What Is a Reverse Mortgage?
If you’re looking for an additional source of funds in retirement, a reverse mortgage could be just the tool you need.
Reverse mortgages have received a bad rap over the years, and for good reason given that they were often saddled with high fees and sold to vulnerable seniors for the wrong reasons.
But with the consumer protections offered through the Federal Housing Administration-backed Home Equity Conversion Mortgage program (HECM), reverse mortgages are highly regulated and can serve as a powerful tool to help you meet your retirement needs.
“Reverse mortgages have changed shape over the last several years and now provide more flexibility and options than ever,” said Tad Herrington, CFP and senior financial planner for John E. Sestina & Company in Columbus, Ohio.
Still, it’s worth proceeding with caution. Reverse mortgages come with significant costs, and using them the wrong way can leave you without any home equity to draw upon if needed later in life.
This article will help you understand how reverse mortgages work and when they may or may not be the right tool for you.
What is a reverse mortgage?
A reverse mortgage is a loan that’s taken out against the equity in your home and it’s unique in that it doesn’t require a monthly payment. The amount you borrow simply accumulates until you either move or pass away, at which point it can be paid off by selling the house or by drawing from other assets.
In the meantime, the loan proceeds can be used for just about any purpose, from helping with day-to-day spending to serving as an alternative source of funds during a market downturn.
“It allows you to use some of your equity now, as opposed to selling the property or waiting until you die,” said Eric Rittmeyer, CRMP and president of Fidelis Mortgage in Baltimore. “You get to convert part of your equity into spendable cash so you can use it for things you need now.”
And while there are some downsides to reverse mortgages, which are covered below, the FHA-backed HECM program has created strict regulations that limit the costs and protect consumers, making reverse mortgages a viable option for people who want to use their home equity to support their retirement goals.
How does a reverse mortgage work?
There are several different ways that you can structure a reverse mortgage in order to access the equity available in your current home.
According to Rittmeyer, the most common method is taking out a line of credit which can be used to pay off any existing mortgage, thereby eliminating that monthly payment. This can greatly reduce your monthly expenses and make it easier to handle your other needs.
“When someone gets rid of their mortgage payment, that’s often 50% of their total monthly income,” said Rittmeyer. “Now, they can pay for their medication, pay for a trip or give some money to their grandkids.”
Another benefit to a line of credit is that it grows over time, and can even exceed the value of your home.
“That credit limit begins growing at a variable rate currently around 5% per year and is not tied to your home’s value,” said Justin Chidester, fee-only CFP at Wealth Mode Financial Planning in Logan, Utah. “As long as you are still living in your home and staying current on your property taxes and homeowners insurance, you have access to that amount whenever and however you want.”
You can also receive your reverse mortgage proceeds as a fixed monthly payment, which can come in one of two forms:
- Term – Provides a fixed monthly payment for a set period of time.
- Tenure – Provides a fixed monthly payment for as long as you live in the house and as long as it qualifies as your primary residence.
According to Rittmeyer, the term payment is most often used when someone has a temporary need, such as waiting to start collecting Social Security. The tenure payment is more effective as long-term supplemental income, given that it’s guaranteed to continue for as long as you’re in the home, even if the value of the loan exceeds the value of the house.
Reverse mortgages are also available on a new home purchase through the HECM for Purchase program, as long as you have the cash available to pay for the difference of the reverse mortgage and the home price, plus closing costs.
“This is good for somebody who wants to downsize to a smaller place, or be closer to their kids,” said Rittmeyer. “It gives them the ability to sell their existing house, use the proceeds for a down payment on a new home, and the reverse mortgage is put on the new home, so they buy the house and have no monthly payments.”
One additional benefit of reverse mortgages taken out through the HECM program is that they are non-recourse, which means that you will never owe more than the home is worth. Even if the loan balance exceeds the value of the home, neither you nor your heirs will be held liable for that excess. Though it’s worth noting that if your heirs can’t pay the debt from other sources, they will need to sell the house in order to settle it.
