Reverse Mortgage Explained – What are They and How do They Work?
Financial insecurity is one of the most significant challenges seniors without a stable income face during their twilight years.
Without enough money, catering for everyday expenses such as food and groceries, clothing, transportation, healthcare, and utility bills can be an issue.
Fortunately, you are a prime candidate for a reverse mortgage loan if you have a valuable home with considerable equity and have already paid off your mortgage.
This exclusive loan can help you sort out your bills without usurping your savings or retirement benefits.
So, how do reverse mortgages work?
This detailed pillar post explains everything you need to know about reverse mortgages, how they work, and whether it is ideal for you.
Keep reading to learn more!
What is a Reverse Mortgage?
A reverse mortgage is a unique loan available to senior homeowners ages 62 years and older.
This loan is called a reverse mortgage because it operates inversely to how a forward or traditional mortgage works.
The loan facility allows you to borrow money against your home’s value and receive monthly payments, a cash lump sum, or a line of credit from the lending institution to help sort your bills and expenses.
You can use the funds for your financial needs ranging from home renovations and repairs to vacations and leisure travels. The lender has no control over spending your money or what you spend it on.
The best part is that funds from a reverse mortgage are tax-free, but you will remain responsible for HOA fees, home insurance, and property taxes.
Another point worth mentioning is that reverse mortgages become due when you pass away. Your heirs cannot take over the loan and continue receiving payments, meaning the lender can claim the home under such circumstances unless the heirs pay off the mortgage.
Since your home acts as collateral for the loan, a reverse mortgage can also become due when you sell the property or move out permanently. If you opt to take this route, you must fully repay the loan to avoid foreclosure.
Understanding how a reverse mortgage works can help you decide if it is the ideal option for safeguarding your savings and finances.
Differences Between a Reverse Mortgage and a Traditional Mortgage
A reverse and traditional mortgage might share a similar name, but they differ significantly.
First, reverse mortgages are only available to senior citizens aged 62 years and older, while anyone above 18 years can legally get a traditional mortgage without a co-signer.
Unlike a traditional mortgage, whereby the lender expects you to remit payments to repay your loan, funds from a reverse mortgage come as monthly payments, lump-sum cash, or a line of credit from the lending institution.
Besides, you can use the funds from a reverse mortgage without any restrictions, primarily for living expenses. In contrast, money from a traditional mortgage goes directly to pay for your house.
With a traditional mortgage, you build your equity with each repayment as your loan balance decreases. In contrast, a reverse mortgage attracts monthly interest, and your debt increases over time. Your home equity also decreases with a reverse mortgage.
Another significant difference between a reverse mortgage loan and a traditional mortgage is the line of credit growth.
The line of credit option is not available with a conventional mortgage. When you select this channel with your reverse mortgage loan, the lender can avail more funds to you over time.
The only notable similarity between a traditional and reverse mortgage is that you have to continue HOA fees, property taxes, and home insurance and conduct routine maintenance and repairs.
How Do Reverse Mortgages Work?
It is essential to learn how reverse mortgages work to help you decide whether it is the ideal solution to your financial needs and goals.
Reverse mortgages work inversely to traditional mortgages. Instead of borrowing money to buy a house and repaying the debt monthly, the lender gives you a loan against your home equity. The amount you are eligible to receive depends on your home’s value.
In essence, instead of you remitting monthly payments to repay the mortgage, the lender will be making payments to you. You will only pay interest on the amount received when the loan becomes due.
To apply for a reverse mortgage, you must be a homeowner with the home you are borrowing the loan against as your primary residence.
Unlike a traditional mortgage, where the lender owns an interest in your property, a reverse mortgage allows you to keep the title of your home.
You can choose how you want to receive the payments depending on your financial needs. Some homeowners prefer equal monthly payments, while others opt for lump sum cash. You can also choose the line of credit option, where funds are available to borrow as needed.
Here’s a breakdown of how you can choose to receive your reverse mortgage:
Equal Monthly Payments - The lender will send equal monthly payments to you for the duration you live in the home as your principal residence.
Lump-sum Cash - You will receive the entire mortgage amount at once when you close the loan. This option has a fixed interest rate, unlike others that are adjustable.
Line of Credit - With the line of credit option, funds are available whenever you need to borrow. You will only pay interest on the amount borrowed from the LOC.
