverse mortgage. The amount of money paid to you each month will depend on how long you choose to receive these monthly installments. For example, if you choose to get payments over the span of 10 years, you will get the same amount of money each month for 10 years, or 120 months. After that amount of time, you will not receive any more payments.

Monthly tenure payments: With the tenure payment option, you’ll receive monthly installments that last throughout the life of your loan. Once the tenure payment is calculated, you’ll receive that amount of money each month for as long as you stay in the reverse mortgage. This option can help prevent you from outliving your reverse mortgage proceeds.

Line of credit: By choosing the line of credit option, you can access your money from a line of credit whenever you need it. You’ll only pay interest on the amounts you actually borrow, and the money in your line will increase in value annually at the interest rate of your loan, just as it would in a checking or savings account. The line of credit also protects your equity because the value in your line of credit continues to increase even if the value of your home decreases.

A combination of payment options: You can further customize your reverse mortgage payout by combining the different payment options. For example, you could do term or tenure payments in addition to a line of credit, so you still have access to more money if your monthly payment doesn’t cover your expenses for that month. Or, you could get a portion of your proceeds in one lump sum to pay off a debt or make a repair and put the remaining proceeds into a line of credit or have them paid out in monthly installments.

No matter how you choose to receive your proceeds, they are not considered taxable income by the IRS. Instead, the IRS considers the money you receive a loan advance since the loan will eventually be paid back to the lender. That means you won’t be taxed on the money you receive from a reverse mortgage, nor will it affect your Social Security or Medicare benefits. To learn more about other benefits – like Medicaid or Supplemental Security Income – speak to your financial advisor.

Reverse Mortgage Pros And Cons

As with any major financial decision, you should weigh the pros and cons of getting a reverse mortgage and decide if it is right for you. We also recommend speaking to a financial advisor.

7 Pros Of A Reverse Mortgage

Depending on your needs and financial goals, a reverse mortgage may benefit you in the following ways:

  1. You remain the owner of the home. Your name stays on the title.
  2. You can access your equity without selling the home or paying a monthly mortgage.
  3. There are no credit score requirements at this time, though credit history will be reviewed during a financial assessment.
  4. You are protected from declining home values since it is a nonrecourse loan.
  5. There are no restrictions on how the proceeds are spent. In other words, you can use the funds on whatever you want or need.
  6. Even after the borrower dies, non-borrowing spouses who are not listed on the mortgage may still live in the home.
  7. If the loan comes due because you pass away and your heirs wish to keep the home, they can purchase the home for 95% of its appraised value or the balance of the loan – whichever is lower. They can also refinance that cost into a traditional mortgage.

 

7 Cons Of A Reverse Mortgage

Although there are a number of benefits that come with a reverse mortgage, the loan can also have some points that you will want to consider.

  1. Since you’ll be borrowing against the equity in your home, you’ll decrease your equity and increase your amount of debt.
  2. If you choose not to make payments, the loan balance will increase over time as interest accumulates.
  3. Depending on the type of loan you choose and how you handle your money, you may outlive your proceeds.
  4. While heirs will have a few options for keeping your home after you pass away, you may not be able to pass on the home to your heirs without a cost to them.
  5. The loan may come due for several reasons. For example, the loan must be for your primary residence. If you do not live in the home for more than 6 months, the loan could come due. On the same note, a reverse mortgage will come due if you move out of the home or pass away. It could also come due if you fail to uphold your responsibilities of the loan, including maintaining the home and paying your property taxes and homeowners insurance.
  6. A stated above, you must continue to pay property taxes and homeowners insurance. If you do not stay current on these expenses, your loan may come due.
  7. There may be high closing costs and fees associated with the loan.

If you think a reverse mortgage may be right for you, here’s how to determine if you qualify for the loan.

Reverse Mortgage Eligibility And Qualifications

To be eligible for a reverse mortgage, you must meet the following criteria, at a minimum:

  • You must be 62 years or older.
  • You must have enough equity in your home – about 50%, but the required amount varies by lender.
  • You must attend a counseling session from a Department of Housing and Urban Development-approved counselor to learn more about the loan and your options.
  • You must go through a financial assessment to ensure you are in the best position to be successful with your loan.
  • Along with these requirements, your home also needs to qualify for the loan. Here are a few basic requirements:
  • The home must be your primary residence.
  • The home must be in good condition and meet FHA standards.
  • The home cannot be a manufactured or mobile home.
  • If the home is a condo, it must be on the HUD/FHA approved condo list. If it is not, you may still be eligible for a proprietary reverse mortgage.