Reverse mortgage qualifications
The HECM program requires you to meet a number of criteria before taking out a reverse mortgage.
You must be age 62 or older and you must occupy the home as your primary residence. You also must either own your home outright or have paid off enough of the mortgage to qualify for a new loan.
“Typically, if a borrower owes more than 40% of the value of their property, they’re not likely to qualify,” said Rittmeyer. “There needs to be enough equity for the reverse mortgage to be in first lien position.”
Other requirements include not being delinquent on any federal debt and proving that you have the financial resources to continue paying for homeowners insurance, property taxes and regular maintenance.
You also have to go through a counseling session with a HUD-approved HECM counselor, which is a good opportunity to make sure that a reverse mortgage is the right decision for your needs and that you’re not being misled.
“If they’re dealing with a lender who’s doing something crazy, that counseling session should bring that out into the open,” said Rittmeyer.
In addition to meeting the criteria above, your home must fall within one of the following eligible categories:
- A single family home or a 2-4 unit home in which at least one unit is occupied by the borrower
- A HUD-approved condominium project
- A manufactured home that meets FHA requirements
How much can you borrow?
The amount you can borrow for a reverse mortgage through the HECM program is based on three factors:
- The age of the youngest borrower or eligible non-borrowing spouse
- The current prevailing interest rate
- The lesser of the home’s appraised value, its sale price (for the HECM for Purchase program), or the HECM limit of $679,650.
“Someone who is 62 years old can borrow about 50% of the value of their home,” said Rittmeyer. “The older you are, the more you can borrow.”
If you opt for a monthly payment, Rittmeyer said that the amount you receive additionally factors in an assumed growth rate, as well as the length of time you want those payments to continue.
“If you’re opting for a term payment, the borrower tells the lender how much they want to draw per month and the lender determines how long they can make that payment,” said Rittmeyer. “With a tenure payment, the assumption is that the youngest borrower will live to 84. The closer you are to age 84, the more you’re allowed to borrow.”
Reverse mortgage costs
One of the big downsides of taking out a reverse mortgage is that it can be expensive.
HECM loans require a mortgage insurance premium that protects the lender in case your loan value ends up exceeding the value of your home. There is an upfront insurance premium equal to 2% of the loan, as well as an annual premium equal to 0.5% of the outstanding balance.
There is also an origination fee equal to 2% of the home value up to $200,000, plus 1% of the home value above that, with a minimum fee of $2,500 and a maximum fee of $6,000. And there is a servicing fee of up to $35 per month.
On top of that, there are a number of third-party fees that are similar to those you would have to pay for other types of home loans. The specific fees and their amounts will vary from loan to loan, but common fees include:
- An appraisal fee of around $450
- A credit report fee of $20-$50
- A flood certification fee of around $20
- An escrow, settlement or closing fee of $150-$800
- A document preparation fee of $75-$150
- A recording fee of $50-$500
- A courier fee of around $50 or less
- Title insurance that varies by location and loan amount
- A pest inspection fee of around $100 or less
- A survey fee of around $250 or less
Reasons to consider a reverse mortgage
Despite the cost, there are several reasons why a reverse mortgage could be beneficial.
“The No. 1 benefit is the elimination of the current mortgage payment,” said Rittmeyer. “You can take out a line of credit, pay off the existing mortgage, never have to make a payment, and your line of credit actually grows.”
Bill Starnes, CFP and founder of Mallard Advisors in Hockessin, Del., added that a reverse mortgage line of credit can protect retirees from sequence of return risk, which is the risk that poor market returns in the early years of retirement will make it less likely for your portfolio to last throughout your entire retirement.
“With a reverse mortgage line of credit, you can tap into the line of credit instead of selling stocks while they’re down,” said Starnes. “Then when the market pops back up, you can always pay back the reverse mortgage if you want to.”
