Reverse mortgage: What is it and how does it work?

  • By Deborah Kearns,
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What is a reverse mortgage?

A reverse mortgage is a type of home equity loan for older homeowners that doesn't require monthly mortgage payments. The home's equity is generally paid out to the homeowner monthly and the loan is repaid after the borrower moves out or dies.

Reverse mortgages are often considered a last-resort source of income, but they have become a useful retirement planning tool for some homeowners.

The majority of reverse mortgages are home equity conversion mortgages, or HECMs. Insured by the Federal Housing Administration, HECMs allow people who are 62 or older to tap a portion of their home equity without having to move. You also can use a HECM to buy a home.

Who benefits from a reverse mortgage?

Steven Sass, research fellow at the Center for Retirement Research at Boston College, says a reverse mortgage makes sense for people who:

  • Don't plan to move.
  • Can afford the cost of maintaining their home, and keep up with property taxes and insurance.
  • Want to access the equity in their home to supplement their income in retirement.

Some people even use a reverse mortgage to eliminate their existing mortgage and improve their monthly cash flow, says Peter Bell, president and CEO of the National Reverse Mortgage Lenders Association, or NRMLA.

"There are a lot of motivations leading into it," Bell says. "In some cases, people may have an immediate need to pay off debt, or they may have had some unexpected expenses like a home repair or health care situation."

The lender makes payments to the borrower throughout his or her lifetime based on a percentage of accumulated home equity. The loan balance need not be repaid until the borrower dies, sells the home or permanently moves out.

How does a reverse mortgage work?

  • The lender makes payments to the borrower based on a percentage of accumulated home equity.
  • When does it need to be repaid? When the borrower dies, sells the home or permanently moves out.
  • Who is eligible? Seniors age 62 or older who own homes outright or have small mortgages. The home must be your primary residence, and you cannot be delinquent on any federal debts.
  • Is a credit check required? Yes. Lenders also evaluate your income, assets and monthly living expenses. You must also be current on property taxes, and hazard and flood insurance premiums.
  • What type of homes qualify? Homes must meet FHA property standards and flood requirements. Eligible property types include: single-family homes; a two- or four-unit homes with the borrower living in one unit; HUD-approved condo projects; or FHA-compliant manufactured homes.
  • How can the money be used? For any reason. Retirees typically use cash to supplement income, pay health care expenses, retire debt or finance home improvements.

You will never owe more than the value of your home in a reverse mortgage loan, regardless of how much you borrow. And if the balance is less than your home's value at the time of repayment, you or your heirs keep the difference.

A married couple may decide to get a reverse mortgage but leave one spouse off the HECM. If the borrowing spouse dies or moves out permanently, a non-borrowing spouse can continue to live in the home as long as he or she is listed in the HECM documents as such. The surviving spouse must maintain the home and pay taxes and insurance as long as he or she continues to live in the home, and will not receive any of the reverse mortgage proceeds.

How much can you get?

Typically, you can take up to 60 percent of your initial principal limit in the first year of your reverse mortgage. This is known as your first-year draw limit. If the amount you owe on an existing mortgage or other required payments exceeds this amount, you can take out extra money to pay off that loan and associated fees, as well as additional cash of up to 10 percent of your principal limit.

Several factors determine the amount of money you can get through a reverse mortgage, such as:

  • Age (or the age of the youngest spouse in the case of couples).
  • Value of home.
  • Interest rate.
  • Lesser of appraised value or the HECM FHA mortgage limit of $679,650.

To be eligible for a reverse mortgage, you must either own your home outright or have a low mortgage balance that can be paid off at the closing with proceeds from the reverse loan.

A 2017 change in federal rules tightened the amounts that can be borrowed. But generally, the older you are and the more valuable your home, the more money you can get. There are no restrictions for how the money from a reverse mortgage loan can be used.

How you receive a reverse mortgage payout depends on the type of mortgage. Seniors with an adjustable-rate mortgage can collect their payments as a lump sum, fixed monthly payment, line of credit or some combination. Holders of fixed-rate mortgages receive a lump sum.

Pros and cons of a reverse mortgage

Pros

  • Does not require monthly payments from the borrower.
  • Proceeds can be used to pay off debt or settle unexpected expenses.
  • The money can pay off the existing mortgage.
  • Funds can improve monthly cash flow.
  • Non-borrowing spouses not listed on the mortgage can remain in the home after the borrower dies.

Cons

  • Fees and other closing costs can be high.
  • Borrower must maintain the house and pay property taxes and homeowners insurance.
  • A reverse mortgage drains a key asset of your estate.

Reverse mortgage costs

You can expect to pay higher-than-average closing costs based on the value of your home, including origination fees, mortgage insurance premiums and servicing fees.

Most HECM costs can be financed into your reverse mortgage loan, saving you from out-of-pocket expenses. Doing so, however, reduces the loan amount available to you.

Here's a breakdown of HECM fees and charges, according to HUD:

Mortgage Insurance Premium (MIP). You'll pay a 2 percent initial MIP at closing, as well as an annual MIP equal to 0.5 percent of the outstanding loan balance. MIP can be financed into the loan.

Origination fee. Lenders charge the greater of $2,500 or 2 percent of the first $200,000 of your home's value in order to process your HECM loan, plus 1 percent of the amount over $200,000. The FHA caps HECM origination fees at $6,000.

Servicing fee. Lenders can charge a monthly fee to maintain and monitor your HECM for the life of the loan. Monthly servicing fees cannot exceed $30 for loans with a fixed rate or an annually adjusting rate, or $35 if the interest rate adjusts monthly.

Third-party charges. Third parties charge their own fees for closing costs, such as the appraisal, title search and insurance, inspections, recording fees and mortgage taxes.

The interest rate you pay for a reverse mortgage is also generally higher than that of a traditional mortgage.

"Always explore all other sources of income first before tapping into your home equity," Cook advises. "Liquidate your portfolio and cut down on your living expenses. If you still don't have enough, a reverse mortgage may make sense."

Who wouldn't benefit?

A reverse mortgage isn't a good option if you can't keep up with the costs associated with the home, even without a monthly mortgage payment.

If you die or the home is no longer the primary residence for more than 12 months, the loan comes due, which means either you or your estate has to repay the loan or put the home up for sale to settle it.

Another potential drawback: if the loan balance exceeds the home's value, you or your heirs may need to sign a deed-in-lieu of foreclosure and give the house to the lender.

Homeowners interested in taking out a HECM must receive mandatory counseling with an independent agency approved by the U.S. Department of Housing and Urban Development. Typically, counseling is free or available at a reduced cost.

"As you get older, it gets harder to grasp some of the terms in these kinds of transactions, so it's not a bad idea to have someone younger who you trust, like an adult child, involved in the process," says Phillip Cook, a certified financial planner in Manhattan Beach, California.

How to find reverse mortgage help

To locate a FHA-approved lender or HUD-approved counseling agency, you can visit HUD's online locator or call the department's Housing Counseling Line at (800) 569-4287.

The National Reverse Mortgage Lenders Association maintains a database of lenders. Learn more about HECMs from HUD's website.

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