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what is reverse mortgage

In a word, a reverse mortgage is a loan. A homeowner who is 62 or older and has considerable home equity can borrow against the value of their home and receive funds as a lump sum, fixed monthly payment, or line of credit. Unlike a forward mortgage—the type used to buy a home—a reverse mortgage doesn’t require the homeowner to make any loan payments.1

Instead, the entire loan balance, up to a limit, becomes due and payable when the borrower dies, moves out permanently, or sells the home. Federal regulations require lenders to structure the transaction so that the loan amount won’t exceed the home’s value. Even if it does, through a drop in the home’s market value or if borrower lives longer than expected, the borrower or borrower’s estate won’t be held responsible for paying the lender the difference thanks to the program’s mortgage insurance.1

KEY TAKEAWAYS

  • A reverse mortgage is a type of home loan for seniors ages 62 and older.1
  • Reverse mortgage loans allow homeowners to convert their home equity into cash income with no monthly mortgage payments.
  • Reverse mortgages can be a great financial decision for some seniors but a poor financial decision for others.
  • Be sure to understand how reverse mortgages work and what they mean for you and your family before borrowing.

Cash in Equity

Reverse mortgages can provide much-needed cash for seniors whose net worth is mostly tied up in their home equity: their home’s market value minus the amount of any outstanding home loans. Yet, these loans can be costly and complex, as well as subject to scams. This article will teach you how reverse mortgages work and how to protect yourself from the pitfalls, so you can make an informed decision about whether such a loan might be right for you or a loved one.

According to the National Reverse Mortgage Lenders Association, homeowners ages 62 and older held $10.19 trillion in home equity in the third quarter (Q3) of 2021. The number marks an all-time high since measurement began in 2000, underscoring how large a source of wealth home equity is for retirement-age adults.2

Home equity is only usable wealth if you sell and downsize or borrow against that equity. That’s where reverse mortgages come into play, especially for retirees with limited incomes and few other assets—but also for retirees who want to diversify their income and reduce investment risk, sequence risk, and longevity risk.

How a Reverse Mortgage Works

With a reverse mortgage, instead of the homeowner making payments to the lender, the lender makes payments to the homeowner. The homeowner gets to choose how to receive these payments (we’ll explain the choices in the next section) and only pays interest on the proceeds received. The interest is rolled into the loan balance so that the homeowner doesn’t pay anything up front. The homeowner also keeps the title to the home. Over the loan’s life, the homeowner’s debt increases and home equity decreases.

As with a forward mortgage, the home is the collateral for a reverse mortgage. When the homeowner moves or dies, the proceeds from the home’s sale go to the lender to repay the reverse mortgage’s principal, interest, mortgage insurance, and fees. Any sale proceeds beyond what was borrowed go to the homeowner (if still living) or the homeowner’s estate (if the homeowner has died). In some cases, the heirs may choose to pay off the mortgage so that they can keep the home.

Reverse mortgage proceeds are not taxable. While they might feel like income to the homeowner, the Internal Revenue Service (IRS)considers the money to be a loan advance.1

Types of Reverse Mortgages

There are three types of reverse mortgages. The most common is the home equity conversion mortgage (HECM). The HECM represents almost all of the reverse mortgages that lenders offer on home values below the conforming loan limit (set annually by the Federal Housing Finance Agency) and is the type that you’re most likely to get, so that’s the type that this article will discuss. Also called a Federal Housing Administration (FHA) reverse mortgage, this type of mortgage is only available through an FHA-approved lender.3

If your home is worth more, however, you can look into a jumbo reverse mortgage, also called a proprietary reverse mortgage.4 

When you take out a reverse mortgage, you can choose to receive the proceeds in one of six ways:

  1. Lump sum: Get all the proceeds at once when your loan closes. This is the only option that comes with a fixed interest rate. The other five have adjustable interest rates.
  2. Equal monthly payments (annuity): For as long as at least one borrower lives in the home as a principal residence, the lender will make steady payments to the borrower. This is also known as a tenure plan.
  3. Term payments: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years.
  4. Line of credit: Money is available for the homeowner to borrow as needed. The homeowner only pays interest on the amounts actually borrowed from the credit line.
  5. Equal monthly payments plus a line of credit: The lender provides steady monthly payments for as long as at least one borrower occupies the home as a principal residence. If the borrower needs more money at any point, they can access the line of credit.
  6. Term payments plus a line of credit: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years. If the borrower needs more money during or after that term, they can access the line of credit.1

It’s also possible to use a reverse mortgage called a “HECM for purchase” to buy a different home than the one in which you currently live.5

In any case, you will typically need at least 50% equity—based on your home’s current value, not what you paid for it—to qualify for a reverse mortgage.