Term Payments - The lender will make equal monthly payments to you for a given period, such as 5, 10, or 15 years. The loan becomes due when this period elapses.
Equal Monthly Payments & Line of Credit - With this combi, the lender will pay you equal payments monthly, plus you can access additional funds whenever you need them for as long as you live in the house as your primary residence.
- Term Payments & Line of Credit - In this arrangement, the lender will make equal monthly payments for an agreed period, and you can still access the line of credit and borrow more funds as needed.
A reverse mortgage becomes due when the homeowner passes away or sells the home. Proceeds from the house sale go to repay the lender the principal amount, interest, mortgage insurance, and any other fees.
If the sale proceeds exceed the borrowed amount, you or an appointed estate executor will receive the balance. Your heirs may opt to pay off the mortgage if they wish to keep the home, but they cannot take over the loan and continue receiving payments.
Types of Reverse Mortgages
Like any other home loan, reverse mortgages are available in three different forms. These include:
1. Home Equity Conversion Mortgage (HECM)
Home Equity Conversion Mortgage (HECM) is the most common reverse mortgage, backed by the Federal Housing Administration (FHA).
As the name implies, you get to convert your home equity into cash. You can use the received money for any purpose. The loan is popular with homeowners since it is tax-free and has no income limitations.
Another reason this reverse mortgage is popular because it positively impacts your home equity. Your home’s value will grow between 4% and 6% annually, no matter the prevailing economic situation. With this in mind, a HECM loan might be the financial security you need to safeguard your future.
As explained earlier in the how do reverse mortgages work section, the HECM mortgage has several disbursement options. You can choose how you want to receive the money, such as fixed monthly payments, term payments, line of credit, or a combination of monthly payments and line of credit.
Choosing the ideal disbursement method can be overwhelming, considering the numerous payment options available. Consulting a reliable mortgage expert can help you decide based on your financial needs and goals.
Since this government-insured loan is available under the Department of Housing and Urban Development (HUD), you must receive HUD-approved counseling before loan disbursement. The counseling session will help you understand the payment options, costs, and other obligations.
The only slight concern about HECM reverse mortgages is their high upfront costs and comparatively higher interest rates. You also have to pay for HUD-approved counseling before closing the loan.
2. Proprietary Reverse Mortgage
A proprietary reverse mortgage is another popular home equity loan option for senior homeowners.
The loan is not any different from a HECM reverse mortgage. However, unlike a HECM, proprietary reverse mortgages are from private lending institutions. Moreover, it does not have federal backing.
Another benefit of a proprietary reverse mortgage is lenient regulation requirements. Besides, it is more flexible than the federally-insured HECM since you will be dealing with private lenders.
HECM reverse mortgages usually offer lower amounts, but this is not the case with a proprietary reverse mortgage. With this loan, you can receive higher payments, but your home’s value must be above the FHA-set limit for HECMs to be eligible for this mortgage.
Since a proprietary reverse mortgage is not government-insured, it does not have upfront costs or monthly insurance premiums. Interest rates and other related fees vary depending on the lender.
Counseling is not mandatory as with a HECM reverse mortgage, but it can be helpful by providing a comprehensive comparison between the benefits and costs of each reverse mortgage.
You can apply for a proprietary reverse mortgage and receive a substantial amount even if you have a pending mortgage. If you have a high-value home with little to no mortgage balance, consider applying for this loan.
3. Single-Purpose Reverse Mortgage
A single-purpose reverse mortgage might not be as common as a HECM or proprietary reverse mortgage but is worth considering.
This unique loan is the least expensive reverse mortgage offered by non-profit organizations, state, or local agencies for specific purposes.
While other reverse mortgages give you the leeway to use your loan the way you like and for any purpose, single-purpose reverse mortgages require you to use the funds only for a specific purpose approved by the lender.
For instance, you may receive funding to remodel your property to make it handicap accessible.
The municipal or local government may also offer you a single-purpose reverse mortgage to build a septic tank or install a new sewer system on your property.
This loan allows you to upgrade or renovate your home without paying for it upfront from your savings. The best part is that you do not have to repay the loan until you sell the property, move out, or pass away.
Single-purpose reverse mortgages are ideal if you don’t have a steady income and would like to upgrade your home without touching your retirement benefits or savings.
The only downside is that single-purpose reverse mortgages are not available in all states.
What Can You Use a Reverse Mortgage For?
