What Is a Reverse Mortgage? Pros and Cons
A reverse mortgage is a kind of loan that allows you to cash out your home’s equity while you still live in the house.
Instead of making monthly mortgage payments to the lender, the way you would with a traditional mortgage, the lender pays you. You don’t have to pay back the money until you move out, sell the house, or pass away.
How Does a Reverse Mortgage Work?
Types of Reverse Mortgages
Home Equity Conversion Mortgage (HECM)
Proprietary Reverse Mortgage
Single-Purpose Reverse Mortgage
Who Can Get a Reverse Mortgage?
What Can a Reverse Mortgage Be Used For?
How Much Money Can You Get with a Reverse Mortgage?
Costs of Borrowing
Reverse Mortgage Payment Options
How Do You Pay Back a Reverse Mortgage?
Pros and Cons of Reverse Mortgages
Pros of Reverse Mortgages
Cons of Reverse Mortgages
How Can I Avoid Reverse Mortgage Scams?
Bottom Line
How Does a Reverse Mortgage Work?
To understand how reverse mortgages work, first, you need to understand what equity is.
In real estate terms, equity is the real market value of your property minus any mortgages still owed on it.
For example, if your home is valued at $300,000 and you still owe $100,000 on the mortgage, your equity is $200,000.
That’s the amount you would be able to borrow through a reverse mortgage.
If, on the other hand, you don’t have a mortgage on the house, then the full market value of the property is the equity you have available.
When you apply for a reverse mortgage, the bank will issue you a payment for the equity amount you want.
This money is yours tax-free and may be paid upfront in a single lump sum, in monthly payments, as a line of credit, or in a combination of all three.
Types of Reverse Mortgages
There are three types of reverse mortgages to choose from.
Home Equity Conversion Mortgage (HECM)
The Home Equity Conversion Mortgage (HECM) is the most common type of reverse mortgage in the market.
HECMs are insured by the Federal Housing Administration (FHA) and regulated by the US Department of Housing and Urban Development.
This kind of loan is a non-recourse debt, which means that even if your house loses value after you take out the reverse mortgage, you won’t be responsible for paying the difference if you sell the house or default on the loan.
For 2021, HECM loans are capped at $822,325 but there are no limits on how you can use the money. You’ll be required to attend HUD counseling and to pay mortgage insurance premiums.
Proprietary Reverse Mortgage
A proprietary reverse mortgage — also known as a jumbo reverse mortgage — is a kind of loan offered by private reverse mortgage lenders and is not insured by the federal government.
These types of loans are usually used for homes with values that exceed the loan limits set by HUD.
Proprietary reverse mortgages require the borrower to pay mortgage insurance or to receive financial counseling.
Otherwise, it is virtually the same as a HECM: borrowers can get the money as a lump sum or as a monthly annuity, and the money can be used for any purpose.
Single-Purpose Reverse Mortgage
Single-purpose reverse mortgages are offered by local and state government agencies and nonprofit entities. You may find them under the name “deferred payment loan” or “property tax deferral loan.”
The money from this loan may only be used for a specific purpose, such as paying off property taxes or making home repairs.
This kind of reverse mortgage is less expensive than the other two types: fees and interest rates both tend to be lower.
Eligibility requirements also tend to be less strict, so this is one type of reverse mortgage low-income borrowers and homeowners can afford.
Who Can Get a Reverse Mortgage?
To be eligible for a reverse mortgage, you must be at least 62 years old, own your home, and live in it as your primary residence.
You can have an existing traditional mortgage on the property, but there must be enough equity for the reverse mortgage amount you need.
You must also be able to pay the taxes and homeowners insurance premiums on the house and to keep the house in a good physical state.
In the case of a HECM, you will also be required to attend financial counseling with a HUD-approved counselor.
The purpose of this counseling is to make sure you understand the risks and responsibilities associated with a HECM.
For more information on the counseling process, visit the Housing Counseling Program’s page on the HUD website.
If you receive Medicaid or Supplemental Security Income (SSI) benefits from the Social Security Administration, you may want to consult a financial expert to find out if your benefits will be affected by this kind of home equity loan.
What Can a Reverse Mortgage Be Used For?
Depending on the kind of reverse mortgage you choose, there may be limits placed on how you can use the money.
For single-purpose reverse mortgages, the purpose for the money needs to be reviewed and approved by the lending agency.
HECMs generally don’t put limits on how you can use the money; however, the house has to comply with HUD’s minimum property standards, so you may have to use some of the loan money to pay for improvements so the structure can be eligible for the loan.
How Much Money Can You Get with a Reverse Mortgage?
The amount you will be able to borrow with a reverse mortgage depends on the type of reverse mortgage loan you select, the age of the youngest borrower, interest rates, and the value of the home.
There is a mortgage limit of $822,325 for HECMs insured by the FHA in 2021. If the appraised value of your home exceeds it, your loan amount will be based on the limit.
