Reverse Mortgage – How it Works

Reverse Mortgage - How it Works

A reverse mortgage is a popular, but complex, home loan just for senior homeowners. It is an option for older homeowners to supplement their retirement income and still enjoy life in the home they’ve grown to love. The reverse mortgage allows seniors to convert part of the equity in their homes into cash without having to sell their homes or take on additional monthly bills.

 

Article table of contents:

What is Reverse Mortgage?

In a regular mortgage, you make monthly payments to the lender. But in a reverse mortgage, you receive money from the lender and generally don’t have to pay it back for as long as you live in your home. Instead, the loan must be repaid when you die, sell your home or no longer live there as your principal residence. Reverse mortgages can help homeowners who are house-rich, but cash-poor stay in their homes and still meet their financial obligations.

A reverse mortgage is exactly what its name implies – a loan whose features make it essentially the reverse of a traditional “forward” mortgage. Instead of paying your lender, your lender pays you. Instead of reducing your debt as the loan term progresses, you increase it. Instead of turning your income into equity, you turn your equity into income.

The monthly payments you made to pay off your original mortgage generally served a common purpose-to decrease your debt and increase your equity. The payments you receive with a reverse mortgage have exactly the opposite effect-they increase your debt and decrease your equity.

The ability to turn your equity into income is what most distinguishes a reverse mortgage from other loans, and it’s what makes it so valuable to many senior homeowners. Having spent years repaying the mortgage that allowed you to buy your home, you can now tap into that investment to help you achieve your goals later in life. However, you plan to use your equity – whether traveling, paying medical expenses, improving your home or just adding a bit of cushion to your monthly budget – you will have a golden opportunity to put your nest egg to good use.

Reverse mortgages are still largely unknown to many seniors, but they are gaining in popularity. The loans are not for everyone. They require borrowers to shoulder substantial fees, which are not always readily visible since they are built into the loan itself. The amount of cash available to homeowners can also vary greatly, depending on their age, the value of their house, where they live and fluctuations in interest rates.

What Happens to the Home?

Nothing happens to your home, you remain the owner for as long as you live there, and you will never be forced to move. If you decide to sell or move from your home, the outstanding balance of your reverse mortgage will become due, just as it would with a traditional mortgage.

Unlike a traditional mortgage, however, your balance can never exceed the value of your home when you sell it. So no matter how much money you receive through your reverse mortgage, you will never owe more than your home is worth. Having that assurance is important. After all, you’ve put a lot of money into your home, and you should have control over how to take it out.

Who is Eligible for a Reverse Loan?

To be eligible for a reverse mortgage, all owners listed on the home’s title must be at least 62 years of age and occupy the home as their principal residence for the majority of the year. The property must be a single-family or a two-to-four unit dwelling. Townhomes, detached homes, condominium units, planned unit developments (PUDs) and some manufactured homes are eligible.

The mortgage on your home must be fully or nearly paid off. Generally, the amount you can borrow depends on the value of your home, the amount of equity you have in the home and your age at the time of the loan application.

Speaking with an approved reverse mortgage counselor is another important eligibility requirement. The Department of Housing and Urban Development (HUD) supervises counseling agencies that can work with you in person or, more commonly, over the phone.

Three Types of Reverse Mortgages

The three basic types of reverse mortgage are:

  1. Single-purpose reverse mortgages, which are offered by some state and local government agencies and nonprofit organizations. Single-purpose reverse mortgages generally have very low costs. But they are not available everywhere, and they only can be used for one purpose specified by the government or nonprofit lender. For example, to pay for home repairs, improvements or property taxes. In most cases, you can qualify for these loans only if your income is low or moderate.
  2. Federally-insured reverse mortgages, which are known as Home Equity Conversion Mortgages (HECMs), and are backed by the U. S. Department of Housing and Urban Development (HUD). HECMs and proprietary reverse mortgages tend to be more costly than other home loans. The up-front costs can be high, so they are generally most expensive if you stay in your home for just a short time. They are widely available, even if you have no income or medical requirements and can be used for any purpose.
    Before applying for a HECM, you must meet with a counselor from an independent government-approved housing counseling agency. The counselor must explain the loan’s costs, financial implications and alternatives. For example, counselors should tell you about government or nonprofit programs for which you may qualify and any single-purpose or proprietary reverse mortgages available in your area.
    The amount of money you can borrow with a HECM or proprietary reverse mortgage depends on several factors, including your age, the type of reverse mortgage you select, the appraised value of your home, current interest rates and where you live. In general, the older you are, the more valuable your home, and the less you owe on it, the more money you can get. The HECM gives you choices in how the loan is paid to you.
    You can select fixed monthly cash advances for a specific period or for as long as you live in your home. Or you can opt for a line of credit, which allows you to draw on the loan proceeds at any time in amounts that you choose. You also can get a combination of monthly payments plus a line of credit.
    HECMs generally provide larger loan advances at a lower total cost compared with proprietary loans. But owners of higher-valued homes may get bigger loan advances from a proprietary reverse mortgage. That is, if you have a higher appraised value without a large mortgage, then you may likely qualify for greater funds. Location (for example, your neighborhood) is only one part of the determination of appraised value.
  3. Proprietary reverse mortgages, which are private loans that are backed by the companies that develop them.

