What Is a Reverse Mortgage and How Does It Work?
A reverse mortgage is a mortgage that almost seems too good to be true because you won’t have to make monthly payments and you’ll get cash in hand in return. While reverse mortgages have undeniable appeal for cash-strapped seniors, they also have enormous costs and many potential pitfalls. It’s important to know the basics, including how reverse mortgages work, interest rates and fees, the pros and — perhaps most importantly — the cons, as well as some alternatives to this type of mortgage that you may want to consider before signing on the dotted line.
What is a reverse mortgage?
A reverse mortgage is a very specific kind of loan for homeowners ages 62 or older that allows the borrower to turn their home equity into cash without having to make monthly payments. While the borrower pays back the lender on a traditional mortgage, a reverse mortgage actually works in the opposite way. The reverse mortgage lender makes payments to the borrower by tapping into — and, unfortunately, slowly draining — the equity you’ve built up in your house. In most cases, you can use the money for anything. Payments are usually tax-free.
As long as you still live in your home, you won’t need to pay back the loan. However, if you sell the house, move out or die, it must be repaid immediately — whether that’s by you, your spouse, your heirs or your estate.
Who is eligible for a reverse mortgage?
Reverse mortgages aren’t available to everyone. You have to be at least 62 to even be considered, and then you must meet other qualifications on top of that. To be eligible, your mortgage has to be paid off or close to it, you can’t be delinquent on any federal debt, your home has to meet the required property standards and the property must be your primary residence. If you fail to meet any of these requirements, you will not qualify for a reverse mortgage.
How to use a reverse mortgage
The funds from a reverse mortgage can be used for various reasons. One of the most beneficial reasons is to avoid foreclosure on a home. Homeowners can do this because the funds they are being paid from their equity can be used to pay off the current mortgage. Keep in mind, though, that the balance on the traditional mortgage must be very low in order to qualify for a reverse mortgage, so if you’re carrying a large amount on your mortgage, this will not be a viable option.
While there are certain reverse mortgages that have specific parameters as to what the funds can be used for, the most common types don’t have any restrictions. If the funds aren’t being used to avoid foreclosure, many homeowners will use them for home improvements or to pay off other debts. No matter what your financial needs are, though, it’s still wise to consider alternative options to a reverse mortgage that may offer lower interest rates or up-front fees.
Types of reverse mortgages
There are three different kinds of reverse mortgages: home equity conversion mortgages, single-purpose reverse mortgages and proprietary reverse mortgages.
Home equity conversion mortgages, also known as HECMs, is the most popular type of reverse mortgage. HECMs are insured by the Federal Housing Administration, though the money still comes from private mortgage lenders. You will be required to receive borrower counseling before you can get an HECM.
Single-purpose reverse mortgages are different from other reverse mortgages because the lender specifies what the money can be used for, such as home renovations. According to the Federal Trade Commission, these are available through some state or local government agencies and nonprofits.
Proprietary reverse mortgages are the type you’re likely to receive if you go through a private lender. These aren’t subject to the same rules and regulations that come with federally backed reverse mortgages. Proprietary reverse mortgages might be a better bet for owners of high-value homes who want to receive more of their equity than they could get through the federal HECM program.
Pros and cons of a reverse mortgage
Reverse mortgage pros
- Needed income: This is the most obvious benefit of a reverse mortgage. If you’re barely scraping by, a reverse mortgage can give you the additional funds you need to stay afloat, whether that’s for day-to-day expenses, medical bills or other debts.
- Relaxed eligibility: Most conventional loans require a steady income and good credit. However, as long as you’re over 62 and own most or all of your home, you’ll probably still be eligible for a reverse mortgage.
- Flexibility: Most reverse mortgages can be paid out as a lump sum, a monthly payment or a line of credit and typically can also be used for any purpose.
- Tax-free payments: Your reverse mortgage payments are not considered income; rather, they’re considered loan advances and aren’t taxable. However, note that interest is not tax-deductible until the loan is repaid.
Reverse mortgage cons
- High interest rates and fees: A reverse mortgage comes with rates and fees that are heftier than conventional mortgage rates or home equity loan rates. Once you account for them, you may be surprised at how little you actually receive. High fees make a reverse mortgage a bad deal for anyone who thinks they may move in the near future.
- Loss of long-term freedom: While you’ll gain short-term financial stability by receiving reverse mortgage payments, it could cost you your long-term financial freedom. For example, if your health suddenly nose dives and you must move in with an adult child or an assisted living facility, you’ll suddenly have to repay your loan.
- Can affect benefit eligibility: Depending on how you receive your funds, a reverse mortgage may affect your eligibility for Medicaid or Supplemental Security Income (SSI) because you are limited to a certain amount of liquid assets to qualify. Regular Social Security and Medicare benefits should not be affected.
- Potential scams: Scammers are notorious for targeting seniors and the reverse mortgage scam is no different. These scams usually come in the form of a bogus contractor or vendor offering cheap home improvements just to get some quick cash from the homeowner.
- A burden for your heirs: After you die, your children or other heirs are responsible for paying off the reverse mortgage loan. Though the lender can’t try to seize your heirs’ assets for payment, they’ll still have the burden of deciding what to do with your home.
Factors to consider before getting a reverse mortgage
A reverse mortgage can seem extremely enticing on paper, but the truth is that it is a loan with very high interest rates and fees. Moreover, it’s a loan that must be repaid eventually, despite typically being advertised as a loan with no monthly payments. Advertisements for these mortgages can be full of false promises of financial security, when in reality offer no such thing. Reverse mortgages also come with a multitude of fees the homeowner either have to be paid upfront or will be ongoing. This includes standard closing costs, loan origination fees, mortgage insurance premiums (MIP) and appraisal fees. You can get a reverse mortgage too soon and run out of equity, or you can fall behind on property taxes and upkeep and be forced out of your home. Even if a reverse mortgage keeps you afloat, it can mean you won’t have as much, if anything, to pass on to your heirs. In short, there’s a reason most financial experts only recommend reverse mortgages as a last resort. Be sure to weigh all the pros, cons and alternatives before you opt for a reverse mortgage.
Alternatives to a reverse mortgage
If money is tight, be sure to investigate all of your options before opting for a reverse mortgage. With the alternatives below, your house will still be your own asset to leave to your heirs or do with it what you please.
- Refinance your existing mortgage: If you’re still paying down your first mortgage and can wrangle a lower rate by refinancing, you can reduce your monthly payment and get a little more breathing room in your budget. You will pay closing costs, but if you are going to be in your home for several more years, it makes sense.
- Home equity loan or HELOC: Home equity loans and home equity lines of credit (HELOCs) generally have lower interest rates and fees than a reverse mortgage, and the interest is usually tax-deductible. A fixed-rate home equity loan can be easy to budget for, and a HELOC can provide the convenience of cash on an as-needed basis. Keep in mind that home equity loans may also come with closing costs and up-front fees. While HELOCs may be appropriate for some borrowers, they’re not for everyone. “As with all loans, borrowers need to make sure they understand the full costs of borrowing when taking out a HELOC,” says Michelle McLellan, Senior Vice President and Product Management Executive at Bank of America.
- Sell your house and downsize: If you’re struggling to deal with the expense of upkeep or high property taxes, it makes more sense to access your equity through a sale and find a smaller, less expensive place to call home.