Many seniors find themselves in a situation where their retirement funds fall short of their needs, including costs associated with long-term care. A reverse mortgage loan may be a good option for seniors who have considerable equity in their homes and need to supplement their retirement funds. Reverse mortgages may be a good financial decision for some seniors, but it could be a poor decision for others. Many seniors wonder, what is a reverse mortgage, and how does a reverse mortgage work?
Be sure to understand how these loans work and also how it impacts you and your family. It is a good idea to look at all of your options before deciding, so you are making the best decision. In this post, we review:
- What a reverse mortgage is
- How a reverse mortgage works
- The types of reverse mortgages
- The pros and cons of these loans
- Reverse mortgage scams, and
- Alternatives to these loans
What is a Reverse Mortgage?
A reverse mortgage refers to a type of loan that allows homeowners aged 62 years and above to convert part of their home equity into cash. The loan allows a senior to take out a loan against the equity they have in their home.
The lender pays the homeowner. The homeowner borrows the money using the equity in their home as security for the loan. Consequently, the senior is required to continue paying homeowners insurance and property taxes. In addition, the senior must use the home as their principal residence. Furthermore, the senior must maintain the property in good working condition.
The borrower does not have to repay the loan during their lifetime as long as they live in the home and still own it. Instead, the loan repayment occurs when the senior no longer lives in the house.
Each month the loan balance grows because the loan accumulates interest and fees. The senior (or their heirs) will have to pay back the loan, usually when they sell the home.
It’s important to understand how does a reverse mortgage work so you make the best decision for you!
How Does a Reverse Mortgage Work?
The senior must either have considerable equity in their property. Typically at least 50% equity is required. The borrow reviews the different programs and applies for the loan that is right for them.
The senior can borrow against their home equity and receive funds. If the loan is approved, you also choose how you want the funds distributed. For example, loan payments can be:
- a lump sum
- fixed monthly payment, or
- even as a line of credit
Restrictions May Apply
Some reverse mortgage loans have restrictions on how you can use the funds. However, other loans are unrestricted. In addition, the loan becomes payable when the borrower
- sells the home,
- no longer uses it as a primary residence, or
The initial principal is the total amount a borrower could receive from a loan. However, seniors may not be able to borrow the entire equity value of their property, even if the is no outstanding mortgage.
The initial principal amount is usually significantly less than the property’s appraised value. The initial principal is lower because some equity is needed to pay for the interest accrued on the mortgage over the years. In addition, other factors impacting the principal limit include:
- the age of the youngest borrower
- the interest rates
- the home’s value, and
- the mortgage program’s limit
Lenders will ensure the loan amount does not exceed the home’s value because reverse mortgages are non-recourse loans. A non-recourse loan means that if the house sells for a lesser amount than the borrower owed, the lender has no power to demand the difference from you or your heirs.
However, if the home sells for more than what you owed, the lender must give the extra amount to you or your heirs.
What Can a Reverse Mortgage be Used For?
Some of the common reasons why homeowners borrow using a reverse mortgage include:
- To boost their retirement savings to enable them to enjoy a better standard of living.
- Some want to clear or reduce the monthly mortgage payments.
- To consolidate current debts.
- It is also an option to fund necessary home improvements.
- Because you will have better access to your home’s net worth.
Reverse Mortgage Loan Eligibility Requirements
Eligibility requirements include:
- A homeowner must be a minimum of 62 years old to qualify.
- You must pay any existing mortgage using the proceeds from the loan.
- The home must have built enough equity. Usually, 50% or more equity is required, but different lenders vary in the percentages.
- You must live in the house as your primary residence.
- You’re also required to remain current on homeowners insurance, property taxes, and other obligations (like homeowners association dues).
- Homeowners must attend a consumer information session led by a HUD-approved counselor to learn about the reverse mortgage and other available options.
- The property must be a single-family house, a manufactured home (built after June 1976), s townhouse, a condominium, or a multi-unit property with four units.
What are the three types of reverse mortgages?
There are three types of reverse mortgages. Each type is customized to meet the financial needs of different homeowners. The three mortgage types include:
Home Equity Conversion Mortgage (HECM)
HECM, the most popular type, is a federally insured mortgage and is offered only by FHA-approved lenders. The HECM represents most loans for home values less than $765,000. They have higher upfront costs, and homeowners are required to undergo HUD-approved counseling to understand the payment options, costs, and responsibilities you have with the loan.
Proprietary Reverse Mortgage
A proprietary mortgage is a type of private loan that the Federal Government does not back. It is usually for a larger advance for a home appraised at a high value (higher than the lending limit for the HECM loan – $765,000 in 2020).
Lenders have their eligibility requirements, fees, terms, and rates. While these loans can be the quickest and easiest to get, they are known to attract unethical professionals who use them as an opportunity to scam borrowers out of their home equity.
Single-Purpose Reverse Mortgage
The single-purpose loan is offered only by a nonprofit organization and state or local government-approved agencies. The loan amounts are usually much smaller and restricted for a specific purpose. For example, the loan may be restricted to use for a home repair or a handicap-accessible remodel. The loan is usually not as expensive as the others, and they are only available in certain areas.
