When people are younger and think of cashing in on their home equity, they imagine renting or selling their house. If you’re at least 62 years old, you have a third option: a financial product called a reverse mortgage. This lets you borrow against the equity in your home and get a fixed monthly payment or a line of credit. No repayment of the mortgage is required until you permanently move out, sell the home, or pass away.
Before jumping in, however, it’s important to understand the basics, including how reverse mortgages work, how they are obtained and the costs involved.
How Reverse Mortgages Work
If you are like most people, you purchased your home with a regular (or forward) mortgage. With a forward mortgage, you borrow money from a lender, make monthly payments to pay down the balance (principal and interest), and steadily build equity in the home. Over time, your debt decreases and your home equity increases, and when the mortgage is paid in full, you have full equity and own the home outright.
A reverse mortgage works differently. Instead of making monthly payments to a lender, a lender makes payments to you, based on a percentage of the value in your home. You choose whether the cash is paid as a single lump sum, a regular monthly cash advance, a line of credit (where you decide when and how much to borrow), or a combination of these methods.
Throughout the life of the reverse mortgage, you keep title to your home, which acts as security for the loan. You are charged interest only on the proceeds you receive, and both fixed and variable interest rates are available. Most reverse mortgages are variable interest rate loans tied to short-term indexes, such as the 1-Year Treasury Bill or the London Interbank Offered Rate (LIBOR), plus a margin that can add an extra one to three percentage points. Any interest compounds over the life of the reverse mortgage until repayment occurs.
As the loan progresses, your debt increases while your home equity decreases. When you move, sell the home or pass away, the lender sells the home to recover the money that was paid out to you. After lender fees are paid, any equity left in the home goes to you or your heirs. If you receive more payments than your home is worth (if you “outlive” the loan), you will never owe more than the value of the home, according to the Federal Trade Commission.
Note: A reverse mortgage can become due if you fail to meet the obligations of the mortgage; for example, if you fail to pay your taxes and/or insurance, or if the property falls into disrepair. You remain responsible for paying property taxes, insurance and maintaining your home.
How to Get a Reverse Mortgage
While there are several different types of reverse mortgages, the Home Equity Conversion Mortgage (HECM) is the most common. HECM loans are issued by private banks and insured by the Federal Housing Administration (they are the only reverse mortgage products guaranteed by the U.S. federal government). These loans have no income limitations or medical requirements, and there are no restrictions on how the money can be spent. The primary drawback to this type of reverse mortgage is that the maximum loan amount is limited (currently, it's the lesser of the appraised value or the HECM FHA mortgage limit of $625,500).
Non-HECM loans are also available from various lending institutions. These loans offer loan amounts that are higher than HECM loans; however, that potential benefit comes at a cost: non-HECM mortgages are not federally insured and can be considerably more expensive than HECM loans. Few non-HECM loans are made, and usually only to very high-value homes.
Because the vast majority of reverse mortgages are HECM loans, we’ll focus on these loans. To qualify, you must:
Be at least 62 years old
Own the home outright (or have a low mortgage balance)
Occupy the home as your primary residence
Not be delinquent on any federal debt
Be capable of making timely and full payments for ongoing property charges (e.g. property taxes, insurance, HOA fees, etc.)
Participate in a consumer information session offered by a HUD-approved HECM counselor (these sessions are free)
Note: Lenders are now conducting financial assessments to ensure that borrowers are able to meet mandatory financial obligations, such as property taxes and insurance. Your income, assets, monthly living expenses, and credit history will be verified during the loan process.
In addition, your home must be:
A single family home or a two-to-four unit home (and you occupy at least one of the units)
A HUD-approved condominium project or townhouse
A manufactured home that meets FHA requirements (built after June, 1976)
The amount of money you receive depends on a number of factors, including the age of the youngest borrower (couples can borrow, not just individuals), the current interest rate, the value of the home and – in the case of a HECM loan – the lending limit. In general, the older you are, the more valuable your home and the more equity you have it, the more money you can get for a reverse mortgage.
Here's an example of how it can work for two houses in the same area, both worth $300,000: John was born on January 1, 1942, and may be able to get a home equity loan of $174,900 (before fees, insurance and closing costs). John’s neighbor, Jim, born on January 1, 1952, will likely be able to borrow only $154,200 because of his younger age.
The Costs of Reverse Mortgages
Reverse mortgages involve a number of costs that can be paid upfront or financed into the loan. The fees and charges include:
Mortgage Insurance Premium (MIP). Mortgage insurance guarantees that you will receive your loan advances if the company managing your account (the loan servicer) goes out of business. You will typically be charged an upfront MIP of 0.50% of the home’s appraised value (or 2.5% if you take more than 60% of available funds in the first year). You will also be charged MIP on an annual basis, equal to 1.25% of the outstanding loan balance. This amount accrues over time and is paid when the loan becomes payable.
Third party charges. These include closing costs for items such as appraisals, title searches and insurance, inspections, credit checks, surveys, recording fees and mortgage taxes.
Loan origination fee. If your home is valued at less than $125,000, your lender can change an origination fee up to $2,500. If you home is valued at more than that amount, the lender can charge up to 2% of the first $200,000 of your home’s value, plus up to 1% of any amount greater than $200,000. Origination fees for HECM loans are capped at $6,000.
Servicing fee. Lenders can charge you a monthly servicing fee of $30 if the loan has an annually adjusting interest rate, or $35 if the interest rate adjusts on a monthly basis. The fee covers things like sending your account statements, customer service and disbursing loan proceeds.
The Bottom Line
Reverse mortgages may be a good option for people who are “house-rich and cash-poor," those with lots of home equity who could use more income during retirement. Only when you move, sell the house or pass away does the loan become due (or if you fail to pay your taxes and/or insurance, or let the house fall into disrepair).
As with a regular mortgage, it pays to shop around for a reverse mortgage. Compare your options and the terms offered by the various lenders and be sure to get good tax and legal advice. At this time of life, it is difficult to recover from financial reverses and there have been problems with this relatively new financial instrument. See 5 Reverse Mortgage Scams.
Like other loan products, reverse mortgages also have a number of upfront and ongoing fees and costs that should be evaluated when deciding if this choice makes financial sense for you. See Top Alternatives To A Reverse Mortgage,
Because reverse mortgages use up equity in your home, it’s important to understand that this type of loan will leave you and your heirs with fewer assets. For more information, read Steps To Retiring With A Reverse Mortgage and Reverse Mortgage Pros And Cons.
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