You can use a reverse mortgage for various purposes except for a single-purpose reverse mortgage that restricts you to use it for a single, lender-approved reason.
Once you close the deal and secure your loan, you can use it to:
- Supplement your retirement income
- Settle your living expenses
- Pay off your pending regular mortgage
- Repair or renovate your home
- Pay for medical expenses
- Cover your vacation expenses
- Cover transportation costs
Who Should Apply for a Reverse Mortgage?
Any homeowner aged 62 years and older can apply for a reverse mortgage. This unique loan is only available to working or retired senior citizens who are homeowners and seek financial assistance to cover their daily living expenses.
If you own a home, and it happens to be your principal residence, consider applying for a reverse mortgage against your home’s equity. The funds can help cover your medical and transportation costs and boost your savings. The money can also help increase your equity and grow your line of credit.
You can be an ideal candidate for a reverse mortgage if you are a homeowner with no urgent need for money but want to build your cash reserves for financial security after retirement.
We live in an era of financial unpredictability with inflation, recessions, and pandemics destabilizing financial markets. Securing a reverse mortgage can help safeguard your finances, especially if you don’t have a stable income.
You should also consider applying for a reverse mortgage if your current mortgage balance is substantial and you have many years remaining to pay it off.
The monthly mortgage payments can take a toll on your finances. You can use the funds from the reverse mortgage to pay your regular home loan off and use the freed-up funds to cover your living expenses and other bills.
Reverse Mortgage Eligibility Requirements
Like any other loan, reverse mortgages have various eligibility requirements. You must meet the minimum requirements to qualify for the loan.
Here is a comprehensive list of reverse mortgage eligibility requirements:
You must be aged 62 years or older to apply for a reverse mortgage
You must be a homeowner living in the home as your primary residence
Qualifying properties include single-family homes, townhouses, FHA-approved condominiums, and HUD-approved manufactured homes built on or after June 15, 1976
Cooperative housing owners cannot apply for reverse mortgages since they do not own the entire estate
You must own the home fully or have at least 50% home equity to apply for a reverse mortgage
You must pay an origination fee, mortgage insurance (except for proprietary reverse mortgage), loan servicing fees, closing costs, and interest
You must complete and pay for a HUD-approved counseling session conducted by a credible mortgage counselor
- You must meet your financial obligations, including maintaining your home, paying property taxes, home insurance, and HOA fees
How Much Can You Get From a Reverse Mortgage?
The amount of money you can get from a reverse mortgage depends on several factors, including your age, the home appraised market value, current interest rates, financial obligations, and the selected disbursement option.
Regardless of the type of reverse mortgage you take out, you should not expect it to match your home value. Lenders will only give you a specified percentage depending on the above determinant factors.
Here is a breakdown of the critical factors that determine how much you can borrow:
Age - Your age determines your borrowing limit (principal limit). Younger borrowers have a lower borrowing limit since they have more time to repay the loan, while older applicants are eligible for more cash when taking out a reverse mortgage.
Home Value - Your home value is a significant factor in determining how much money you can get from a reverse mortgage. A lower home value means a lower borrowing limit, while higher-valued homes attract more cash. A valuer has to appraise the home to define its current market price. Existing mortgages and liens can also impact your home’s value.
Current Interest Rates - Lenders usually evaluate current interest rates before deciding how much they are willing to offer the borrower. Lower interest rates mean you will likely receive more cash, while higher rates translate to a lower borrowing limit. With this in mind, consider searching for mortgage offerings when the interest rates are at their lowest.
Financial Obligations - Your current debts and other financial obligations can also determine how much you can get from a reverse mortgage. Lenders want to evaluate how you pay your homeownership bills such as home insurance and property taxes before deciding how much to give you. If you have an existing mortgage, the proceeds from the reverse mortgage will go into paying your initial loan before you receive the rest of the money.
- Disbursement Option Selected - You can choose how you want to receive the money, such as fixed monthly payments, term payments, line of credit, or a combination of monthly payments and line of credit. The disbursement method selected determines your loan amount. The line of credit option has the highest possible proceeds, while the lump-sum distribution method has the lowest limit.
The Cost of a Reverse Mortgage
Taking out a reverse mortgage comes at a cost. You must pay an upfront premium, origination fee, servicing fees, mortgage insurance premiums, third-party fees, closing costs, and other miscellaneous charges.
The good news is that a HUD-approved counselor can take you through how reverse mortgages work and what fees you should expect to pay before and after securing the loan.
