Reverse Mortgage: How Does It Work?
For many retirees, their largest asset is their home — but they might not be ready to sell to cash in on their equity. That’s where a reverse mortgage can come into play. A reverse mortgage allows people aged 62 and older to continue to live in and own their home while they take out a loan against their home equity. This type of loan is a good option for some, but it’s important to understand how reverse mortgages work before you apply.
How Does a Reverse Mortgage Work?
When you take out a reverse mortgage, the lender makes payments to you, the homeowner, rather than the other way around.
There are three primary types of a reverse mortgage:
- Single-Purpose: Offered by some local and state governments for a specific purchase, such as major home repairs. This may be the least expensive option, but availability is limited.
- Proprietary Reverse Mortgage: Offered by private lenders. Private loans can be the fastest, cheapest and easiest to get, but beware of scams.
- Home Equity Conversion Mortgage: FHA-backed reverse mortgage offered only by FHA-approved lenders. This is the safest and by far the most common type. The FHA-backed reverse mortgage is the only one legitimately called a Home Equity Conversion Mortgage.
Good To Know
The FBI and HUD urge consumers to be vigilant when seeking reverse mortgage products due to an increase in fraud. Beware of offers of a free home, investment opportunity or foreclosure or refinance assistance associated with a reverse mortgage, and consult with an FHA-approved housing counselor before you apply.
How Do You Repay a Reverse Mortgage?
Unlike a conventional mortgage or home equity loan, an HECM offers a flexible repayment feature so you can better control your monthly expenses and cash flow. As long as you maintain your home and stay current with your property taxes, homeowners insurance and homeowners association fees, if applicable, you don’t have to repay the loan until you die, move out or have another “maturity event” that causes the loan to be called due. Maturity events include:
- Death of the last surviving borrower or qualified non-borrowing spouse
- Home is no longer the primary residence
- Borrower vacates the property for more than 12 months
- Borrower fails to maintain the property
- Borrower fails to stay current on property taxes, homeowners insurance premiums and homeowners association fees.
Who Can Get a Reverse Mortgage?
You must meet these requirements to qualify for an HECM:
- Be age 62 or older
- Occupy your home as your principal residence
- Own your home outright or have significant equity
- Pass a financial assessment to ensure that you can keep current with property taxes, insurance and maintenance.
Also, your home must meet HUD minimum property standards. Houses and most condos qualify, as do manufactured homes that meet FHA requirements — typically, those manufactured on or after June 15, 1976.
Homes with a second mortgage and borrowers with unpaid federal debt are ineligible for HECMs.
How To Get a Reverse Mortgage
Aside from meeting the aforementioned requirements, you must:
- Fill out an application
- Undergo a financial and credit assessment
- Have a pre-loan consultation with an independent FHA-approved reverse mortgage counselor.
The consultation ensures that you understand the benefits and risks of a reverse mortgage and make an educated decision about whether it’s the best product for you.
Here are some questions to consider before taking out a reverse mortgage:
- How long do I plan to live in my home?
- How would a reverse mortgage help me accomplish my retirement goals?
- How would a reverse mortgage strengthen my retirement security?
- How does a reverse mortgage fit into my estate plan?
Pros and Cons of Reverse Mortgages
A reverse mortgage can help senior homeowners get access to funds to cover living expenses while also remaining in their homes — but there are some drawbacks to taking out this kind of loan.
Pros of a Reverse Mortgage
Understand all the advantages of this financial plan so you can better see how it might work for you.
- Flexibility: You can get your funds as a lump sum, in monthly payments or as a line of credit.
- Existing mortgage payoff: You can use HECM funds to pay off your existing mortgage.
- No monthly payments: No monthly mortgage payments are required as long as you live in the home, continue to pay property taxes and homeowners insurance, and maintain the property.
- No extra taxes: Generally, loan proceeds aren’t considered taxable income. Consult a tax professional to make sure your situation meets the requirements.
- Beneficial to heirs: An HECM could increase the amount of a client’s retirement savings that could transfer to their heirs.
- Equity ownership: You remain the owner of your home. After the loan is repaid, any remaining home equity belongs to you or your heirs.
- Delay using retirement savings: Money from a reverse mortgage lets you delay tapping into your investments and savings. You might also be able to hold off on collecting Social Security benefits, which could increase your benefits by 8% per year up to age 70.
Cons of a Reverse Mortgage
To determine whether an HECM is the right solution for you, you should understand the challenges that come along with this kind of loan.
- Increasing debt: The loan balance increases over time as you draw funds and interest accumulates.
- Decreasing assets: As you use home equity, you reduce your assets. You can still leave the home to your heirs, but they’ll have to repay the loan balance.
- Higher fees: Fees might be higher than with a traditional mortgage.
- Effect on benefits: Eligibility for need-based government programs, such as Medicaid or Supplemental Security Income, could be affected. Consult a benefits specialist to find out details.
- Possibility of foreclosure: The loan becomes due and must be repaid when a “maturity event” occurs. If the lender calls the loan due and you’re unable to pay off the loan, the lender can foreclose.
- Insurance: Per FHA requirements, HECMs require mortgage insurance.
- Complex terms: This type of loan agreement can be complicated, so it’s important you fully understand what you’re agreeing to before signing on the dotted line.
Reverse Mortgage Costs
As with any loan, there are a variety of fees that come along with a reverse mortgage. However, you don’t have to pay these fees upfront — you can finance them and pay with the proceeds of your loan. If you do finance HECM costs, they will reduce the net loan amount available to you.
HECM Loan Fees
- Mortgage Insurance Premium: The MIP guarantees the lender will be repaid if you fail to meet your loan obligations. A 2% upfront MIP is charged at closing. After that, you’ll pay 0.05% per year on the outstanding mortgage balance.
- Third-party charges: These costs can include fees for appraisal, title search and insurance, surveys, inspections, recording, mortgage taxes and credit checks.
- Origination fee: The lender fee for processing your loan can be the greater of $2,500, or 2% of the first $200,000 of your home’s value plus 1% of the amount over $200,000. This fee is capped at $6,000.
- Interest: Interest is paid on the loan at either an adjustable or fixed rate. As of December 2021, the average ARM interest rate for HECM loans was 3.02%, and the average fixed interest rate was 3.35%, according to HSH. Current interest rates range for ARMs range from 3.52% to 4.52% and 5.81% to 6.18% for fixed-rate loans.
- Servicing fee: Lenders may charge a servicing fee. This fee can be as much as $30 for annually adjusting or fixed interest rates and as much as $35 for monthly adjusting interest rates. This fee can also be rolled into the interest rate.
Rates and fees will vary by provider, so be sure to shop around.
Keep in mind that if you have a high-priced home, you might not be able to take out a loan for the entire value — the HECM FHA mortgage limit is $822,375. The maximum amount an individual can borrow is based on age, current interest rate and the appraised value or sales price of the home.
Information is accurate as of May 13, 2022.