There are two ways to look at a reverse mortgage.
First: Only get a reverse mortgage if you absolutely have to. Doing so will encumber a home you should own outright, limiting your ability to move or pass the home on to your family.
Second: A reverse mortgage lets you use your home as a semi-liquid investment property. For a fee you can access the cash value of your house without having to sell it, allowing you to both tap it as a financial resource and still live there.
Here’s what you should know.
What Is a Reverse Mortgage?
A reverse mortgage is a supplemental retirement program built around a loan.
Homeowners who are over 62 can take a reverse mortgage out on a home that they own. The lender issues a loan based on the assessed value of the house, and the borrower can take that money in either a lump sum, installments or as a standing line of credit.
Where a standard mortgage gives someone money to buy a home that they don’t yet own, a reverse mortgage gives someone money based on property they currently hold. Hence the name.
There are no monthly loan payments under a reverse mortgage. The loan becomes due once the borrower dies, sells the home or moves out of it permanently. If the borrower wants to sell the house, they will have to use the proceeds to pay off their loan. If the borrower dies, the home will either pass on to their heirs, subject to the loan balance, or it will simply pass into the hands of the lender who will auction it off.
The Purpose of Reverse Mortgages
Reverse mortgages are designed to give Americans access to their home’s equity without having to sell.
Most Americans who own a home consider it a major investment. That house is considered part of their net worth, and it’s typically their most valuable asset. The problem is that your home isn’t a liquid asset. Unlike a stock certificate you can’t simply sell this off to raise some cash. For a homeowner to turn this investment into spending money means moving out and probably spending any money that they raised just finding another place to live.
A reverse mortgage is intended to help retirees solve that problem. It gives them access to the value of their property without having to actually move out of the house altogether.
Debt, Equity and Underwater Mortgages
A reverse mortgage is structured to steadily grow against the equity of the house.
Unlike a traditional loan, the borrower doesn’t make any payments against either the principal or the interest on a reverse mortgage. Instead, the lender steadily calculates that interest rate into the total balance of the loan.
Both the initial loan and the interest are calculated against the value of the home. Over time, interest will increase the value of the loan and decrease the borrower’s equity in their house.
However, unlike a traditional mortgage, a reverse mortgage cannot go underwater.
By federal law reverse mortgage lenders have to cap the total value of a regulated loan (interest and fees included) at the value of the house. The lender can also never collect more than the present value of the home if it winds up the loan is greater than the value of the house. This can happen in two main circumstances:
- The interest on the loan grows faster than the value of the house. If the borrower lives long enough, eventually the loan may be worth more than the house itself.
- The value of the house decreases. If the borrower’s real estate market declines, they might end up with a traditionally underwater mortgage.
Regardless of the circumstances, the lender can only collect the lesser of the total value of the loan or the house’s present market price. When the loan exceeds the value of the home the lender must waive the difference.
An Example of a Reverse Mortgage
Allen is 70 and owns a home worth $250,000. His 401(k) lost significant value during the Great Recession. To provide a cushion, he takes a reverse mortgage worth $150,000 and receives this as a lump sum so that he can roll the money into a new series of investments.
First Option: Over time the value of the mortgage grows to $200,000. Allen dies and leaves the house to his son. The value of the house hasn’t changed.
In this scenario, the lender has a claim over the house worth $200,000. In order for Allen’s son to claim the house, he would have to repay the $200,000 loan on the property. Otherwise, the lender will take the house and sell it at auction. It will keep the proceeds up to the value of the loan, and will give the remaining $50,000 to Allen’s son.
Second Option: Over time the value of the mortgage grows to $200,000, however, the local community has collapsed. The house is now only worth $150,000. Allen wants to move.
In this scenario the reverse mortgage is worth more than the house itself. When Allen sells the house that mortgage will come due in entirety. The lender can only collect up to the value of the house. Allen sells the house and turns all the proceeds over to the lender.
Are Reverse Mortgages Taxed?
A reverse mortgage is tax free. This money is a loan with interest, not a gift, and as such the IRS does not consider it income.
This rule applies to retirement benefits as well. Since a reverse mortgage is not income, it will not typically affect access to programs such as Social Security, Medicare or Medicaid.
