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What Is a Reverse Mortgage (HECM) – How It Works, Pro & Cons

Many older adults struggle to make ends meet each month. At the same time, they often own thousands of dollars of real estate equity in their home. Meanwhile, their mortgage payment adds to their monthly living expenses.

If you or your parents are “house-rich” but cash-poor, a reverse mortgage could solve several cash flow problems for you. But they don’t make sense for everyone, and you should understand their pros and cons before moving forward with one.

What Is a Reverse Mortgage Loan?

Reverse home mortgage loans supply money to older homeowners, and the homeowner doesn’t have to make monthly payments on them.

How It Works

Designed for retirees, reverse mortgages allow older homeowners to tap their home equity without the cash flow pinch from monthly payments.

Homeowners have some flexibility in how they draw the loan money. You can take out a lump sum up front, or receive monthly payments from the lender, or use the reverse mortgage as a line of credit like a home equity line of credit (HELOC). You do not pay income taxes on the money you borrow, just like any other loan.

The lender places a mortgage lien against the property. Upon sale of the property or the death of the homeowner, the loan must be repaid in full. In many cases, the lender receives ownership of the property upon the death of the homeowner. However the lender cannot pursue the homeowner or their estate for a deficiency judgment if the sale of the property fails to produce enough money to cover the loan in full. The homeowner or their heirs can also pay off the loan at any time and keep the house.

As part of the contract, you can continue living in the property for the rest of your life, without making monthly payments.

Lenders don’t give out money for free of course. They still charge interest on the loan, but it comes out of the payments they send you, rather than being added to a monthly payment you send them. If you elect to receive your loan in the form of monthly payments or a credit line, the interest rate is variable rather than fixed.

Expect to also pay an upfront origination fee, more commonly known as points.

Reverse Mortgage Example

Imagine you own a home worth $300,000, and your existing mortgage is only $100,000.

A lender offers you a reverse mortgage of $150,000. Using the proceeds of the new loan ($150,000), you pay off the existing mortgage of $100,000, leaving excess proceeds of $50,000.

You then elect to receive payment in one of the following ways:

  1. Take the $50,000 in cash as a lump sum payment immediately at closing. You can spend it or invest it as you see fit. Again, there are no tax consequences.
  2. Take the $50,000 in a series of monthly payments from the reverse mortgage lender. With every payment the bank sends you, your loan balance goes up: the reverse of a traditional mortgage loan. If you live long enough to receive all $50,000 in payments, the monthly payments end.
  3. Take the $50,000 in the form of a line of credit that you can draw upon at any time. Like other HELOCs, you pay interest based on your current balance.
  4. Take the $50,000 in a combination of the above options.

You are never required to make principal or interest payments on a reverse mortgage loan.

How Reverse Mortgages Differ From Traditional Mortgage Loans

Reverse mortgages feel counterintuitive because they work in the opposite direction of traditional mortgage loans. Keep these unusual characteristics of reverse mortgages in mind as you consider them.

Credit History Doesn’t Matter

Your credit report and financial condition don’t factor into the underwriting or interest rate of the loan.

It’s not like you need to make payments!

The Lender Gets Repaid at the End of the Loan Term

Because you don’t make mortgage payments, the lender recovers their principal when you move out, sell the property, or die.

By contract, you can remain in the property as long as you live in the property as your principal residence.

You Can’t Keep a Reverse Mortgage If You Convert Your Home to a Rental

Some retirees use rental properties as a source of passive income in their golden years. And it occurs to many that by taking out a reverse mortgage on their home and moving out, they could kill three birds with one stone: remove their monthly mortgage payment, pull equity out, and collect rental income from the property.

Sadly, lenders don’t allow you to move out of your home without paying off your reverse mortgage balance in full. If you do so, you violate the terms of your loan, and the lender can call the loan.

Traditional mortgage loans do allow you to move out without paying off your balance — as long as you live in the property for at least one year before moving.

Lower LTVs than Traditional Mortgages

Traditional loans come with an exact schedule for repayment, called the amortization schedule. Consequently, some lenders loan up to 100% of the property’s market value — the loan-to-value ratio (LTV).

Reverse mortgage lenders don’t know when they’ll recover their principal. So, they lend lower LTV ratios, typically ranging between 50% and 65%.

The Older the Youngest Borrower, the Greater the LTV

Lenders use the actuarial life expectancy of the youngest borrower as the basis for estimating the term of the loan. However, the loan does not mature until the last living owner dies or moves out of the home. If the borrower dies sooner than expected, the loan principal becomes due at that point; if the owner lives longer than the actuarial tables project, the loan continues until the borrower’s death.

Reverse Mortgage Loan Programs and Eligibility

Homeowners have far fewer options for a reverse mortgage than traditional mortgage loans.