Starnes also mentioned that while many people are hesitant to tap into the equity of their home, he encourages people to think of it as an available asset just like any other saving or investment account.
“You spend down your IRA, so why wouldn’t you spend down your home?” said Starnes. “The equity in your home is an asset and it’s your asset. It’s not something that you have to keep for your kids.”
Reasons to avoid a reverse mortgage
Of course, there are downsides to reverse mortgages and situations in which they likely aren’t your best fit.
If you plan to move in the near future, the upfront costs of a reverse mortgage are likely to outweigh the benefit.
“A reverse mortgage isn’t a good idea for someone who doesn’t want to be in their house,” said Rittmeyer, though he added that the HECM for Purchase program might be a good fit if the plan is to buy a new home.
Even if you don’t plan on moving, you may be forced to move due to health concerns. And while you are allowed temporary absences from your home, your reverse mortgage will need to be paid off if you live elsewhere for more than 12 consecutive months due to medical reasons, and again, in that case, the upfront costs could outweigh the benefit you receive.
According to Starnes, you should also be hesitant to take out a reverse mortgage if you don’t have long-term care insurance.
“Your equity is an asset that you may not want to spend down because then you might have nothing left if you do need long-term care,” said Starnes.
Starnes also mentioned that while reverse mortgage scams are less common due to the regulations within the HECM program and the counseling that borrowers have to go through, there are still situations in which you need to be wary.
“I’m less concerned about lenders and more concerned about investment advisers looking to line their pockets,” said Starnes. “An investment adviser might see that you have a million-dollar house and recommend that you take out the money and hand it to him so he can charge a 2% fee or even buy some high-cost annuities. That’s a pretty big conflict of interest there.”
The FBI offers some tips on avoiding reverse mortgage scams, and Rittmeyer said that one big key is involving people you trust.
“Everybody should be looking for someone that’s a true expert in the program,” said Rittmeyer. “And they should get family involved, get financial planners involved. That’s something I tell all my clients.”
How a reverse mortgage affects you and your family
One of the biggest concerns that many potential reverse mortgage borrowers have is how it will affect their family members.
One important consequence to understand is that because it’s a loan, a reverse mortgage often decreases the amount of money you can pass on to your surviving family members. The loan does need to be paid back, and that money either needs to come from other assets or it requires the sale of the home.
However, there are a few mitigating factors to consider.
First, any co-borrower who is still alive and living in the home upon your death can continue living there and continue receiving the benefits of the loan without having to pay it back.
Second, a spouse who is not a co-borrower but is living in the house, was married to you at the time the loan was issued and was identified in the loan documents can continue living in the property without having to pay back the loan.
Third, if you die and there is no eligible spouse and no other co-borrowers, your heirs will have to pay back the loan, but they will only be responsible for paying back a maximum of 95% of the appraised value of the home. So while they may have to sell the house in order to do that, you won’t be saddling them with a loan that they aren’t able to pay off.
If leaving your home to your children is a top priority, a reverse mortgage may not be the right tool for you. If not, you should generally feel safe taking out the loan without worrying about passing it on to future generations.
|Pros and cons of a reverse mortgage|
Is a reverse mortgage right for you?
If you are age 62 or older and you either have significant equity in your home or are looking to purchase a new home with a significant down payment, a reverse mortgage could be a useful tool. It can eliminate your monthly mortgage payment and provide an additional source of retirement funds, giving you more flexibility to meet a variety of needs.
Of course, it all comes down to your personal needs and the goals you’re trying to achieve. The costs are high and can outweigh the benefits if you don’t plan on staying in your home for an extended period of time. And a reverse mortgage can make it more difficult to pass your home down to family members, which may be an important objective.
As always, it’s a good idea to shop around and compare offers. The U.S. Department of Housing and Development offers a search tool to find FHA-backed lenders in your area, and a HECM counselor can help you compare offers along criteria such as loan size, interest rate and other costs to help you decide whether a reverse mortgage is right for you.