How does a reverse mortgage work?
You’ve saved up a nice little nest egg to fund your retirement, but despite all of your hard work scrimping and saving, you’re worried you might need some extra income to fully enjoy your golden years.
A reverse mortgage can be a great way to access additional funds during your retirement by tapping into the equity you’ve built up in your home. A steady influx of extra cash each month can help you stay on top of everyday expenses and keep your standard of living up to your expectations.
It’s important to remember that reverse mortgage rates may vary compared with other types of home loans. Whenever a reverse mortgage offer lands in your lap, take a moment to see how it stacks up against current mortgage rates before agreeing to anything.
If you’re confused about how reverse mortgages work, don’t worry, you’re not alone. Let’s clear the air about this often-misunderstood — and sometimes unfairly maligned — financial tool.
What is a reverse mortgage?
A reverse mortgage is a loan that you take out using the equity you’ve established in your home. As the name implies, a reverse mortgage flips the roles of the lender and the borrower. In this case, the lender pays money to the borrower based on that equity. Keep in mind that while the lender will make monthly payments to the borrower, you are still responsible for any applicable taxes, insurance premiums and association fees.
Let’s back up a minute, though. With a traditional mortgage, every payment you make builds equity in your home. Eventually, you’ll own a larger share of your house than the bank does, and one day, you’ll pay off that loan in full.
In many cases, that equity isn’t available to homeowners until they sell their property or take out a home equity loan. With a reverse mortgage, however, you can extract some of that equity to pay for other needs, like groceries, clothing or medication, long after you’ve stopped earning a steady paycheck. If you’re worried about making ends meet during your retirement, and you have a lot of equity in your home, a reverse mortgage can help pay the bills and cover your living expenses.
This type of loan is also useful if you’re looking to downsize — say, from a single family home to a townhouse. After using the proceeds from the sale of your current home as a down payment, you can then take out a reverse mortgage on that equity to open up a line of credit. You don’t owe any mortgage payments on your new home, and you can access additional funds whenever you need them. Or simply leave that line of credit alone to accrue interest.
How reverse mortgages work
Although there are a few different flavors of reverse mortgages to consider, the basic idea always remains the same: The bank or lender extends loan payments to the borrower using equity you’ve already paid into the property. It’s almost like getting past mortgage payments back into your pocket — at a cost, of course.
Those payments can come in monthly installments, lump sum deposits or a line of credit to draw from — whatever payment options make the most sense for you. Keep in mind that with every reverse mortgage payout, your equity decreases. So, if your No. 1 priority is to one day own your home outright, this is not the financial tool for you.
The bank expects you to pay the loan back eventually, of course, but only when the house is sold or otherwise changes hands. Until then, you don’t need to worry about making payments on your reverse mortgage loan.
How do you qualify for a reverse mortgage?
Reverse mortgages are highly specialized financial tools created with the express purpose to give retirees and seniors extra money to draw from in the event their life savings and supplemental income aren’t enough to cover their bills. With that in mind, there are several criteria you have to meet to qualify for this type of loan:
- You must be at least 62 years old
- You must own 50% or more of your home’s equity, in most cases
- You can only apply for a reverse mortgage using your primary residence
- Your home needs to be an FHA-approved residence
As you may have noticed, reverse mortgages share a lot in common with home equity loans, but these detailed qualifications really set them apart. Whereas most anyone with significant equity and good financial status can be approved for a home equity loan, a reverse mortgage is limited to people who meet the age requirements and other criteria listed above. Reverse mortgages also typically give you more flexibility in terms of payment options as opposed to a home equity loan.
What are the benefits of a reverse mortgage?
Transferring some of the equity you’ve put into your home into cold, hard cash can be a great way to pay your living expenses during retirement. Compared with a home equity loan, in particular, reverse mortgages have a lot to offer:
- A variety of payment options, including not making a payment at all
- No pressure to make a payment at any time, even if interest rates increase
- Your line of credit will never be frozen if interest rates go up
- The untouched funds in your line of credit grow over time — and it’s completely tax-free
- You can protect other assets in your estate from creditors
- Your line of credit stays the same even if the home’s market value drops
- You don’t need to worry about the risk of foreclosure due to missed principal and interest (P&I) payments, because there are none to make
- Money you would have spent on your conventional mortgage payments can go to other needs
Reverse mortgages are the rare lending tool designed specifically for seniors, helping you continue enjoying the lifestyle you were accustomed to during your working days. It’s hard to put a price on the financial security afforded by reverse mortgages.
How much money can you access?
