In a word, a reverse mortgage is a loan. A homeowner who is 62 or older and has considerable home equity can borrow against the value of their home and receive funds as a lump sum, fixed monthly payment or line of credit. Unlike a forward mortgage – the type used to buy a home – a reverse mortgage doesn’t require the homeowner to make any loan payments. (See Comparing Reverse Mortgages vs. Forward Mortgages.)
Instead, the entire loan balance becomes due and payable when the borrower dies, moves away permanently or sells the home. Federal regulations require lenders to structure the transaction so the loan amount doesn’t exceed the home’s value and the borrower or borrower’s estate won’t be held responsible for paying the difference if the loan balance does become larger than the home’s value. One way this could happen is through a drop in the home’s market value; another is if the borrower lives a long time.
Reverse mortgages can provide much-needed cash for seniors whose net worth is mostly tied up in the value of their home. On the other hand, these loans can be costly and complex – as well as subject to scams. This article will teach you how reverse mortgages work, and how to protect yourself from the pitfalls, so you can make an informed decision about whether such a loan might be right for you or your parents.
With a reverse mortgage, instead of the homeowner making payments to the lender, the lender makes payments to the homeowner. The homeowner gets to choose how to receive these payments (we’ll explain the choices in the next section) and only pays interest on the proceeds received. The interest is rolled into the loan balance so the homeowner doesn’t pay anything up front. The homeowner also keeps the title to the home. Over the loan’s life, the homeowner’s debt increases and home equity decreases.
As with a forward mortgage, the home is the collateral for a reverse mortgage. When the homeowner moves or dies, the proceeds from the home’s sale go to the lender to repay the reverse mortgage’s principal, interest, mortgage insurance and fees. Any sale proceeds beyond what was borrowed go to the homeowner (if he or she is still living) or the homeowner’s estate (if the homeowner has died). In some cases, the heirs may choose to pay off the mortgage so they can keep the home.
Reverse mortgage proceeds are not taxable. While they might feel like income to the homeowner, the IRS considers the money to be a loan advance. (See A Guide to Taxes and Reverse Mortgages.)
There are three types of reverse mortgage. The most common is the home equity conversion mortgage, or HECM. The HECM represents almost all of the reverse mortgages lenders offer on home values below $679,650 and is the type you’re most likely to get, so that’s the type this article will discuss. If your home is worth more, however, you can look into a jumbo reverse mortgage, also called a proprietary reverse mortgage.
When you take out a reverse mortgage, you can choose to receive the proceeds in one of six ways:
Get all the proceeds at once when your loan closes. This is the only option that comes with a fixed interest rate. The other five have adjustable interest rates.
For as long as at least one borrower lives in the home as a principal residence, the lender will make steady payments to the borrower.
The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years.
Money is available for the homeowner to borrow as needed. The homeowner only pays interest on the amounts actually borrowed from the credit line.
The lender provides steady monthly payments for as long as at least one borrower occupies the home as a principal residence. If the borrower needs more money at any point, they can access the line of credit.
The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years. If the borrower needs more money during or after that term, they can access the line of credit.
(For more details on the pros and cons of each option for receiving the proceeds, see How to Choose a Reverse Mortgage Payment Plan.)
It’s also possible to use a reverse mortgage called an “HECM for purchase” to buy a different home than the one you currently live in.
In any case, you will typically need at least 50% equity – based on your home’s current value, not what you paid for it – to qualify for a reverse mortgage. Standards vary by lender.
A reverse mortgage might sound a lot like a home equity loan or line of credit. Indeed, similar to one of these loans, a reverse mortgage can provide a lump sum or a line of credit that you can access as needed based on how much of your home you’ve paid off and your home’s market value. But unlike a home equity loan or line of credit, you don’t need to have an income or good credit to qualify, and you won’t make any loan payments while you occupy the home as your primary residence.
A reverse mortgage is the only way to access home equity without selling the home for seniors who don’t want the responsibility of making a monthly loan payment or who can’t qualify for a home equity loan or refinance because of limited cash flow or poor credit. (For more on this topic, see Reverse Mortgage or Home Equity Loan?)
If you don’t qualify for any of these loans, what options remain for using home equity to fund your retirement? You could sell and downsize, or you could sell your home to your children or grandchildren to keep it in the family – perhaps even becoming their renter if you want to continue living in the home. (For more, see Top 5 Alternatives to a Reverse Mortgage.)
Once you’re 62 or older, a reverse mortgage can be a good way to get cash when your home equity is your biggest asset and you don’t have another way to get enough money to meet your basic living expenses. A reverse mortgage allows you to keep living in your home as long as you keep up with property taxes, maintenance and insurance and don’t need to move into a nursing home or assisted living facility for more than a year. (For more, see 5 Signs a Reverse Mortgage Is a Good Idea.)
However, taking out a reverse mortgage means spending a significant amount of the equity you’ve accumulated on interest and loan fees, which we will discuss below. It also means you likely won’t be able to pass your home down to your heirs. If a reverse mortgage doesn’t provide a long-term solution to your financial problems, only a short-term one, it may not be worth the sacrifice.
What if someone else, such as a friend, relative or roommate, lives with you? If you get a reverse mortgage, that person won’t have any right to keep living in the home after you pass away. (For further reading, see 5 Signs a Reverse Mortgage Is a Bad Idea.)
Another problem some borrowers run into with reverse mortgages is outliving the mortgage proceeds. If you pick a payment plan that doesn’t provide a lifetime income, such as a lump sum or term plan, or if you take out a line of credit and use it all up, you might not have any money left when you need it. (See How to Avoid Outliving Your Reverse Mortgage.)
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