Another factor that will affect how much money you receive is the costs of borrowing.
Costs of Borrowing
Much like when you take out a traditional mortgage, there are origination fees and servicing fees associated with a reverse mortgage, along with other closing costs.
You will also be required to pay mortgage insurance premiums. These expenses can be taken out of the loan amount, so you don’t have to pay them out of pocket, but they will reduce how much cash you actually receive after closing.
Reverse mortgages also tend to have higher interest rates than traditional mortgages.
Reverse Mortgage Payment Options
HECMs give you plenty of payment options: you can select to receive a single lump-sum payment or a monthly annuity for a specific number of months or for as long as you live in the house (also called tenure).
A third option that could give you more control over your debt is a line of credit. The HECM line of credit also has the benefit of growing every year, so long as you don’t withdraw the full amount.
These options can also be combined to fit your needs.
How Do You Pay Back a Reverse Mortgage?
Like we mentioned previously, as long as you are living in your home, you don’t have to pay back the reverse mortgage loan. The loan will become due and payable if one of the following situations happen:
You die.
You sell the house.
You live outside the home for one continuous year (e.g., you move into an assisted living facility or stay with a relative).
You don’t pay property taxes or homeowners insurance.
You don’t maintain the house.
Once the loan is due, you need to speak with your lender to figure out how long you have to settle the loan balance.
The amount of time varies, depending on your situation, but could be as little as 30 days in some cases before the lender begins the foreclosure process.
The most common situation with reverse mortgages is when the elderly homeowner dies, the heirs of the estate have three options: pay the loan and keep the property, sell the house, or take out a new traditional mortgage to pay off the loan.
If the heirs decide not to keep the house, the lender may proceed with foreclosure.
Pros and Cons of Reverse Mortgages
Reverse mortgages may seem like an easy way to get the money you need but there are quite a few downsides associated with this kind of loan.
You should always speak with a financial advisor before deciding to take out a reverse mortgage.
Taking stock of your health is also a good idea before thinking about a reverse mortgage: if there’s a chance you won’t be living in your house for the long-term, this kind of loan may not be the right solution for you.
Pros of Reverse Mortgages
You can have access to a large amount of cash or a steady source of income in your retirement, even if you already have an existing mortgage.
You can choose to receive the money as a lump sum, annuity, line of credit, or a combination of all three.
No payments need to be made until you move out, sell the house, or die.
HECMs are non-recourse loans so you will only owe what you borrowed even if your house loses value.
Reverse mortgage payments are non-taxable because they are classed as loan proceeds, not income.
You have the right to change your mind for any reason and cancel the reverse mortgage within three business days of closing on the loan.
If your spouse is a co-borrower on the loan, they will be able to stay in the house after your death with no repayment required until they die.
Cons of Reverse Mortgages
You must pay mortgage insurance premiums and homeowners insurance for the life of the loan.
Other expenses associated with reverse mortgages, like fees and closing costs, will reduce the amount of cash you get.
If your spouse isn’t a co-borrower on the loan and they outlive you, they may be forced to pay back the loan or move out after your death.
Falling behind on property taxes or insurance payments could trigger default and foreclosure.
If you die before paying back the loan, you’ll be leaving a large debt to your heirs.
If you need to move out of your house, such as into a long-term care facility, the loan becomes due. You must keep the house well-maintained or the lender could declare the loan to be in default.
The loan proceeds could affect your Medicaid and Supplemental Security Income eligibility.
How to Avoid Reverse Mortgage Scams
Unfortunately, reverse mortgages are often used by unscrupulous individuals to scam elderly homeowners.
A USA Today report from 2019 found that over 100,000 reverse mortgages foreclosed after the Great Recession of 2008, many homeowners falling prey to reverse mortgage scams.
Some lenders misconstrue how a reverse mortgage works and don’t explain the fine print to their clients.
Some companies market aggressively to older adults who may not have the financial know-how to understand the implications of taking out a loan like this.
Another popular scam is for a contractor to convince a homeowner that the best way to pay for costly home repairs is to take out a reverse mortgage.
Some homeowners are also tricked into investing the loan proceeds in risky stocks or schemes (like house-flipping) or into signing over the money to a third-party.
The best way to avoid being a victim of a reverse mortgage scam is to fully understand how reverse mortgages work.
Read the fine print before signing any loan documents, and be aware that you have a right to cancel your reverse mortgage loan within 3 business days of closing for any reason whatsoever.
You’ll need to send a request in writing to your lender, who will then have to return whatever loan expenses you have already paid.
If you or someone you know has fallen for a reverse mortgage scam, contact the FBI or file a complaint with HUD.
Bottom Line
A reverse mortgage can be a powerful tool to have access to funds for performing necessary home improvements, paying back property taxes, or other important expenses.
However, homeowners should be fully aware of the risks and responsibilities related to taking out a reverse mortgage.
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