The reputation of reverse mortgages has had its ups and downs since they were first piloted by the Reagan administration.
A financial tool that allows older people to tap home equity and age in place, reverse mortgages can free up cash in retirement and, in some cases, eliminate a monthly mortgage payment.
Recent reforms have helped to correct many flaws that left vulnerable borrowers at risk, but some issues remain. Borrowers who took out reverse mortgages before protections were enacted are more susceptible to getting in trouble, while problems with inflated appraisals and confusing marketing still plague newer mortgages.
From freedom to foreclosure: Read USA TODAY's reverse mortgage investigation
“Ultimately, it’s another financial tool that’s neither good or bad. It just depends on how you use it,” said Joshua Nelson, a certified financial planner at Keystone Financial. “Educate yourself and put together a complete financial plan. Without a plan, it can be destructive.”
Here’s what you should know.
What is a reverse mortgage?
Perhaps the best way to understand a reverse mortgage is to compare it to a regular mortgage.
Both are loans backed by your house that must be repaid to the lender. But with a regular mortgage, you’re given funds upfront to buy a house and you must begin repaying those borrowed funds right away every month for a set number of years.
With a reverse mortgage, you're tapping the home equity you've built up by getting a loan against it. The funds are given as an upfront lump sum payment, over monthly payments, or as a line of credit that you repay only when you sell the house or pass away. There are no monthly payments.
Most reverse mortgages are backed by the Federal Housing Administration and overseen by the Department of Housing and Urban Development. They are called home equity conversion mortgages (HECM).
Who can get a reverse mortgage?
Borrowers: Reverse mortgages were designed for older people to tap their home equity to increase their monthly cash flow without the burden of monthly payments. To qualify for a reverse mortgage, you must be at least 62 years old. Potential borrowers also must go through a home counseling session to ensure that they fully understand the ins and outs of a reverse mortgage.
House: Reverse mortgages are for primary residences only. Investment properties and vacation homes don’t qualify. You must live at the property for more than six months of the year.
Typically, you can’t borrow more than 80% of your home’s value, up to the FHA maximum of $726,525 for 2019. Generally, the older you are, the more you can borrow. The rule of thumb on the percent you can borrow is your age minus 12, said John Stearns, a senior loan officer with American Fidelity Mortgage Services.
“Say someone is 80, take 12 away, that’s 68,” he said. “So, they are looking at getting a loan that’s worth 68% of their home’s value.”
Obligations: You’re also required to pay property taxes, homeowner’s insurance and mortgage insurance premium in addition to maintaining the house. Your lender will evaluate whether you have enough disposable income to meet these obligations. In some cases, lenders may require that some of the equity from the reverse mortgage is set aside to pay those expenses going forward.
How do reverse mortgages work?
Reverse mortgages are a negative amortization loan. That means the loan balance grows over time. For instance, you may borrow $100,000 upfront, but by the time you pass away or sell your home and move, you will owe more than that, depending on the interest rate on the reverse mortgage.
There are five ways to have the funds from a reverse mortgage distributed to you:
Lump sums: You can take the cash you’re entitled to upfront. But you’re required to take the amount in two sums, with the second coming a year after the first. Typically, these types of reverse mortgages come with a fixed interest rate on the outstanding balance.
Tenure payment: You can receive the funds as a monthly payment that lasts as long as you stay in the house. This reverse mortgage generally has an adjustable interest rate.
Term payment: You can receive funds monthly for a specified period. These monthly payments are typically larger than a tenure payment. The interest rate is also adjustable.
Credit line: Under this scenario, you don’t take any cash at all. Instead, you have a line of credit you can draw on at any time. The credit line also grows over time based on its adjustable interest rate.
Mix and match: You can also combine the above options. For example, you can take an upfront lump sum, say $10,000, and then choose to take $500 a month term payment. If you want to change the options later, you can do this is by paying an administrative fee, Stearns said.
Who should consider a reverse mortgage?