The payout from a reverse mortgage depends on several factors:
- Your age
- The market value of your home
- How much equity you have built up
- How up to date you are with other financial obligations like property taxes
- The purpose of the loan and the type of reverse mortgage you’re using
- The current interest rates
In general, borrowers who are older and have more equity in their home will receive more favorable loan conditions. Keep in mind, it’s very unlikely your lender will offer a reverse mortgage loan that’s equivalent to the value of your home or the amount of equity you have in the property. Best-case scenario, you might get 75% of your home’s market value, but you should expect an amount closer to 40%-50%.
There could also be maximum loan limits depending on the type of reverse mortgage you use. As of 2021, reverse mortgages backed by the government can not exceed $822,375.
Know the different types of reverse mortgages
Lenders usually offer three types of reverse mortgages:
- Single-purpose reverse mortgages
- Home equity conversion mortgages (HECM)
- Proprietary reverse mortgages
Single-purpose reverse mortgages
These reverse mortgages are often the least expensive option available but, as the name suggests, you’re pretty limited as far as how you use your loan proceeds. Your lender will need to sign off on the purpose of the loan, whether that’s to pay outstanding property taxes, cover insurance premiums or repair a leaky roof. Given all of that, it’s not surprising that single-purpose reverse mortgages generally cover much smaller dollar figures compared with other available options.
Home equity conversion mortgages
HECM loans, on the other hand, offer far more flexibility to the borrower. You can basically use the loan proceeds any way you like. These types of loans also typically have less stringent requirements regarding the borrower’s financial status and risk profile, making them by far the most popular type of reverse mortgage available.
There are a few caveats to consider, though. For one, only lenders approved by the Federal Housing Administration (FHA) can offer these types of loans, so it’s possible your preferred financial institution won’t even support them. And as noted earlier, there’s a limit on the amount you can receive with any government-backed reverse mortgage.
HECM loans are also typically more expensive on the front end due to the extra costs borrowers have to cover. For instance, the FHA requires borrowers to pay a mortgage premium equivalent to 2% of your home’s market value. That’s an awful lot of money to put down, especially for cost-conscious retirees.
In most cases, FHA reverses will be adjustable rate mortgages (ARM), rather than fixed rate mortgages. ARMs usually make more sense for retirees who want higher cash-out limits, flexible borrowing terms and tax-free growth on their open line of credit.
Speaking of government-mandated criteria, the Department of Housing and Urban Development requires all HECM recipients to speak with a consultant to fully understand the risks and responsibilities that come with a reverse mortgage. Borrowers will need to pay an additional fee for that consultation session, but it’s relatively small compared with the other fees and related costs.
Proprietary reverse mortgages
Unlike HECM loans, proprietary reverse mortgages — also referred to as jumbo reverses — are not backed by the FHA. While that may seem like a negative, it also means proprietary reverse mortgages are not beholden to the maximum limits imposed on HECM loans. As such, these types of reverse mortgages make the most sense for people who want to trade off of their high-value homes to get the largest payout possible.
Clearing up common misconceptions about reverse mortgages
A reverse mortgage can sound too good to be true. After all, you get back money you’ve already paid on your mortgage while continuing to live in your home. Plus, you don’t owe any monthly P&I payments. What’s the catch?
It’s not surprising that so many people look at reverse mortgages with a bit of skepticism. While there are certainly risks to consider — as there are with any financial tool — don’t be so quick to dismiss what reverse mortgages have to offer.
Some of the most common misconceptions about how reverse mortgages work revolve around these concerns:
- Who owns the property?
- What happens if you owe more than the house is worth?
- Will you have fewer assets to pass down to your heirs?
- What time limits are imposed on a reverse mortgage?
Who owns the property?
People often worry about their status as a homeowner when using a reverse mortgage. We’re here to tell you that there’s really nothing to be concerned about. Your home’s title will stay in your name and can be passed on to your heirs just like any other piece of property.
In the meantime, you retain all the rights that come with your title, including the ability to make renovations and sell the property, if you so choose. Keep in mind, you’ll still be expected to stay current on financial obligations like paying your property taxes and homeowners insurance. If you fall behind on those payments, your lender has the option to demand the loan be paid back in full.
What happens if you owe more than the house is worth?
One of the most common misconceptions about reverse mortgages is that you or your heirs will need to pay the deficit if you wind up owing more than your house is worth. But that’s not true. A reverse mortgage is what’s known as a non-recourse loan in the financial world. What that means is you will not be responsible for paying back any amount of the loan that exceeds the value of your home.
So, in those scenarios — which are pretty rare, by the way — your mortgage insurance would cover any outstanding balance left over after the house is sold. On the flipside, if the proceeds from the sale exceed the amount still owed on the reverse mortgage, that money would go to you or your beneficiaries.
Will you have fewer assets to pass down to your heirs?
That depends on how you use those funds. To be absolutely clear, you will lose equity in your home by taking out a reverse mortgage, and every payment you receive is subtracted from the total amount you’ve already put into your home.