43,000

The number of reverse mortgages issued in the United States in 2020, up 23% from the previous year.6

Would You Benefit from a Reverse Mortgage?

A reverse mortgage might sound a lot like a home equity loan or a home equity line of credit (HELOC). Indeed, similar to one of these loans, a reverse mortgage can provide a lump sum or a line of credit that you can access as needed, based on how much of your home you’ve paid off and your home’s market value. But unlike a home equity loan or a HELOC, you don’t need to have an income or good credit to qualify, and you won’t make any loan payments while you occupy the home as your primary residence.7

A reverse mortgage is the only way to access home equity without selling the home for seniors in situations like these:

  • don’t want the responsibility of making a monthly loan payment
  • can’t afford a monthly loan payment
  • can’t qualify for a home equity loan or refinance because of limited cash flow or poor credit

What Is Required for a Reverse Mortgage?

Property Type

If you own a house, condominium, or townhouse, or a manufactured home built on or after June 15, 1976, then you may be eligible for a reverse mortgage. Under FHA rules, cooperative housing owners cannot obtain reverse mortgages since they don’t technically own the real estate they live in: they own shares of a corporation. In New York, where co-ops are common, state law further prohibits reverse mortgages in co-ops, allowing them only in one- to four-family residences and condos.

Age, Equity, and Fees

While reverse mortgages don’t have income or credit score requirements, they still have rules about who qualifies. You must be at least 62 years old, and you must either own your home free and clear or have a substantial amount of equity (at least 50%). Borrowers must pay an origination fee, an up-front mortgage insurance premium, other standard closing costs, ongoing mortgage insurance premiums (MIPs), loan servicing fees (sometimes), and interest. The federal government limits how much lenders can charge for many of these items.8

Counseling

The U.S. Department of Housing and Urban Development (HUD) requires all prospective reverse mortgage borrowers to complete a HUD-approved counseling session. This counseling session, which usually costs around $125, should take at least 90 minutes and cover the pros and cons of taking out a reverse mortgage given your unique financial and personal circumstances.9 It should explain how a reverse mortgage could affect your eligibility for Medicaid and Supplemental Security Income (SSI). The counselor should also go over the different ways that you can receive the proceeds.

Collateral Protection

Your responsibilities under the reverse mortgage rules are to stay current on property taxes and homeowners insurance (and homeowners association fees, if you have them) and keep the home in good repair. And if you stop living in the house for longer than one year—even if it’s because you’re living in a long-term care facility for medical reasons—then you’ll have to repay the loan, which is usually accomplished by selling the house.1

Aside from the potential for scams targeting the elderly, reverse mortgages have some legitimate risks. Despite recent reforms, there are still situations when a widow or widower could lose the home upon their spouse’s death.

What Are the Costs of a Reverse Mortgage?

HUD adjusted insurance premiums for reverse mortgages in October 2017. Since lenders can’t ask homeowners or their heirs to pay up if the loan balance grows larger than the home’s value, the insurance premiums provide a pool of funds that lenders can draw on so that they don’t lose money when this happens.

One change was an increase in the up-front premium, from 0.5% to 2.0%, for three out of four borrowers and a decrease in the up-front premium, from 2.5% to 2.0%, for the other one out of four borrowers. The up-front premium used to be tied to how much borrowers took out in the first year, with homeowners who took out the most—because they needed to pay off an existing mortgage—paying the higher rate. Now, all borrowers pay the same 2.0% rate. The up-front premium is calculated based on the home’s value, so for every $100,000 in appraised value, you pay $2,000. That’s $6,000 on a $300,000 house, for example. In fact, the fee is capped at $6,000, even if your home is worth more.

All borrowers must also pay annual MIPs of 0.5% (formerly 1.25%) of the amount borrowed. This change saves borrowers $750 a year for every $100,000 borrowed and helps offset the higher up-front premium. It also means that the borrower’s debt grows more slowly, preserving more of the homeowner’s equity over time, providing a source of funds later in life, and increasing the possibility of being able to pass down the home to heirs.810

Reverse Mortgage Interest Rates

Only the lump sum (single disbursement) reverse mortgage, which gives you all of the proceeds at once when your loan closes, has a fixed interest rate. The other five options have adjustable interest rates, which makes sense since you’re borrowing money over many years, not all at once, and interest rates are always changing.11 Variable-rate reverse mortgages are tied to a benchmark index, often the Constant Maturity Treasury (CMT) index.

