Paying off your mortgage is a worthy goal and living in a home you own outright provides valuable security. But for many, tapping the equity in their homes is a necessity, especially during retirement.
Because of this, an unusual type of loan called a reverse mortgage is gaining in popularity. It allows homeowners 62 or older with equity in their homes to receive cash payments off that equity, with no repayment required until the home is sold or they no longer live there. Moreover, they’re basically guaranteed this income as long as they remain in the home, even if that income eventually exceeds their home’s worth.
There are several different types of reverse mortgage programs, but the most common by far is the federally insured Home Equity Conversion Mortgage (HECM). Private companies and some nonprofit agencies also offer reverse mortgages, which are generally similar to the loans offered under the federal HECM program. However, private company mortgages have almost become obsolete in the wake of the mortgage crisis.
How Reverse Mortgages Work
A reverse mortgage allows you to convert the equity in your home into payments from the bank. Essentially, the bank lends you this money and uses your home as collateral on the loan. Each payment is added to your loan balance and when you decide to move or no longer use the home as your primary residence, the loan comes due. Most commonly it is repaid with the sale of your home and typically no payments are required until this time.
You begin receiving payments or accessing a line of credit right away and payments are based off your age and may vary with current interest rates. Payments can also be guaranteed until you leave the home, even if you end up borrowing more money than can be repaid by its sale. In this case, most reverse mortgage contracts do not allow the lender to pursue you or your estate for any unpaid balance in excess of the sale price.
Who Can Take Out a Reverse Mortgage?
You can only take out a reverse mortgage if you own your home, use it as your primary residence, and are at least 62 years old. The property can be a single family home, a condo, a manufactured home, or a multi-unit building (up to 4 units) as long as you live in one of the units. You must either own your home outright (no mortgage) or have a small mortgage balance that can be paid off through the reverse mortgage.
For example, if you owe $40,000 on your primary mortgage and qualify for a $100,000 reverse mortgage, the reverse mortgage can pay off the primary loan and leave you access to $60,000. Because you are still the owner of the home, you must continue to make property tax payments and carry homeowners insurance.
Different Payment Options
Reverse mortgages can be set up in various ways, depending on your needs. Most banks will also permit you to change your payment option for a small fee after payments have begun.
- Monthly Check. The most common reverse mortgage payment is a monthly check, which can vary based on several factors (see below). You can choose to receive monthly payments for a fixed period of years or for as long as you live in the home.
- Line of Credit. Another popular option is a line of credit - you can draw on this line of credit until it is exhausted. But unlike a home equity line of credit, you won’t have to make payments until you sell the home.
- Both Monthly Check and Line of Credit. Alternatively, you can choose to both receive a monthly payment and have access to a line of credit. However, both the payments and credit limit will be smaller.
- One-Time Lump Sum. Some lenders will also allow you to receive a one-time lump sum with no further payment or line of credit. This option is frequently used to pay off an existing mortgage (i.e. so that the homeowner no longer has any mortgage payments to make) or when homeowners wish to undertake a large, one-time home renovation.
How the Monthly Payment Is Calculated
If this option is selected, the amount you receive can vary widely depending on several factors, including:
- Age of the Borrower. While the homeowner must be at least 62 years old, the payment amount will go up with the homeowner’s age. If more than one person is on the loan, the amount will be based on the younger person’s age.
- Value of the Home. The more equity you have in your home, the more confident the bank feels that they will see a return on their investment. This, in turn, means that your payment will be larger. However, you may not be able to use the full value of your home as the FHA limits the size of reverse mortgages based on your appraisal and location.
- Mortgage Insurance Premium. A reverse mortgage, like many traditional mortgages, requires you to pay private mortgage insurance. This is in case you end up owing more on the reverse mortgage than the home is worth. You will need to pay a mortgage insurance premium in a lump sum up front when you close. This is based off of the home’s value or the FHA mortgage limit, whichever is less. You can choose to pay a 0.1% premium or a 2% premium, depending on what kind of payout you want. If you pay the 2% premium, you will be able to borrow more and have a larger monthly payment than if you pay the 0.1% premium. Keep in mind, you will also be charged 1.25% of your current loan balance for mortgage insurance each year, which is generally added onto the loan balance.
- Current Interest Rates. Some reverse mortgages are based on a fixed interest rate, but many are variable and the payment you receive each month may fluctuate. In this case, the rate is based on an index, such as the LIBOR, and when the index goes up, your monthly check will be bigger.
Reverse Mortgage vs. Home Equity Line of Credit
A careful examination of your situation can determine whether you’ll be better served by a reverse mortgage or a home equity line of credit. For most, the largest drawback to a reverse mortgage is the high closing costs. Though a HELOC typically has much lower closing costs, it does require that you begin paying back the loan before you sell your home.
Generally, if making payments would be a burden, or if you will need a larger amount of money over time, or if you would like a guaranteed income stream throughout your retirement, a reverse mortgage is probably the better bet. However, if you have the income to make payments and have a one-time or short-term need for a large amount of cash, you may be better off with a home equity line of credit.
Below, we’ll consider how different aspects of both the HECM reverse mortgage and HELOC compare:
- Reverse Mortgage: You don;t have to repay any money you receive until the home is sold or you no longer live there.