Here’s a breakdown of reverse mortgage fees:
Appraisal Costs - A property valuer must appraise your home for the reverse mortgage application. The valuation will help the lender determine how much money you can get from the loan. Most valuers charge about $550 for home appraisals.
Upfront Premium Fee - The lender requires you to pay an upfront insurance premium fee at closing. The fee is 1.75% of the reverse mortgage loan amount. The Federal Housing Administration collects this money, and its purpose is to protect the lender if you default on repaying the loan when it becomes due.
Origination Fee - The origination fee covers the lender’s operating costs. You must pay this charge for the lending institution to process your reverse mortgage loan. The lender will charge whichever is greater between $2,500 and 2% of the first $200,000 of your home’s value and 1% on any amount above $200,000. Origination fees cannot exceed $6,000, no matter your home’s value.
Servicing Fee - In some instances, the lender may have to monitor your reverse mortgage to ensure the loan balance does not increase to unmanageable levels. Maintaining your mortgage loan costs a monthly fee not exceeding $30 per month for fixed-rate mortgages and $35 for adjustable-rate mortgages.
Mortgage Insurance Premiums - Aside from the upfront premium insurance fee, the lender expects you to remit monthly insurance premiums to cover your loan. The MIP is usually 0.5% of the outstanding reverse mortgage loan balance.
Third-Party Fees - Other parties processing your loan can charge additional fees for services rendered. These include home inspection fees, title search, title insurance, credit checks, and recording fees.
- Closing Costs - The closing costs are the lender’s expenses incurred to underwrite and process your loan. The lender may opt to lower your closing costs but increase your interest rate if you cannot afford to pay the fee upfront.
Reverse Mortgage Interest Rates
Reverse mortgage disbursements have different interest rates. The lump-sum option has a fixed interest rate, while the remaining five loan distribution methods have adjustable interest rates.
The single disbursement option has a fixed rate because you will receive all the funds from the reverse mortgage once. In contrast, you will pay interest for the other disbursement options over a long period, and the interest fluctuates depending on various factors, explaining why they have variable rates.
The lending institution may add percentage points to the index rates, increasing your reverse mortgage loan interest. For instance, if the base rate is 2.5% and the lender adds 1.5%, your reverse mortgage interest will be 3.5%.
As you know, your credit score and interest compounds do not affect your reverse mortgage interest rates.
Why Consider a Reverse Mortgage?
The advantages of applying for a reverse mortgage are almost endless. Nevertheless, the three primary reasons you should consider taking out this loan against your home equity include:
1. Cash Injection
Many senior homeowners take out a reverse mortgage against their homes to supplement their income or boost their savings. The loan is a cash injection, and it gives you continuous access to money even with limited liquid assets.
The amount of cash you can get from a reverse mortgage loan depends on your home’s equity and other factors such as age, interest rates, financial obligations, and the selected disbursement option.
If you have a high-value home, you can apply for a substantial cash amount and receive it as a lump sum, monthly payments, a line of credit, or a combination of monthly payments and a line of credit.
You can use the cash you get from a reverse mortgage to cover your living expenses, pay off your medical costs, settle debts, supplement your current income, upgrade your home, or purchase home equipment and appliances.
2. Financial Security
Another reason seniors usually take out reverse mortgages is financial security. If you do not have adequate money, you won’t pay your bills as required.
With the escalating tax burden, not to mention rising healthcare costs, a reverse mortgage loan can prove valuable for your financial security.
Even though you might have adequate savings in the bank, the rising cost of living can take a toll on your finances and ruin your retirement plans.
The funds can help boost your cash flow without pushing you into using your hard-earned savings. It can also help increase your home’s equity and grow your line of credit without requiring you to sell your home.
3. Improved Quality of Life
A reverse mortgage loan can help improve your quality of life through various channels. You can use the proceeds from the loan to supplement your income, upgrade your home, purchase new equipment, cover your healthcare needs, and even go on vacation.
Since reverse mortgages don’t have numerous restrictions on spending, you can use the loan to enhance your lifestyle and that of your household for extra comfort and improved livability.
If you are on a fixed income, a reverse mortgage can bolster your cash flow, especially if you opt for the line of credit disbursement. A line of credit ensures you can borrow money whenever you need it. You can also choose between fixed monthly payments, term payments, or a combination of monthly payments and a line of credit.
