How Does a Reverse Mortgage Work?

What Is a Reverse Mortgage?

A reverse mortgage is a type of home loan that allows homeowners 62 and older to tap into their home equity. To qualify, borrowers need to own their homes outright or have substantial equity.

Reverse mortgages may be helpful for seniors who are living on a pension or Social Security without much other retirement income. As health care and cost of living expenses rise, their fixed income may not keep pace with their financial needs.

How a Reverse Mortgage Works

As its name suggests, a reverse mortgage allows you to use your existing home's equity as collateral for a new loan rather than borrowing money to buy a home—similar to a home equity loan or a home equity line of credit (HELOC).

But unlike a home equity loan or HELOC, you don't have to make monthly payments to pay off the reverse mortgage loan. Instead, the lender takes payment from the outstanding equity when the borrower moves; dies; becomes delinquent on property taxes, homeowners association (HOA) fees or insurance; or doesn't maintain the home's condition.

When applying, borrowers can choose from three distribution options:

• Lump sum
• Fixed monthly payment for a predetermined period
• Fixed monthly payment for as long as you remain in the home
• A line of credit you can draw upon when needed

You can also opt for a combination of a credit line and monthly payments. You'll typically get more money if you choose the fixed payment over a set period. How you can use your funds may be limited based on the type of reverse mortgage you get.

Reverse Mortgage Requirements

The requirements for getting a reverse mortgage can vary depending on which type of loan you choose. However, the most popular type is the home equity conversion mortgage (HECM), which has the following requirements:

• The home: The home must be your primary residence, and you must either own it outright or have substantial equity in it. The property must also meet Federal Housing Administration (FHA) standards and flood requirements and be either a single-family home, a manufactured home, a condominium approved by the Department of Housing and Urban Development (HUD) or a two- to four-unit home with the borrowers living in one of the units.
• Borrowers: Borrowers must be 62 or older. There's generally no minimum requirement for income and credit scores, but lenders will review your credit reports. Lenders will also typically look for your payment history on mortgages, revolving credit and other loans, collections, charge-offs, judgments or delinquent federal debt and bankruptcies. You'll also need to meet with a HUD-approved HECM counselor to discuss the reverse mortgage.
• After approval: Borrowers must be able to pay the expenses associated with the home, such as property taxes, HOA fees and homeowners insurance, without the assistance of the loan. Additionally, homeowners must maintain their home to avoid having it fall into disrepair.

Types of Reverse Mortgages

There are three different types of reverse mortgage loans from which you can choose. Here's how they work:

• Home equity conversion mortgage: This most popular type of reverse mortgage also offers the most flexibility. HECMs are insured by the FHA and are limited to a maximum of $970,800 in 2022. The proceeds of the loan can be used for any purpose you want. You may even be able to use HECM funds to purchase a new home, albeit with a significant down payment.
• Single-purpose reverse mortgage: Nonprofit organizations or state and local government agencies sometimes offer this type of reverse mortgage. The lender restricts the purposes the mortgage proceeds can be used for. For instance, you might be able to use a single-purpose reverse mortgage only to pay your property taxes or to make improvements to the home.
• Proprietary reverse mortgage: If your home is worth more than the HECM limit, or if your home doesn't meet the FHA standards for a HECM, you may want to look into a proprietary reverse mortgage. Offered by private lenders, these loans can be used for any purpose, and there's no limit on the amount you can borrow.

Pros and Cons of Reverse Mortgages

As with any financial product, reverse mortgages have both advantages and disadvantages to consider before applying. Here's what to think about.

Pros

• Less pressure on your budget: Many seniors don't have enough income to qualify for or repay loans that require immediate repayment, such as a home equity loan or HELOC. A reverse mortgage allows you to get the money you need while delaying repayment.
• No need to move: Another way to get the equity out of your home is to move, but if you don't want to find a new place to live, a reverse mortgage lets you stay put as long as you meet the requirement of keeping current on property taxes, homeowners insurance, HOA fees and other associated home expenses to keep the home in good condition.
• The income isn't taxable: Because the IRS classifies the payouts as a loan advance, a reverse mortgage offers tax-free income in most cases (although you should always consult a tax professional to be sure how taxes apply in your situation).

Cons

• Loan costs: During the application process, you'll need to pay for an appraisal, loan origination fees, servicing fees and other closing costs. If you still have a primary loan, you'll still need to make that payment, as well as property taxes, HOA fees and insurance.
• You could lose your home: If you don't keep up on the required expenses and maintenance of the home, or if you don't live in the home for 12 or more months for health-related or other reasons, the lender may foreclose on the property.
• Your heirs will need to pay to keep the home: If your loved ones want to keep the home after you die, they'll need to pay off the reverse mortgage or refinance it with a new mortgage loan. Alternatively, they can sell it and keep the difference or, if the loan balance exceeds the home's value, leave it to the lender.
• All borrowers must meet the age requirement: If one spouse is under age 62, they may have to be removed from the property deed for the older owner to qualify for a reverse mortgage. Removing their name on the title can put the non-borrower spouse at risk. If the borrower dies, the non-borrower will no longer receive reverse mortgage disbursements. Worse, they could lose their home if they can't pay off the loan.

Learn more >> Can You Inherit Debt?

Should I Get a Reverse Mortgage?

Because reverse mortgages eat into your equity and increase your total debt, they aren't always an ideal financial move. That said, reverse mortgages can also be a valuable tool for seniors who want to improve their financial stability in retirement.

A reverse mortgage may be a good fit if:

• You're 62 years or older
• You live in your home the majority of the time
• You have substantial equity
• You plan to stay in the home for a long time
• You have the funds to keep up with home expenses, such as repairs, taxes and insurance
• You've weighed and discussed how a reverse mortgage will impact your heirs

If this describes the situation you're in, a reverse mortgage could be a good choice. However, if you're not sure about the potential risk of losing your home by not following the lender's requirements, you may want to explore other alternatives, such as:

• Refinancing
• Getting a home equity loan or HELOC
• Selling your home

Learn more >> How to Use Your Home Equity for Retirement Income

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