What Does A Reverse Mortgage Cost?

Just like a traditional mortgage, there are costs associated with getting a reverse mortgage, specifically the HECM. These costs are typically higher than those associated with a traditional mortgage. Here are a few fees you can expect:

Upfront MIP: The upfront mortgage insurance premium is paid to the FHA when you close your loan. The MIP protects you and the lender by making the loan a nonrecourse loan. If the home sells for less than what is due on the loan, this insurance covers the difference so you won’t end up underwater on your loan and the lender doesn’t lose money on their investment. It also protects you from losing your loan if your lender goes out of business or can no longer meet its obligations for whatever reason. In that case, FHA takes over so you can still access your loan proceeds.

The cost of the upfront MIP is 2% of the appraised value of the home or $726,535 (the FHA’s lending limit), whichever is less. For example, if you own a home that’s worth $250,000, your upfront MIP will cost around $5,000.

Along with an upfront MIP, there is also an annual MIP that accrues annually and is paid when the loan comes due. This charge is usually around .5% of the loan balance.

Origination fee: The origination fee is the amount of money a lender charges to originate and process your loan. This cost is 2% of first $200,000 of the home’s value plus 1% of the remaining value after that. The FHA has set a minimum and maximum cost of the origination fee, so no matter what your home is valued, you will not pay less than $2,500 nor more than $6,000.

With the same $250,000 home mentioned above, the origination fee would cost around $4,500 (2% of $200,000 and 1% of $50,000).

Servicing fee: The servicing fee is a monthly charge by the lender to service and administer the loan and can cost up to $35 each month.

Appraisal fee: Appraisals are required by HUD and determine the market value of your home. While the true cost of your appraisal will depend on factors like location and size of the home, they generally cost between $300 and $500.

Third-party charges:These are the smaller charges from businesses other than your lender. These costs may include:

  • Credit report fees: $30-$50
  • Document preparation fees: $50-$100
  • Courier fees: $50
  • Escrow, or closing fee: $150-$800
  • Title insurance: depends on your loan and location

Interest rates:There are many factors that influence the interest rate for a reverse mortgage, including the lender you work with, the type of loan you get and whether you get a fixed- or adjustable rate loan.

Most of these costs can be rolled into your loan, but you can pay any of them out of pocket, if you want to forgo financing them. Talk to your lender to get the most up-to-date costs as fees may change over time.

Reverse Mortgage Calculator: How Much Equity Can You Access?

Now that you have a better understanding of how a reverse mortgage works, you may be wondering how much you can get from the loan. Depending on the type of reverse mortgage you choose, you may be able to access up to 60% of your home’s equity. However, the actual amount of money you’ll receive from a reverse mortgage is based on the age of the youngest borrower, the amount of equity you have in the home, and the current interest rate. If you have an existing mortgage, you may want to subtract that amount from your total, since the lender will use that money to pay your mortgage off first. You may also want to factor in closing costs if you’d like to use some of your proceeds to pay those off as well, though they can be rolled into the loan balance, too.

To get a good estimate of just how much money you can get, use a reverse mortgage calculator. To get a more accurate estimate that takes your specific lifestyle and financial goals into consideration, call a reverse mortgage specialist.

How To Apply For A Reverse Mortgage In 5 Steps

After you decide that a reverse mortgage is the right option for you, the next action to take will be applying for the loan. From application to closing, the process for getting a reverse mortgage is done in five steps. The reverse mortgage application process from start to finish takes about 30-45 days on average.

1. Talk To Your Lender

Before filling out your application, talk to a reverse mortgage lender to make sure you qualify for the loan. They’ll ask you a few qualifying questions about your age, credit, income, equity and credit to make sure you’re eligible. After that, they’ll talk to you about your financial situation and your goals. They may ask why you are considering getting a reverse mortgage and explain to you how the loan works and the various ways it could help you reach your goals. Through your conversation, they’ll be able to put together a customized loan option. If you’re interested in moving forward or learning more, they’ll share with you the next steps and provide time to answer any questions you may have about the loan or the lending company.