In addition to one of the base rates, the lender adds a margin of one to three percentage points. So if the index rate is 2.5% and the lender’s margin is 2%, then your reverse mortgage interest rate will be 4.5%. As of January 2022, lenders’ margins ranged from 1.5% to 2.5%. Interest compounds over the life of the reverse mortgage, and your credit score does not affect your reverse mortgage rate or your ability to qualify (though it does affect whether the lender may require a Life Expectancy Set Aside account for your property taxes, homeowners insurance, and other required property charges).12

How Much Can You Borrow with a Reverse Mortgage?

The proceeds that you’ll receive from a reverse mortgage will depend on the lender and your payment plan. For an HECM, the amount that you can borrow will be based on the youngest borrower’s age, the loan’s interest rate, and the lesser of your home’s appraised value or the FHA’s maximum claim amount, which is $970,800 as of Jan. 1, 2022.13

However, you can’t borrow 100% of what your home is worth, or anywhere close to it. Part of your home equity must be used to pay the loan’s expenses, including mortgage premiums and interest. Here are a few other things that you need to know about how much you can borrow:

  • The loan proceeds are based on the age of the youngest borrower or, if the borrower is married, the younger spouse, even if the younger spouse is not a borrower. The older the youngest borrower is, the higher the loan proceeds.
  • The lower the mortgage rate, the more you can borrow.
  • The higher your property’s appraised value, the more you can borrow.
  • A strong reverse mortgage financial assessment increases the proceeds that you’ll receive because the lender won’t withhold part of them to pay property taxes and homeowners insurance on your behalf.4

How much you can actually borrow is based on what’s called the initial principal limit. The federal government lowered the initial principal limit in October 2017, making it harder for homeowners, especially younger ones, to qualify for a reverse mortgage. On the upside, the change helps borrowers preserve more of their equity. 

The government lowered the limit for the same reason that it changed insurance premiums: because the mortgage insurance fund’s deficit had nearly doubled over the past fiscal year. This is the fund that pays lenders and protects taxpayers from reverse mortgage losses.

To further complicate things, you can’t borrow all of your initial principal limit in the first year when you choose a lump sum or a line of credit. Instead, you can borrow up to 60%, or more if you’re using the money to pay off your forward mortgage. If you choose a lump sum, the amount that you get up front is all you will ever get. If you choose the line of credit, then your credit line will grow over time, but only if you have unused funds in your line.

Avoiding Reverse Mortgage Scams

With a product as potentially lucrative as a reverse mortgage and a vulnerable population of borrowers who may either have cognitive impairments or be desperately seeking financial salvation, scams abound. Unscrupulous vendors and home improvement contractors have targeted seniors to help them secure reverse mortgages to pay for home improvements—in other words, so they can make bank. The vendor or contractor may or may not actually deliver on promised, quality work; they might just steal the homeowner’s money.

Relatives, caregivers, and financial advisors have also taken advantage of seniors either by using a power of attorney to reverse mortgage the home, then stealing the proceeds, or by convincing them to buy a financial product, such as an annuity or whole life insurance policy, that the senior can only afford by obtaining a reverse mortgage. This transaction is likely to be only in the so-called best interest of the financial advisor, relative, or caregiver. These are just a few of the reverse mortgage scams that can trip up unwitting homeowners.1

Do This to Avoid Foreclosure From a Reverse Mortgage

Another danger associated with a reverse mortgage is the possibility of foreclosure. Even though the borrower isn’t responsible for making any mortgage payments—and therefore can’t become delinquent on them—a reverse mortgage requires the borrower to meet certain conditions. Failing to meet these conditions allows the lender to foreclose.

As a reverse mortgage borrower, you are required to live in the home and maintain it. If the home falls into disrepair, it won’t be worth fair market value when it’s time to sell, and the lender won’t be able to recoup the full amount that it has extended to the borrower.

Reverse mortgage borrowers are also required to stay current on property taxes and homeowners insurance. Again, the lender imposes these requirements to protect its interest in the home. If you don’t pay your property taxes, then your local tax authority can seize the house. If you don’t have homeowners insurance and there’s a house fire, the lender’s collateral is damaged.

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