If you want to stay in your home for a long time in your retirement and have no desire to pass down your house to your children, then a reverse mortgage may work for you. If you also want to preserve other assets or investments in retirement, a reverse mortgage is one way to tap more funds.
The ideal reverse mortgage borrowers also are those who have built up substantial and diversified retirement savings. “But they have considerable wealth in their home and they want as much spendable funds in their retirement as possible,” said Jack Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania.
Who should avoid a reverse mortgage?
If you don’t have enough equity in your home, a reverse mortgage won’t work well for you. If you don’t fully understand the mortgage, you should also avoid it. “These are complex products,” Nelson said. “It’s a mind twister to think about equity going away.”
If you want to leave your home to your children after you pass away or move out of the home, a reverse mortgage isn’t a good option for you either. That’s because the reverse mortgage balance must be paid off – usually by selling the home.
What can go wrong with a reverse mortgage?
Foreclosure: If you don’t make your property tax and insurance payments, that could trigger a foreclosure. Similarly, if you don’t respond to annual correspondence from your lender, that could also prompt foreclosure proceedings.
The impact: Explore foreclosures across the U.S.
Unfortunately, minor infractions like not returning a residency postcard, missing tax or property insurance payment, or poor servicing can lead to foreclosure quickly. In those cases, seniors can face long stressful battles to hold onto their homes and sometimes they still lose them anyway.
Non-borrowing spouse: If your spouse is not a co-borrower on the reverse mortgage when you pass away, what happens next depends on when the reverse mortgage was taken out.
If it was taken out on or after Aug. 4, 2014, a non-borrowing spouse can stay in the home after the borrower dies – but does not receive any more of the loan funds – as long as he or she meets these eligibility requirements:
• Married to the borrower when the loan closed
• Remain married until the borrower dies
• Named as a non-borrowing spouse in the loan documents
• Live and continue to live in the home as the primary residence
• Able to prove legal ownership after the borrower dies
• Pay the taxes and insurance and maintain the home’s upkeep
The borrower and spouse must certify at the loan’s closing and every following year that they are still married and the spouse is an eligible non-borrowing spouse. When the borrower dies, the spouse must certify his or her eligibility every year. If these conditions aren’t met, the spouse can face foreclosure.
For reverse mortgages taken out before Aug. 4, 2014, non-borrowing spouses have fewer protections. The lender does not have to allow the non-borrowing spouse to stay in the home after the borrower dies. A borrower and his or her spouse can ask a lender to apply to HUD to allow the non-borrowing spouse to remain in the house.
If that doesn’t happen, the surviving spouse can be hard hit, receiving a foreclosure notice within weeks of their husband or wife's death.
Non-HECM loans: Some lenders offer HECM lookalikes but with loan limits that exceed the FHA limit. These reverse mortgages often are similar to HECMs. But it’s important to understand any differences.
Brokers: Know how your reverse mortgage professional gets paid. If paid on commission, be wary if the professional encourages you to take the maximum upfront cash, which means a bigger commission.
Shop around, too.
“This is something you want to get out in front of," said David Mullins, a certified financial planner in Richlands, Virginia. "People don’t look at reverse mortgages until it becomes a need. They can be desperate."
Alternatives to reverse mortgages
There are other ways for seniors to unlock the equity they built up in their homes over the decades without taking out a reverse mortgage. If you need the equity for your retirement years, it's key to consider all options.
Downsize: You can sell your current home and buy a cheaper apartment, condominium or smaller house to extract equity. The downside is giving up the family home. But potential upsides include moving closer to family and purchasing a home more suitable for aging in place.
Refinance: You can either refinance or take out a new mortgage if you don't have an existing one and cash out some of the equity. The advantage is that you can tap only what you need, but you still have monthly payments.
Loan or HELOC: You could also borrow against your home equity using a home equity loan or line of credit. A loan allows you to take a lump sum upfront that you pay back in installment payments. With a line of credit, you can borrow from it at any time, up to the maximum amount. You also have to make minimum monthly payments after you borrow from the line of credit.
This article originally appeared on USA TODAY: Reverse mortgages: How do they work, and who should consider one?