The Three Types of Reverse Mortgage
A reverse mortgage can come in three forms:
The Home Equity Conversion Mortgage (HECM)
The home equity conversion mortgage is a standard reverse mortgage. Unless otherwise specified, all discussion of reverse mortgages in this article refer to HECMs.
This form of loan is overseen by the Federal Housing Administration. The FHA insures the mortgage, allowing lenders to offer better terms than they otherwise might, while at the same time requiring certain protections for seniors, such as the rule that this loan can never go underwater.
Single-Purpose Reverse Mortgage
This is a reverse mortgage offered by a government agency or nonprofit. It follows the rules of an HECM but unlike an HECM it is issued to pay for specific, lender-approved expenses. Typically, those expenses have to do with keeping and maintaining the property. For example, a senior might take out a single-purpose reverse mortgage to pay for property taxes or necessary home repairs.
These loans are generally given at highly favorable terms. Like an HECM they do not become due until the borrower moves, sells the home or passes away.
Proprietary or “Jumbo” Mortgage
Due to FHA rules, a lender cannot issue an HECM worth more than $726,525. For high value homeowners the alternative is called a jumbo mortgage. Retirees over 62 with homes worth enough to borrow above the FHAs cap can use a jumbo reverse mortgage to access up to $6 million.
There are two catches to jumbo mortgages. First, they are not insured by the FHA. This means that the loan terms can be significantly more expensive and are more likely to include a variable interest rate than an HECM.
Second, very few lenders issue them, so you will not find a competitive marketplace. While jumbo mortgages typically follow the rules set by the FHA, most notably that the lender cannot collect beyond the value of the house, they are not obligated to do so. Borrowers should read the terms of their contract carefully.
Does the Title Change Hands?
In a reverse mortgage you remain the owner of this home. That means that you will continue to be responsible for all maintenance, property taxes, homeowner’s insurance and any other related expenses.
Borrowers should note: Failure to keep up with necessary expenses can result in the lender collecting on their loan early. If you don’t pay your property taxes, for example, or allow the property to fall into critical disrepair, the lender may have the right to collect early.
How Much Can You Borrow?
As noted above, an HECM caps lending based on FHA regulations. At time of writing that maximum was $726,525. To borrow beyond that you will need to take out a proprietary loan.
Below the maximum a reverse mortgage is based on several factors, including:
• Value of the home,
• Your age,
• The type of reverse mortgage you are applying for,
• Equity in the house and any outstanding loans against it,
• Current interest rates, and
• The lender’s assessment of your ability to pay property taxes and maintain the home.
The older you are, the higher the value of the home and the less you owe on it, the more money you can get. While income and credit history are generally not an issue with securing an HECM loan, based on these factors your lender may require you to set aside a portion of the loan to pay for property taxes and maintenance.
There are also typically limits to how much you can take from an HECM mortgage in a single year. Even if you choose to take your money in a lump sum, your lender will still calculate a maximum disbursement. That is typically around 60% of the loan amount.
A Note of Caution
If your lender does not arrange for a meeting with an FHA counselor, there is a good chance that this is a scam.
And beware of reverse mortgage lenders trying to push you into a sale. If your lender recommends how you can spend your money, there is a good chance that they are trying to take it away from you. As the Federal Trade Commission writes:
Some reverse mortgage salespeople might suggest ways to invest the money from your reverse mortgage – even pressuring you to buy other financial products, like an annuity or long-term care insurance. Resist that pressure. If you buy those kinds of financial products, you could lose the money you get from your reverse mortgage. You don’t have to buy any financial products, services or investment to get a reverse mortgage. In fact, in some situations, it’s illegal to require you to buy other products to get a reverse mortgage.
Some salespeople try to rush you through the process. Stop and check with a counselor or someone you trust before you sign anything. A reverse mortgage can be complicated, and isn’t something to rush into.
The bottom line: If you don’t understand the cost or features of a reverse mortgage, walk away. If you feel pressure or urgency to complete the deal – walk away. Do some research and find a counselor or company you feel comfortable with.
Be careful when dealing with reverse mortgages.