Reverse Mortgage Calculator
Using an online calculator can give you a rough estimate of how much money you can qualify for, depending on the type of reverse mortgage. Most lenders can give homeowners up to 60% of their current home equity.
There are different criteria to determine the qualifying amount. For example,
- the youngest borrower’s age
- your home’s equity, and
- the current market interest rates
Subtract any existing mortgage from the loan amount. That’s what your reverse mortgage lender will initially do. Engaging a reverse mortgage specialist can help you get a more accurate figure.
How Much Does a Reverse Mortgage Cost?
Similar to a conventional mortgage, applying for a reverse mortgage comes at a cost. For example, when you seek a reverse mortgage such as Home Equity Conversion Mortgage (HECM), you may incur the following costs:
- Origination fee: This is the amount that a lender charges to originate and process your home loan. In most cases, the mortgage origination fee is 2% of the first $200,000 of the home’s value plus 1% of any subsequent value. If you seek an FHA reverse mortgage, the cost will range between a minimum of $2,500 and a maximum of $6,000.
- Servicing fees: These are monthly fees charged by the lender to service and administer the loan. Typically, the standard servicing fee should not exceed $35 per month.
- Mortgage Insurance Premium (MIP): MIP is paid by homeowners to the FHA when they close their loan. It protects both the lender and the homeowner by turning the loan into a non-recourse type. This means home insurance will usually cover the difference (when it’s time to sell) if the home sells for less than what is due on loan. Upfront MIP is charged at 2% of the appraised home value or at the current FHA’s lending limit, whichever is less. Then an annual MIP is usually 0.5 percent of the loan’s outstanding balance.
- Interest rates: The amount of interest charged on a reverse mortgage varies depending on various factors. For example, the choice of a lender, time, and the type of loan.
- Other third-party charges: Third-party charges are charges that homeowners incur when dealing with other businesses apart from the lender. For example, charges may include courier fees, document preparation fees, insurance, credit report fees, home appraisal fees, and closing fees.
What are the Pros and Cons of Reverse Mortgages?
As a homeowner, it’s essential to understand the benefits and downsides of a loan before deciding.
Is a Reverse Mortgage a Good Idea?
Here are some of the pros:
- The loan can provide much-needed cash for those who have a lot of their net worth tied up in their home value.
- Even after you have received the reverse mortgage loan, you will still maintain homeownership.
- If you face foreclosure, borrowers can use a reverse mortgage to clear the existing mortgage.
- The borrower does not have to repay the loan out of pocket.
- Borrowers are not required to have a high credit score. It’s usually a credit history assessment that is needed.
- Homeowners can access a portion of their home equity. This is good for those who do not want to sell their property.
What is the Downside to a Reverse Mortgage?
The Cons include:
- A reverse mortgage is a loan against your home equity. However, you continuously increase your debt while your home equity declines.
- The loan costs can be expensive. For example, costs include associated fees and closing costs.
- If a borrower chooses not to make any payments, the loan interest will continue to grow.
- The borrower must maintain the property. For example, maintaining the property includes paying property taxes and home insurance. If you don’t comply, your loan may become due.
- You may outlive your mortgage proceeds. Meaning, if you choose a payment plan (like a term plan or lump sum) or take a line of credit and spend the money, you may run out of money.
- Heirs must repay the loan if they want to inherit the property.
- Most reverse loans require borrowers to have mortgage insurance.
- Be careful of scams.
Reverse Mortgage Scams
Be aware of scammers and learn how to avoid them. Scammers frequently target seniors. Some scam techniques include, for example:
- Home improvement contractors sometimes target seniors. Scanners pressure seniors to secure loans to pay for home improvements. For example, the contractor will say they want to get “paid.” The contractor may not even make the home improvements as promised. Meaning, sometimes the scammer takes the money without doing any work.
- Some unscrupulous people, including relatives and financial advisors, use a power of attorney to get a reverse mortgage on the senior’s home. They then get the proceeds by either taking the money or convincing the senior to buy something that benefits the scammer.
- It’s always advisable to be vigilant when making any financial decisions. For example, put great thought into granting someone your power of attorney. Your power of attorney should be someone you trust because they can take advantage of you.
- Never sign a contract under pressure, as this is one of the red flags of a scammer.
Alternatives to Reverse Mortgages
Some may not qualify for a reverse mortgage. For example, if you do not have enough equity in your home or are not over 62 years old. There are other ways to get the finances you need. For example:
- Home equity loan
- Conventional mortgage
- Home equity line of credit
- Sell the home
- Borrow against a life insurance policy
A reverse mortgage loan may be suitable for some people, depending on your circumstances. It may be a way for seniors to supplement retirement income, pay for home improvements or long-term care. There are eligibility requirements and limits to reverse mortgage loans. It is a good idea to talk with a HUD-approved counselor before you decide to apply for a reverse mortgage. This way, you will understand how does a reverse mortgage work. If you apply for a HECM reverse mortgage loan, you will be required to speak with a counselor. A counselor can review how the reverse mortgage loan works, the pros and cons, and how it may impact your heirs. To find an FHA-approved lender, check out the HUD online locator.