- HELOC: Usually, you need to begin payments within ten years.
- Reverse Mortgage: Rates are generally better than a HELOC, but interest is not deductible until the year the home is sold.
- HELOC: Interest is deductible in the year you pay it, up to certain limits, but rates are higher than a reverse mortgage.
- Reverse Mortgage: Closing costs are steep, generally $5,000 to $10,000. They are much higher than for a traditional mortgage, especially if you want to borrow more money and choose to pay the higher mortgage insurance premium.
- HELOC: Closing costs are lower, generally $2,000 to $4,000.
- Reverse Mortgage: You will be charged a mortgage insurance premium of 1.25% of your loan balance each year, which is usually added to the loan balance and must be paid when the home is sold.
- HELOC: Other than closing costs and interest, you are usually not charged ongoing fees.
- Reverse Mortgage: There is no upper limit to the monthly payment; it is determined as above according to your age, the value of your home, and current interest rates. If using a line of credit, the amount available is higher than a HELOC.
- HELOC: The amount you can access either in a lump sum or as a line of credit is generally lower than a reverse mortgage.
When You Sell
- Reverse Mortgage: If the loan exceeds the sales proceeds from your home, the lender cannot go after your or your heirs’ assets.
- HELOC: At the time of sale, your primary mortgage will be paid first and the HELOC will be paid with whatever is left. If the sale does not pay off both the primary mortgage and the HELOC, the bank may go after your income and other assets for the remainder of the loan balance.
- Reverse Mortgage: You are required to undergo a financial counseling session before applying for a reverse mortgage. The fee for this session is usually about $125. However, it can be paid from loan proceeds or you may have the fee waived if you cannot pay.
- HELOC: No counseling is required.
Beware of Fraudsters
Unfortunately, many companies prey on older people and companies offering reverse mortgages are no exception. Reverse mortgages that adhere to the federal HECM guidelines are limited in what they can charge for some fees, such as origination fees. However, that doesn’t necessarily stop them from tacking on excessive fees elsewhere in the closing costs.
It’s very important to review the loan documents carefully, preferably with a financial professional like an elder law attorney, to ensure that you are getting the loan at a fair price. Also, some companies attempt to force their customers into purchasing other products, such as annuities or life insurance, in order to get the mortgage. This is not required and is probably illegal in your state.
Another common sales pitch is for home repair companies to suggest extensive, costly home improvements and then pressure you to pay for them with a reverse mortgage provided by a bank they work with frequently. Even if you do need the home repairs, this is a sign of shady dealings. Legitimate home improvement companies will give you estimates without trying to “help” you afford them!
Do not sign financial paperwork without having it reviewed by a neutral financial professional or attorney, especially if it was given to you by a home improvement company. If you decide to pursue a reverse mortgage, shop around and apply with other banks. You are absolutely not required to use the bank suggested by the home improvement company. In fact, you may want to also seek estimates from other home improvement companies regarding the recommended upgrades to your home.
Pros & Cons: Is a Reverse Mortgage Right for You?
A reverse mortgage can be a wonderful tool to help you tap the equity in your home, but due to its cost and complexity, it’s not right for everyone.
- You Don’t Have to Pay It Back Until You Leave the Home. Living on a fixed income means little room for extra bills. Adding the extra money from a reverse mortgage can help raise your income without then adding the stress of trying to figure out how to pay it down later.
- You Won’t Run up a Bill You Can’t Pay. The bank is only permitted to be repaid with the equity in your home. If you end up receiving more in monthly payments than your home is worth, the bank won’t go after your other assets or your heirs’ assets.
- Your Payments Are Guaranteed. If you choose the monthly payment option, the bank must continue sending you that monthly check as long as you live in the home. They can’t cut off your income stream unless you no longer live in the home or you sell it.
- Your Heirs May Have to Sell Your Home to Pay off the Loan. Unless your heirs can come up with the money to pay off the reverse mortgage, the bank can actually foreclose on the home and sell it. So if your home has been in the family for a long time, or you’re absolutely sure you want to pass it down, this may not be the best option.
- The Costs Are Not for the Faint of Heart. Because setting up a reverse mortgage can cost up to $10,000, it’s not a good idea if you only want to take out a little money. Make sure that this is the right move for your financial future before handing over a big fat fee. There’s also additional fees each year that add to your loan balance, unlike HELOCs or other types of credit products which generally just charge interest.
Reverse mortgages can be a great product to help older homeowners tap home equity and supplement their incomes for as long as they live in their homes. But due to their cost, they may not be a good fit for those with shorter-term needs or those who don’t plan to stay in their home for a long time. Many homeowners use their reverse mortgage checks to supplement their pensions or Social Security income and are, therefore, able to stay in their homes longer and enjoy a more comfortable retirement.
However, using a reverse mortgage depletes the equity in your home and if the balance is large enough, very little or no equity may be passed on to your heirs. Because these products and the population they are aimed at are frequent targets of fraud, make sure to have all paperwork reviewed by a qualified professional before signing.
Have you ever gone through the process of getting a reverse mortgage? What was it like, and would you do it again?
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