2. Provide All Necessary Paperwork

Once you’re ready to apply for a reverse mortgage, your lender will send you an application to complete, which will ask for such information as:

  • Identifiers like your name, address, Social Security number and date of birth
  • Your monthly income, real estate assets and other assets
  • Any liens against your property and other non-real estate debts you have
  • The type of property you have and who holds the title
  • The type of loan you’re applying for and how you wish to receive payments

Once you complete the application, you’ll send it back to your lender. There are a few other documents you will need to provide.

  • Photo identification, such as a license or passport
  • Document that proves your home is your primary residence, such as a recent mortgage statement, copy of tax bill or homeowners insurance policy
  • Proof of income, like your W2s, paycheck stubs, bank statements or a Social Security or pension award letter
  • Documents for special circumstances like past bankruptcy, flood insurance, Power of Attorney or guardianship
  • Counseling certificate, which indicates you completed the required reverse mortgage counseling (see step #3)

You cannot move forward with the reverse mortgage process until you complete the HUD-approved counseling session and provide the lender your counseling certificate.

3. Attend A HUD-Approved Counseling Session

After applying, you’re required to go through a third-party, educational counseling session. This is how the government ensures you fully understand the loan, your responsibilities and the repayment process. During the session, the counselor will discuss your financial needs and goals and provide information on the reverse mortgage loan and any other options you may have to receive assistance. They’ll explain what the loan is and the impact it could have on you and your family. The counselor’s goal is not to steer you in one direction or the other or tell you what to do. Their job is to provide you enough information to make an educated decision on whether you should get a reverse mortgage. The counseling session is also your chance to ask questions about the loan program.

Counseling may take place on the phone or face to face, depending on your state laws. You will be responsible for contacting the counseling agency and scheduling an appointment. Your lender may provide you a list of counseling agencies in your area or you can find one on the HUD website. The session usually lasts about 90 minutes and costs under $200, an out-of-pocket cost to you.

4. Financial Assessment

When you apply for a reverse mortgage, you go through a process known as financial assessment. During this step, your lender looks at your income, credit history and assets to get a picture of your financial situation and determine whether or not you can comfortably meet the financial obligations of the loan.

If necessary, the lender will hold back part of your proceeds from the loan and put them in an escrow account to pay your property taxes and homeowners insurance for you.

5. Appraisal, Closing And Payment

Next, an appraiser will determine the value of your home. This helps the lender calculate how much money you’re eligible to receive. An appraisal for a reverse mortgage is the same as an appraisal for purchasing a home. A third-party appraiser will visit and inspect your home, then research similar homes in the area to determine the fair market value of your home.

The final step is closing the loan in the comfort of your home with a title agent or attorney. During closing, you’ll confirm how you wish to receive your proceeds, sign the final documents and pay any closing costs you wish to pay out of pocket.

After closing, you can access the funds after three business days. During those three days, also known as “the right of rescission,” you’ll be able to change your mind and cancel the transaction with no penalty. Once those three days are over and you can receive your reverse mortgage proceeds, you can use them however you wish.

Reverse Mortgage Line Of Credit Vs. HELOC

The reverse mortgage line of credit is one way to receive your HECM proceeds. It is similar to a Home Equity Line Of Credit (HELOC), but differs in the following ways:

  • As long as you continue to uphold the responsibilities of the loan, your reverse mortgage line of credit will not be suspended or called due.
  • Any money that is left in the line of credit will increase in value throughout the life of the loan.
  • You can make payments on the loan if you want, but no monthly payment is required.
  • The reverse mortgage line of credit is typically more expensive in terms of closing costs and application fees.
  • You must be at least 62 years old to get a reverse mortgage line of credit.

Whether you have a reverse mortgage line of credit or HELOC, you will only be charge interest on the money you use.

Is A Reverse Mortgage Right For You?

A reverse mortgage can be a great financial tool in retirement, but it’s not always the right option. To determine whether you should get a reverse mortgage, ask yourself the following questions:

  • How will I use the loan?
  • Will I run out of money in the future?
  • Am I willing and able to uphold the financial obligations of the loan, including paying property taxes and homeowners insurance?
  • How long do I plan on staying in the home?
  • Do I have other options to consider?
  • How will the loan affect my family?
  • How will the loan affect any government assistance programs I am enrolled in?
  • Will my spouse be on the loan?
  • Do I fully understand the loan?

While we don’t offer reverse mortgages, a cash-out refinance could be the right option for you. If you’re interested in getting started, you can start an application online today.