What Happens When a reverse Mortgage Is Due?
A reverse mortgage can become due when you pass away, sell your home, or permanently move out from the property. The lender can initiate foreclosure to sell the house and recoup the loan balance.
If you sell the home or move out, you must pay the loan balance within an agreed period. Failure to pay may result in legal action against you via a foreclosure procedure.
Since your heirs cannot take over the loan and continue enjoying monthly payments, they can opt to pay off the loan balance if they wish to stay in the home. If you had a co-borrower, the responsibility of repaying the loan would transfer to them.
What Can Make a Reverse Mortgage Become Due?
Reverse mortgages are unique in that you do not have to remit monthly payments to repay the loan. Instead, the lender pays you monthly or over an agreed period. You may also opt to receive your cash once with a single disbursement.
Like any other loan, your reverse mortgage can become due, and you or your heirs may have to repay the loan according to your mortgage agreement.
In most cases, a reverse mortgage becomes due when the homeowner passes away. However, it can also become due when you sell the home or permanently move out.
Here are some factors that can trigger a reverse mortgage to become due:
1. You pass away
As mentioned earlier, a reverse mortgage becomes due when you, the borrower, pass away. Unfortunately, your heirs cannot take over the loan and continue receiving payments from the lender unless they are co-borrowers.
If you did not have your spouse or any other eligible family member listed as a co-borrower, the lender is at liberty to claim the home. If your dependents wish to stay in the house, they have to pay the loan balance fully.
To avoid any inconveniences and leave your dependents homeless, consider listing an eligible spouse as a co-borrower during the loan application.
2. You sell the home
A reverse mortgage is a loan against your home’s equity, meaning your house is the loan’s security. Since your home acts as collateral, the lender does not expect you to sell it anytime soon. The home will remain under your name and ownership for the loan duration.
Selling the home you took the loan against is a triggering factor. Your decision could land you in trouble since it’s more like a breach of the loan agreement.
The lending institution can take legal action against you or the buyer by initiating a foreclosure process. To protect the lender from incurring losses, the buyer of the house has to pay off the loan before any transfer of ownership.
3. You move out of the home
Reverse mortgage eligibility requirements state that you must be a homeowner living in the home as your primary residence for a specified period.
Staying in your primary residence might not always be possible due to unavoidable circumstances like illness and cognitive disorders. Some homeowners may have to move to rehabilitation centers, hospices, or residential homes to get the much-needed assistance.
However, living away for twelve consecutive months might trigger the reverse mortgage to become due and payable. Some lenders might allow more time for you to return home, but they may have no other option but to initiate foreclosure if your condition does not improve.
The only way to avoid this situation is to list an eligible family member, say your spouse, as a co-borrower. Your co-borrower will take over the loan until you return home after your condition improves.
4. You miss your homeowners’ insurance or property tax payments
While a reverse mortgage loan is tax-free, it does not exempt you from paying property taxes. One of the requirements for taking this loan is that you must demonstrate your capability to meet your other financial obligations, including paying home insurance and HOA fees
Your qualifying chances are minimal if you are delinquent on your debts. Missing payments or even late submissions can disqualify you from receiving a reverse mortgage. If you already have a reverse mortgage, the lender might cancel it and deem the loan due and payable.
5. Failure to maintain your home
Many people overlook the implications of poor home maintenance. Failure to maintain your home might land you in trouble with the lender, giving them the right to foreclose.
The money you get from the reverse mortgage is a percentage of your home’s value. If you leave your home dilapidated, its value will likely decrease instead of appreciating as the lender expects.
The loan balance will become higher than the home’s value, making the mortgage unsustainable. The lender won’t be able to recoup their money if the value depreciates. For this reason, the lender may have no other option but to list your loan as due and payable to help recover their money.
If you are a working or retired homeowner aged 62 years or above seeking financial assistance to cover their daily living expenses, consider taking out a reverse mortgage against your home’s equity.
A reverse mortgage can supplement your current income, cover your living expenditure, settle your medical costs, and even cover your vacation trips. You can use your loan to pay off existing mortgages and use the freed-up funds for other expenses.
The eligibility requirements are lenient and attainable, and your credit score does not even matter during the application phase. Besides, you have several disbursement options depending on your financial needs and goals.
Ensure you talk to a HUD-approved counselor to understand how reverse mortgages work and get a clear picture of the benefits and demerits of this type of loan.