However, if you use some of those funds as an investment vehicle — say, to buy shares of a stable market index — you could potentially increase the total value of your estate even as your home equity goes down. Given the volatility of financial markets, this is a pretty risky route to go down, and we would caution borrowers against using payouts in this fashion. At the very least, you should always consult a financial advisor or professional loan officer before considering this course of action.
Also, keep in mind that your open line of credit will accrue interest over time. Depending how much of that credit you use and the duration of the loan, you could gain quite a bit of money through that interest.
What time limits are imposed on a reverse mortgage?
One of the most common concerns people have about reverse mortgages is how much time their family and loved ones have to sell the property after they’ve passed away. Reverse mortgages are beholden to the same estate guidelines as any other asset: The IRS requires the estate to file a final estate tax return within 9 months of the individual’s death.
Another question that frequently comes up is what happens if the borrower needs to leave the home for an extended period of time — say, to move into a nursing home or receive extensive treatment for a health condition. In those cases, the mortgage lender will wait a year before recommending that the property be sold to pay off the reverse mortgage loan.
What are the downsides to a reverse mortgage?
Given all of the advantages discussed here, why do some people view reverse mortgages in a negative light? The truth is there are some downsides to these types of loans that you need to take into account:
- Origination fees
- Interest rates
- Extra fees
- Loss of equity
Just like you would with a conventional mortgage, the borrower needs to pay closing costs on a reverse mortgage — in this case, they’re known as origination fees. The origination fee is usually a little bit higher than the closing fee on a conventional mortgage, due to upfront FHA mortgage insurance costs. With a reverse mortgage, the FHA mortgage insurance will reflect 2% of the home’s appraised value. FHA mortgage insurance on a conventional mortgage, meanwhile, will usually total 1.75%.
That being said, all other closing costs, such as title fees and appraisal fees, are pretty comparable across both conventional and reverse mortgages.
Reverse mortgages often have higher interest rates than traditional mortgage loans, so you may wind up paying more in interest than if you had kept paying off your original mortgage.
We noted earlier that your mortgage insurance will cover any deficits when it comes time to settle your debt. That insurance isn’t free, though, and your lender will require you to foot the bill for your coverage. In addition, there could be other servicing fees tacked on that will add to the total cost of your loan.
Loss of equity
The payout from a reverse mortgage is a huge boon in certain situations, but it also comes at the expense of the equity you’ve put into your home. Retirees need to consider how much equity they’re comfortable giving up to enjoy the benefits of a reverse mortgage.
When does it make sense to use a reverse mortgage?
There are certainly pros and cons to consider when taking out a reverse mortgage. Let’s be clear: Reverse mortgages are not right for everyone. As noted, if you want to own your house outright, steer clear of these types of loans.
With the age of retirement steadily creeping up, though, there are a lot of people out there who worry about how they’re going to pay for their twilight years. Those are the folks who stand to benefit from a reverse mortgage. Having that extra line of credit or steady flow of monthly deposits can go a long way toward addressing those concerns. Even if you have a substantial nest egg saved up, you might prefer to put your home’s equity to work rather than dip into those funds for your living expenses and other purchases.
Another point to keep in mind is that traditional retirement funds like 401Ks and IRAs are beholden to the financial markets — and by extension, their inherent volatility. If your primary source of retirement income is an investment-based account, you can’t afford to ride out a bear market. You need that money in your hands, regardless of how the market’s performing. As such, you could wind up taking a loss on those investments by withdrawing money or selling stocks during a market swoon.
On the other hand, a reverse mortgage gives you an extra source of income that’s not directly tied to market performance. You can leave your investments untouched to appreciate in value after a potential market rally, while you still have the funds you need to live your life.
Also, consider the tax penalties you may face when withdrawing funds from certain retirement accounts. The IRS doesn’t consider reverse mortgage payments to be taxable income, so you could save money by lowering your tax liability.
If you’re a retiree and still wondering if a reverse mortgage is right for you, first ask yourself:
- Do you want to feel like you have more control over your cash flow?
- Do you want to increase the buying power of your assets?
- Do you want peace of mind about your financial future?
- Do you want to get the most value from your available assets?
If you answered yes to those questions, then a reverse mortgage could be right for you.
Reverse mortgages can provide peace of mind for folks who are worried about making ends meet during their retirement. Using the equity you’ve already put into your home opens up new sources of income to keep you in good financial standing while letting you stay put in the home you love and cherish.
Those funds do come at the expense of your home equity, though, so be sure you’re prepared to make that trade-off before asking a lender for a reverse mortgage. It’s also important to keep in mind that the inheritance you leave behind may be smaller as a result of the loss of equity.
As with any financial decision, it’s important to carefully consider your home loan options, assess the pros and cons of each and decide if the reward outweighs the potential risks. In the right circumstances, though, a reverse mortgage can be a game changer for retirees and seniors.