Reverse Loan Features

Reverse mortgage loan advances are not taxable, and generally do not affect Social Security or Medicare benefits. You retain the title to your home and do not have to make monthly repayments. The loan must be repaid when the last surviving borrower dies, sells the home or no longer lives in the home as a principal residence. In the HECM program, a borrower can live in a nursing home or other medical facility for up to 12 months before the loan becomes due and payable.

 

These are the basic steps and features regarding a reverse mortgage.

  • Borrower seeks information from lender, but must be age 62 to participate.
  • Counseling provides borrower with information on reverse mortgage, including eligibility and other available options.
  • Borrower fills out application, selects payment options, is provided estimated costs of loan and pays for appraisal.
  • An appraiser determines the value and condition of property.
  • If approved, the closing is scheduled. Closing costs and fees incurred can be financed as part of the loan; there is zero to minimal out of pocket costs to you.
  • Borrower has access to the funds according to the option selected.
  • No repayment is made until the home is sold or the owner permanently moves out or passes away.
  • You will never owe more than the value of your home.
  • There is no income qualification.
  • Interest is paid at the time the loan is repaid.
  • When the loan is due, your heirs have choices-they can repay the loan and keep the house, or sell the home and repay the loan.
  • You own your home – the lender does not take control of the title.
  • Interest rates are adjustable and can change periodically; however, this does not affect the amount you will receive.

Getting the Best Reverse Mortgage

If you are considering a reverse mortgage, shop around to compare your options and the offered terms. Learn as much as you can about reverse mortgages before you talk to a counselor or lender. It will help you ask more informed questions, which could lead to a better deal.

  • If you want to make a home repair or improvement or need help paying your property taxes, you may want to find out if you qualify for any low-cost single-purpose loans that may be available in your area. Area Agencies on Aging (AAAs) generally know about these programs. To find the nearest agency, visit www.eldercare.gov or call toll-free, 1-800-677-1116. Ask the AAA for information about available “loan programs for home repairs or improvements,” or “property tax deferral” or “property tax postponement” programs.
  • If you are interested in a federally insured HECM, know that all HECM lenders must follow HUD rules, and that many of the loan costs including the interest rate will be the same no matter which lender you select. Still, some costs including the origination fee, other closing costs and servicing fees may vary among lenders.
  • If you live in a higher-valued home, you may be able to borrow more from a proprietary reverse mortgage. But it generally will cost more. The best way to see key differences between a HECM and a proprietary loan is with a detailed side-by-side comparison of future costs and benefits. Many HECM counselors and lenders can provide you with this important information.
  • No matter which type of reverse mortgage you are considering, be certain you understand all the conditions that could make the loan due and payable. Ask a counselor or lender to explain the Total Annual Loan Cost (TALC) rates, which show the projected annual average cost of a reverse mortgage, including all itemized costs.

Reverse Mortgage Fees

Many of the same costs that someone pays to obtain a home purchase loan, or to refinance their existing mortgage, apply to reverse mortgages too. In most cases, these fees and costs are capped and may be financed as part of the reverse mortgage.

