What is a reverse mortgage and how does it work?

Americans have about $24 trillion set aside in retirement savings — but according to the AARP 55 percent of workers don’t have any employment-based savings and three-quarters of Americans between 55 and 64 have less than $30,000 saved. The combination of longer life spans, increasing health care costs, and the disappearance of pensions, means many seniors aren’t on track to be able to cover their living expenses in retirement. If you’re among them, you may have heard about reverse mortgages or sell-leaseback programs as a way to stay in your home and get money to live on. Both give you cash and help you stay in your home, but they are not the same product. Below we dive into reverse mortgages so you can decide for yourself what’s the best fit.

What is a reverse mortgage?

With a reverse mortgage, homeowners who are at least 62 and have a low or zero balance on their mortgage can convert a portion of their home equity to cash. The loan is paid back when the borrower leaves the home instead of through monthly principal and interest payments.

Almost all reverse mortgages are federally-insured Home Equity Conversion Mortgages (HECM, pronounced “heck’em”), which are backed by the Federal Housing Administration and are available from FHA-approved lenders. Some state and local governments and non-profit organizations offer single-purpose non-HECM reverse mortgages, generally for homeowners with lower incomes. Other lenders offer “jumbo” or proprietary non-HECM reverse mortgages, typically for borrowers with higher home values.

Who can qualify for a reverse mortgage?

The U.S. Department of Housing and Urban Development defines the qualification requirements of HECMs. Typically to qualify, you must:

  • be at least 62 years old;
  • own your home outright or have a small balance due;
  • occupy the home as your principal residence;
  • not be delinquent on any federal debt;
  • have financial resources to continue covering ongoing property expenses, such as property taxes, insurance, Homeowner Association fees, etc.;
  • participate in a consumer information session given by government-approved counseling agency to make sure you fully understand the terms of the loan.

Lenders offering non-HECM loans have their own unique requirements, which generally include age, home value, amount of home equity, and income. But similar to other types of loans, requirements vary by lender.

How much can you borrow with a reverse mortgage?

Even if your home is completely paid off, you won’t be able to borrow against 100 percent of your home’s equity. In fact, under HUD and FHA guidelines, you cannot access more than 66 percent of your home’s equity through a reverse mortgage. The more typical HECM loans offer borrowers a loan-to-value ratio around 30-40 percent.

Lenders use several factors to determine how much you are qualified to take out, including your age and the age of a co-borrower or spouse, the value of your home, and current interest rates. You may come across the terms maximum claim amount (MCA) and principal limit factor (PLF) when learning about reverse mortgage loans. These terms unique to reverse mortgages and are specifically what lenders will use to calculate your loan amount, but they incorporate age, interest rate and the value of your home.

You’ll generally be able to access more funds the older you are, the more equity you have in your home, the less you owe on it, and the lower the expected interest rate. For example, an 85-year old with free-and-clear ownership of a home worth $500,000 would likely be able to access more funds than a 65-year old who still owes a balance on a mortgage for a home worth $300,000.

What can you use the funds for?

Funds from federally-insured HECM and proprietary reverse mortgages can be used however you wish, including to cover living expenses, home improvements, medical costs, additional insurance. With a single-purpose reverse mortgage, you must use the funds for one purpose, as specified by the lender. For example, your lender may designate the funds only be used for home repairs.

How long does it take to get funds from a reverse mortgage?

Once you start the process, it typically takes 30-45 days to complete a reverse mortgage.

How do you access the funds from a reverse mortgage?

You can get your funds several different ways:

Lump sum
Get all your money at once. This option is good if you have large expenses.

Monthly payout
Receive equal monthly payments for either (1) as long as one borrower lives in the home, or (2) for a fixed number of years.

Line of credit
Withdraw money at times and in amounts of your choosing until the maximum loan amount is reached. Interest is due only on the money you withdraw, and the amount of funds available to you grows over time

Combination
You also have the option to combine a monthly payout with a line of credit.

The money you receive from a reverse mortgage is usually tax-free, as it is technically a loan advance, not income. As a result, the funds won’t likely affect your Medicare or Social Security benefits

What are the costs to take out a reverse mortgage?

Lenders typically charge an origination fee and other closing costs, such as appraisal and title search fees. HECM origination fees are capped at $6,000. Lenders can also charge servicing fees over the life of the loan. You can choose to pay these costs out of pocket or from the loan proceeds. If you take out a federally-insured HECM, you’ll also have to pay a mortgage insurance premium (MIP). The MIP paid up front generally equals 2% of the home’s appraised value, and the MIP charged annually equals 0.5% of the outstanding loan balance.

Could you lose your home?

With a reverse mortgage, you keep the title of your home, which means you’ll have to continue to pay ongoing expenses like property taxes, utilities, HOA fees, and maintenance. If you fail to pay some of these expenses, you could face foreclosure. These ongoing expenses often become more costly over time and can be somewhat unpredictable, so it’s important to think carefully about whether you’ll be able to afford the necessary bills in the coming years.

How does repayment work?

Full repayment of a reverse mortgage is due when the last remaining borrower passes away, sells the house, or permanently moves out. At that point, the loan balance — including all fees and interest — becomes due. Anyone living in the home who is not a co-borrower or eligible spouse will be required to move out or repay the loan when you move or pass away.

It’s important to note that the balance of your reverse mortgage increases over time as your home equity decreases. As your balance grows, the amount of interest, mortgage insurance, and fees owed also grows.

Equity to debt

Most reverse mortgages have variable interest rates, which means they can move up or down depending on changes in the broader financial market. Variable interest rates introduce an element of unpredictability to having a reverse mortgage, as it can be difficult to predict exactly how much the loan will cost. Some HECM loans are available with fixed rates, though these loans usually require you to take a lump sum at closing and typically don’t give you as much cash as variable-rate loan will.

Consider all your options: You may have a better choice

If you’re considering a reverse mortgage, be sure to examine all your available options. For people who want to stay in their homes and gain access to money needed for retirement, a sale-leaseback arrangement may be a smart alternative. A sale-leaseback allows you to capitalize on the equity in your home and take the stress out of retirement, without having to move. You can sell your home at an attractive price then stay in it as long as you’d like through a long-term lease agreement. Your monthly lease payments will be predictable, and you won’t be responsible for property taxes or homeowner’s insurance. Plus, sale-leasebacks are available to people of all ages and you can use the proceeds from your sale however you wish, including to fund a responsible investment plan.

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