How Does a Reverse Mortgage Work?

Retirement - something we all look forward to and have been preparing for our entire working-bee lives. Still, people often find themselves needing more funds even in retirement due to the ever-changing economy and living costs. Luckily, senior homeowners don’t have to worry - there are solutions for those needing additional funds to enjoy their retirement to the fullest.

One of those is the reverse mortgage option. These are excellent solutions for covering many unforeseen expenses seniors might experience and putting their minds at ease regarding money. So, what do these solutions entail, and how do they work? Let’s uncover the answers to these questions so you can be thoroughly informed before getting such a loan.

What Is a Reverse Mortgage?

A reverse mortgage is a type of loan available to senior homeowners. The main requirements are that the borrower must be no less than 62 years old and have enough home equity. If these conditions are met, you can borrow against the value of your home and get funds as a lump sum, line of credit, or fixed monthly payment.

Unlike your regular mortgages or situations where you take a personal loan to purchase a house, here you would take a loan with your home as a form of collateral to fund other expenses.

What Is Home Equity?

Home equity is the difference between your home’s current worth and what you still owe on the mortgage. Let’s say your house is worth $20, and you still owe $5. That means you have $15 equity in your home. The equity commonly rises if your home’s value increases, and it also rises as you keep paying off your mortgage debt.

Loans based on home equity are some of the most popular solutions for getting the needed funds. 

How Reverse Mortgages Work 

The way a reverse mortgage works is typically the opposite of a regular mortgage - instead of the borrower making payments to the lender, the lender pays the borrower. 

When you take such a loan, you can choose how you will receive these payments. It typically depends on the specific reverse mortgage type you opt for. Ultimately, your house is used as collateral, and the loan borrower only pays the interest on the loan - which is included in the overall balance, so there are no upfront costs.

The homeowner taking the loan also gets to keep the title to the house. 

If the homeowner decides to move, the proceeds from the sale will be used to repay the principal, interest, and any other fees, and the homeowner gets to keep the rest. If the homeowner dies, the heirs may choose to pay these expenses, in which case they become its owners.

The Three Types of Reverse Mortgages

These mortgages come in three shapes: single-purpose reverse mortgages, federally insured reverse mortgages, and proprietary reverse mortgages. Let’s discuss them in more detail to help you get an idea of which one would fit your needs.

Single-Purpose Reverse Mortgages 

These represent the most limited but also the least expensive option. As the name suggests, you can use them for only one purpose, which the lender specifies. Typically, the lenders are local or state government agencies or non-profit organizations, and these loans are usually intended for low- or moderate-income homeowners.

Federally-Insured Reverse Mortgages

Known as home equity conversion mortgages (HECM), this type is the most common of the three types. It is generally backed and supervised by the US Department of Housing and Urban Development. 

Unlike the previous option, HECM has higher upfront costs and is typically more expensive overall. However, it carries no income-based restrictions, and there are no limits on how you can spend your money.

When applying, you’ll get a counseling session during which you can seek advice from an expert on whether this solution is right for your needs. Then, you’ll find out how much you can borrow, depending on current interest rates, the value of your home, and your age. Typically, you’ll also need to have at least 50% of home equity to qualify for the loan.

With HECM, you can choose one of the five options for getting the proceeds: 

1. Lump sum - All the proceeds when the loan closes; fixed interest rates. 
2. Tenure plan - Equal monthly payments for as long as the borrower lives there; adjustable rates.
3. Term payments - Monthly payments over a set period; adjustable rates.
4. Line of credit - Money is available on an as-needed basis; flexible rates
5. Term/monthly payments and a line of credit - a combination of the second/third and the fourth option; flexible rates.

Proprietary Reverse Mortgages

This type of loan is typically used for a more significant advance and is considered for high-value home appraisals. These solutions are not federally backed, and they don’t include monthly mortgage insurance premiums.

However, whether one would get more with this type of loan depends mostly on the lender, as they might ask for higher interest rates and lend less to make up for the lack of insurance. 

Things to Consider

There are a couple of things to keep in mind when considering taking this type of mortgage.

Loan Proceeds Are Tax-Deductible, Interest Isn’t

Even though the IRS does not count loan proceeds as taxable income, the interest isn’t tax-deductible.

You Will Owe More Over Time

Interest never sleeps - it constantly accompanies the balance that you still owe on your loan. As a consequence, the outstanding balance keeps growing every month. 

Interest Can Change

This aspect typically depends on the type of loan you take, but variable-rate loans can come with a higher sum you can borrow. Variable reverse mortgage rates are tied to a financial index and will change with the market, but they give you more options for getting your money. 

There Are Fees and Additional Costs

As with other loans, you should calculate any additional fees up front. Lenders generally charge origination and closing costs, servicing fees, and occasionally mortgage insurance premiums. You should get familiar with all the prices beforehand so that there are no unwelcome surprises once you sign up.

You Still Have To Cover Your House’s Expenses

As mentioned before, you keep the title to your home, so it’s your responsibility to ensure that the house is in excellent condition and that all the expenses are paid, including property taxes, home insurance, and more.

Some lenders might require you to give back the loan if you fail to meet these requirements. In addition, all lenders will perform a financial assessment and may require a “set-aside” amount to be used to pay certain tax and insurance expenses. 

Associated Fees

There are plenty of fees involved in getting this type of mortgage. The up-front premium fee currently stands at 2%, and all borrowers must pay annual insurance premiums of 0.5% of the amount borrowed. 

The origination fee is also included, usually costing 2% of the first $200,000 and 1% of the remaining value. These rules, set up by the Federal Housing Administration, also state that this type of fee cannot surpass $6,000. Some lenders may omit the origination costs completely. However, they will usually require a monthly servicing fee, which is typically up to $35 monthly. 

You should also prepare for appraisal expenses, which generally cost between $300 and $500 and are used to pay an appraiser’s services for determining your home’s worth. There is also a closing fee, ranging from $150 to $800, document preparation fees, and credit report fees. 

Pros and Cons of Reverse Mortgages

There are advantages and disadvantages to any significant financial decision, and a reverse mortgage loan is no different. Therefore, it is recommended to consult a financial advisor first and go with a reputable reverse mortgage company. To give you a general idea, though, we’ve outlined some of the positive and negative aspects of this loan that you should factor in before applying:

Pros

• You gain access to your home equity without having to sell the house.
• Your name stays on the title, meaning you remain the homeowner, and you can leave the house to your spouse/children. 
• Typically, there are no restrictions on how you can spend the proceeds.
• There is no credit score requirement for these loans. 
• A decline in home values won’t affect your loan, as it’s considered a non-recourse debt. 

Cons

• A reverse mortgage decreases equity and increases debt.
• Interest can accumulate over time.
• It might cost your heirs to take ownership of the home. 
• The loan can come due if the house is not your primary residence for longer than six months. 
• You have to repay the loan to move out.
• You need to keep paying property taxes such as homeowners insurance. 

Avoiding Scams and Foreclosure

As mentioned before, many unscrupulous lenders will turn this excellent opportunity into a payday for them and a chance to take homeowners’ money without providing anything in return. 

Considering it’s the seniors who are eligible for such loans, it is essential to have a trustworthy advisor by your side when applying for a reverse mortgage loan and be wary of offers that sound too good to be true. 

Another thing to avoid is foreclosure. While you cannot become delinquent on your mortgage payments, you will have to meet certain conditions. As we’ve mentioned in the Cons section above, you should pay your property taxes and homeowners insurance to avoid foreclosure. Also, you’d need to continue living in that particular home and keep it in good condition.