Besides interest, getting a reverse mortgage typically involves four types of fees:

  1. An origination fee. The origination fee covers a lender’s operating expenses-including office overhead for making the reverse mortgage.
    Under the HECM program, which accounts for 90% of all reverse mortgages made in the U.S., the origination fee is equal to the greater of $2,000 or 2% of the maximum claim amount based on county FHA loan limits.Proprietary reverse mortgage borrowers are charged an origination fee that may not exceed 2% of the value of the home. With either product, the entire amount of the origination fee may be financed as part of the mortgage.
  2. Third-party closing costs. These fees are not controlled or determined by the lender, and vary by state. These costs could include:
    • Appraisal fee. An appraiser is responsible for assigning a current market value to your home. Appraisal fees generally range between $300-$400.In addition to placing a value on the home, an appraiser must also make sure there are no major structural defects, such as a bad foundation, leaky roof, or termite damage. Federal regulations mandate that your home be structurally sound, and comply with all home safety codes, in order for the reverse mortgage to be made.If the appraiser uncovers property defects, you must hire a contractor to complete the repairs. Once the repairs are completed, the same appraiser is paid for a second visit to make sure the repairs have been completed. The cost of the repairs may be financed in the loan and completed after the reverse mortgage is made. Appraisers generally charge $50-$75 dollars for the follow-up examination.
    • Flood certification fee. Determines whether the property is located on a federally designated flood plane.
    • Escrow, Settlement or Closing fee. Generally includes a title search and various other required closing services.
    • Recording fee. Fee charged to record the mortgage lien with the County Recorder’s Office.
    • Title insurance. Insurance that protects the lender (lender’s policy) or the buyer (owner’s policy) against any loss arising from disputes over ownership of a property. Cost of title insurance varies by size of the loan, though in general, the larger the loan amount, the higher the cost of the title insurance.
    • Pest Inspection. Determines whether the home is infested with any wood-destroying organisms, such as termites. Pest Inspection. Determines whether the home is infested with any wood-destroying organisms, such as termites.
    • Survey. Determines the official boundaries of the property. It’s typically ordered to make sure that any adjoining property has not inadvertently encroached on the reverse mortgage borrower’s property.
  3. Mortgage insurance premiums. Under the HECM program, borrowers are charged a mortgage insurance premium (MIP), equal to 2 percent of the maximum claim amount, or home value, whichever is less, plus an annual premium thereafter equal to 0.5 percent of the loan balance. The MIP guarantees that if the company managing your account-commonly called the loan “servicer”-goes out of business, the government will step in and make sure you have continued access to your loan funds. Furthermore, the MIP guarantees that you will never owe more than the value of your home when the HECM must be repaid.
  4. Service Fee Set-Aside. The service fee set-aside is an amount of money deducted from the available loan proceeds at closing to cover the projected costs of servicing the reverse mortgage account. Federal regulations allow the loan servicer (which may or may not be the same company as the originating lender) to charge a monthly fee that usually ranges between $30-$35. The amount of money set-aside is largely determined by the borrower’s age and life expectancy. Generally, the set-aside can amount to several thousand dollars.

    Note: The servicing set aside is just a calculation and not a charge. The only amount added to the loan balance is the monthly servicing fee.
    A useful reference for comparing the cost-including interest-of different reverse mortgage programs is the Total Annual Loan Cost (TALC), which expresses all of the loan’s various costs as an annual percentage. This formula serves a purpose similar to that of the Annual Percentage Rate (APR) that is often used to compare forward mortgages.

Reverse Mortgage Payment Plans

Depending on the specific reverse program you choose, you can select one of four options for receiving your reverse mortgage funds:

  1. All at once, in a single lump sum of cash.
  2. As a regular monthly cash advance.
  3. As a “credit line” account that lets you decide when and how much of your available cash is paid to you.
  4. As a combination of these payment methods.

No matter how this loan is paid out to you, you don’t have to pay anything back until you pass away, sell your home or permanently move out of your home.

Reverse Mortgage Interest Rate Adjustments

All reverse mortgages carry adjustable interest rates, but with some programs you can choose a rate that adjusts annually or monthly.

  • Annual rate adjustments are usually capped at two points per year and five points over the life of the loan. On the other hand, they offer a lower maximum loan amount.
  • Monthly rate adjustments offer a larger maximum loan amount, but they usually have no annual adjustment cap, and instead are usually capped at 10-12 points over the life of the loan.

If you choose to receive your reverse funds as monthly cash advances, note that these rate adjustments will not change the amount you receive each month. They only affect the amount of interest that is charged on the total loan balance.

In Considering a Reverse Mortgage Be Aware

Reverse mortgages can dramatically improve the quality of life for many older Americans. But they need to go into the transaction with their eyes wide open.

