What is a reverse mortgage, and how does it work?

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A reverse mortgage is a type of home loan for people age 62 or older. It’s for people who have gained equity in their home since originally buying it, and likely have paid off their mortgage already.

A forward mortgage — which you probably think of as a regular mortgage — is a type of loan you’d use to buy a home. You make monthly payments to the lender until the home is paid off, and over time, your debt decreases.

A reverse mortgage, on the other hand, is used after you’ve already bought the home. The lender pays you, and the money comes out of the equity you’ve acquired in the house. Over time, your debt increases.

A reverse mortgage is not the same thing as a home equity loan or a home equity line of credit. All three are tools for tapping into your home equity, but they operate differently.

You have several options for how and when to receive your money with a reverse mortgage. But with a home equity loan, your only choice is to receive the money in one lump sum. A HELOC is a line of credit, so you just withdraw money as needed. With a home equity and HELOC, you make monthly payments, but you don’t make monthly payments to repay a reverse mortgage. Instead, you sell the home for the proceeds to pay back your lender. 

Each of these three options has its pros and cons, but you’ll want to go with either a home equity loan or a HELOC if you’re under age 62, because unlike a reverse mortgage, they don’t have age restrictions.

You may or may not be able to tap into all your home equity when you get a reverse mortgage. There are rules surrounding how much you can borrow. You should receive higher monthly payments the older you are, and the more your home is worth.

The money you get from a reverse mortgage is tax-free. The IRS sees it as a loan, not as taxable income.

You have several options for how and when to receive the funds: 

  • Lump sum. Receive the full amount when you close on your reverse mortgage, and pay a fixed interest rate.
  • Monthly payments. You may receive equal monthly payments as long as a borrower lives in the home. If you choose term monthly payments, you’ll get money every month for a set number of years. Either way, you’ll pay an adjustable interest rate.
  • Line of credit. Rather than receiving monthly payments, you can borrow money as needed. You’ll pay an adjustable rate, and you’ll only pay interest on the amount you use from the line of credit. You may also choose to combine equal monthly payments or term monthly payments with a line of credit.

When you eventually sell the home (whether you’re living or dead), the proceeds go to the lender to pay off your debt from the reverse mortgage. Any additional money from the sale will go to you if you’re living, or to your estate if you’re dead.

If your heirs want to keep the property, then they can pay off the reverse mortgage themselves.

You must be 62 or older to get a reverse mortgage. If you live in the home with your spouse, then ideally, you’d both be at least 62 years old. But you do have options if one spouse is younger.

If you’re the older spouse, then you can be the sole borrower of the reverse mortgage. In this case, though, your younger spouse could lose the home if you die first, or have to pay off the mortgage when you die to avoid selling the home to pay off the lender.

Depending on the situation, your spouse might be able to keep living in the home after you die, but they would no longer receive the mortgage payments. Talk to your lender or Department of Housing and Urban Development counselor about your options if your spouse is under age 62.

Home equity conversion mortgage (HECM)

This is the most common type of reverse mortgage, and it’s backed by the government. You must meet with a HUD counselor before closing so they can explain the process, pros, and cons to you.

The loan amount is within the limits set by HUD, which is $765,600 in 2020.

You’ll pay more in upfront costs with a HECM than with other types of reverse mortgages, but you can use the money for anything.

Proprietary reverse mortgage

With a propriety reverse mortgage (also known as a jumbo reverse mortgage), you borrow an amount that exceeds the HUD limit. This could be the case if your home is worth a lot of money and you’ve either paid off the original mortgage or have a low amount left to pay.

Proprietary reverse mortgages aren’t backed by the government. You’ll get one through a private lender. 

Single-purpose reverse mortgage

A single-purpose reverse mortgage only allows your funds to be used for one thing. For example, the lender may tell you the money can only go toward home repairs or property taxes.

This is the most affordable type of reverse mortgage, so it’s probably best for people with low-to-moderate incomes or who haven’t built as much equity in their home yet.

You’ll get a single-purpose reverse mortgage from a nonprofit organization, or from your local or state government. 

As with a regular mortgage, you’ll have to pay closing costs on a reverse mortgage. You may be able to roll closing costs into your monthly payments rather than pay them upfront. But this payment method means you’ll receive less in cash each month.

You can expect to pay the following closing costs:

  • Mortgage insurance premiums: There’s a 2% MIP closing cost, then an annual MIP of 0.5% of the amount you’ve borrowed.
  • Origination fees: Your origination fees are capped at $6,000.
  • Real estate closing costs: You’ll pay fees to third parties for things like a home appraisal, home inspection, and credit checks.

There are other fees to keep in mind, too. Remember that you’re required to meet with a HUD counselor before closing on an HECM, and you’ll have to pay them. You’ll also pay interest and servicing fees to your lender.

Pros and cons of a reverse mortgage

The pros of a reverse mortgage

  • It can be used as supplemental income. Payments from a reverse mortgage can be useful if your retirement savings and Social Security checks just aren’t cutting it. They could also help you enjoy retirement more, provided you are fine with the house selling after you die.
  • It can be used to prevent a foreclosure. Although it isn’t ideal, you can use the proceeds from a reverse mortgage to cover your remaining payments on your regular mortgage. This is a possible last resort if you’re facing losing your home.
  • You don’t have to make monthly payments. Unlike with most debts, you don’t have to make monthly payments on a reverse mortgage. Instead, you’ll pay back the loan when your home sells.

The cons of a reverse mortgage

  • If anyone else lives with you, then they might have to move if you die. Depending on the situation, a spouse or anyone else living in your home could be stuck when you die, because the house will sell to pay back the lender.
  • Fees eat into your payments. You may not receive as much money each month as you’d expect. Expenses like service fees and annual MIPs are taken out of what the lender pays you. You’ll earn even less each month if you decide to roll your closing costs into the monthly payments rather than pay them at closing.

Some people are looking to take advantage of older people who might be losing their sensibilities, or even just don’t understand technology or lending very well. Fake lenders could come out of the woodwork to offer you a reverse mortgage that isn’t real, and they steal your money.

To avoid a scam, don’t respond to unsolicited emails or phone calls about reverse mortgages. Do your own research and approach a lender, instead of responding to a lender who approaches you.

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