  • Lenders generally charge origination fees and other closing costs for a reverse mortgage. Lenders also may charge servicing fees during the term of the mortgage. The lender generally sets these fees and costs.
  • The amount you owe on a reverse mortgage generally grows over time.Interest is charged on the outstanding balance and added to the amount you owe each month. That means your total debt increases over time as loan funds are advanced to you and interest accrues on the loan.
  • Reverse mortgages may have fixed or variable rates. Most have variable rates that are tied to a financial index and will likely change according to market conditions.
  • Because you retain title to your home, you remain responsible for property taxes, insurance, utilities, fuel, maintenance and other expenses. So, for example, if you don’t pay property taxes or maintain homeowner’s insurance, you risk the loan becoming due and payable.
  • Increasing your debt may not seem like a wise financial strategy at first-indeed, it isn’t for everyone-but your reverse mortgage debt is different from most other kinds. Usually, taking out a loan means you must commit to repay it using money that you will earn in the future-in other words, using money that isn’t guaranteed.
  • Non-recourse Loan. When you take out a reverse mortgage, on the other hand, you are guaranteed to have the money to pay it off because the loan is based on the equity you already have in your home. That’s because a reverse mortgage is what is known as a non-recourse loan, which means that your home is the lender’s only recourse to collect on the debt. None of your other assets are affected. Only when you sell or move from your home, or when you pass away, will the lender be able to collect on the debt, and if the home’s value is less than the outstanding balance, you will not owe a single dollar of the difference. On the other hand, if you sell the home for more than the loan balance at that time, you or your heirs will keep the difference.
  • Talk to a counselor. Seniors considering a federally funded reverse loan, called a Home Equity Conversion Mortgage, are required to talk it over with a counselor. The US Department of Housing and Urban Development maintains a list of all counselors. Older American advocacy groups such as AARP also have lists of counselors. (www.AARP.org and search “reverse mortgage.”)Websites with calculators to give seniors an idea of how much money they’ll be able to borrow with a reverse mortgage are available on the Internet.
    This is an important new financial tool for many people, but it is essential that the inner workings of the transaction be clearly understood.
  • Financial security. You may already have plans for how you want to use your reverse mortgage proceeds. But it’s wise to remember all the work that’s gone into building up those funds, and how important they are to your financial security–particularly if your home is your largest remaining financial asset.
    Of course, there was a reason you sought a reverse mortgage in the first place.Whether it was to improve your home, supplement your income or pay for medical expenses, the important thing is that you decided to use your equity to improve your lifestyle and stay in your home. As long as you manage your money wisely and keep your goals in mind, your reverse mortgage will help you do just that.
  • How much of your home’s equity will be left after repaying the loan depends on many factors: the size and frequency of your loan advances, increases or decreases in your home’s value, future interest rates and others. Because so many variables are involved, no estimate will be absolutely certain. But a reverse mortgage counselor or specialist can help you estimate your leftover equity as accurately as possible, based on how and when you plan to use your loan proceeds.
  • Consider your heirs. Whether you tap into your home equity with a reverse mortgage or through some other financing program, the more of that equity you spend now, the less will be left for your heirs. That’s why it is important to think about how you want to involve your children or other loved ones in the process.
    Often, the adult children of senior borrowers are happy to see their parents continue living in their homes, and relieved to know that they are financially secure.
  • Tax and public benefit considerations. The IRS currently treats reverse mortgage proceeds as loan advances rather than as taxable income. You may encounter tax implications if you use the funds to purchase an annuity, however, so you should check with your tax advisor regarding your vulnerability.
    Proceeds from a reverse mortgage will have no affect on Social Security orMedicare benefits because they are not need-based. Benefits such as SSI and Medicaid, however, may be affected if you carry any of your reverse funds over from one month to the next. You should check with your local benefits program administrator to find out if you are in danger of becoming ineligible.
  • Be cautious if anyone tries to sell you something, like an annuity, and suggests that a reverse mortgage would be an easy way to pay for it. If you don’t fully understand what they’re selling, or you’re not sure you need what they’re selling, be even more skeptical. Keep in mind that your total cost would be the cost of what they’re selling plus the cost of the reverse mortgage. If you think you need what they’re selling, shop around before you buy.
  • Three days to reconsider. No matter why you decide to take a reverse mortgage, you generally have at least three business days after signing the loan documents to cancel it for any reason without penalty. Remember that you must cancel in writing. The lender must return any money you have paid so far for the financing.

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