In fact, most reverse mortgage borrowers go through the Federal Housing Administration’s (FHA’s) loan program. But don’t be surprised to see more innovation and options for reverse mortgages in the coming years.

FHA’s Home Equity Conversion Mortgage

The most popular reverse mortgage program is FHA’s Home Equity Conversion Mortgage (HECM) loan program.

It comes with the following eligibility criteria:

  • Borrowers must be age 62 or older.
  • The purchased home must be the primary residence of the borrowers.
  • The property must be a single-family home, 2- to 4-unit multifamily, or an FHA-approved condominium.
  • Borrowers must complete a U.S. Department of Housing and Urban Development (HUD) approved counseling session to ensure they understand the financial costs and legal requirements of the HECM loan.
  • Borrowers must have the financial capability to pay mandatory expenses such as property taxes, homeowners insurance, and normal maintenance.

The maximum mortgage loan allowed under the HECM program is $822,375 as of 2021.

As an FHA loan, it comes with a mortgage insurance requirement, despite the low LTV. Expect to pay an upfront fee of 2% of the loan balance: $2,000 for every $100,000 borrowed. Plus, borrowers must pay ongoing monthly payments toward FHA’s mandatory mortgage insurance premium (MIP), amounting to 0.5% of the original loan balance per year.

Not all conventional mortgage lenders offer HECM loans. You may need to shop around to find local lenders or brokers who can close these loans for you.

Finance of America Reverse’s EquityAvail Program

A more recent addition, specialist lender Finance of America Reverse has started offering a hybrid reverse mortgage program called EquityAvail.

The program gives borrowers a lump sum payment upfront, and then for the next 10 years the borrower makes monthly payments to the lender, albeit smaller ones than a traditional mortgage loan. After 10 years, the monthly payments cease, and the borrower lives payment-free until they move out, sell the property, or kick the bucket.

EquityAvail offers several distinct advantages over the more typical HECM loans. First, it doesn’t require borrowers to pay mortgage insurance. Second, it allows slightly younger borrowers, starting at age 60, because borrowers do make payments for the first 10 years.

These sorts of hybrid reverse mortgages may become more popular in the coming years, as baby boomers continue retiring in record numbers.

Advantages of Reverse Mortgages

Reverse mortgage loans come with plenty of pros for retirees. Consider the following as you evaluate whether a reverse mortgage fits your cash flow and estate planning needs.

  • No Monthly Payments: As long as you live in the property, you don’t need to make monthly payments. That can slash your living expenses significantly.
  • You Can Stay Forever: Reverse mortgage loans do not have a fixed term, but come due only upon move-out, death, or sale of the property.
  • Non-Recourse: Neither you nor your estate are at financial risk if the home drops in value and becomes upside-down. The lender can’t pursue you or your estate for a deficiency judgment if they don’t receive the full payoff amount.
  • Pay Off Any Time: You and your estate both have the option to repay the reverse mortgage loan and retain house ownership at any time. The lender doesn’t “automatically” become the owner of the property upon your death.
  • Bad Credit Allowed: Lenders don’t consider your credit among the criteria for issuing a reverse mortgage loan. A personal bankruptcy or other black marks on your credit do not affect the reverse mortgage status as long as you meet the other loan requirements.
  • Flexibility: You can draw your equity in the form of a lump sum, monthly payments for a set term or amount, as a line of credit, or a combination of all three.

Risks and Downsides of Reverse Mortgages

All financial products have risks and downsides. If they didn’t, everyone would use them!

Make sure you understand the potential drawbacks of reverse mortgages before signing on the dotted line.

  1. Residence Requirement: To qualify for a reverse mortgage, you must live in the property. You can’t move out and keep the property as a rental like you can with traditional mortgages. Nor can you move into a nursing home and retain the property without paying off your reverse mortgage.
  2. Low LTV: Lenders limit the loan-to-value ratio to extremely low levels, typically 50% to 65%. That’s the downside of a non-recourse loan: lenders don’t take any chances on the loan becoming upside-down.
  3. Age Restriction: Only borrowers age 62 or older qualify for an HECM reverse mortgage.
  4. Limited Interest Tax Deduction: Borrowers can’t deduct the interest on the reverse mortgage until they pay off the loan. For many, that occurs only after death, which is not particularly useful to them. But with the standard deduction so much higher after the Tax Cuts and Jobs Act of 2017, fewer Americans itemize their taxes, so this downside affects fewer taxpayers than it once did.
  5. Mortgage Insurance: Borrowers using the HECM program must pay FHA’s mortgage insurance premium of 2.0% of the loan amount upfront, and 0.5% of it each year forever.
  6. Mandatory Counseling: Borrowers require HUD-approved financial counseling before approval.
  7. Few Lending Options: Not many lenders offer reverse mortgage loans, and there are even fewer loan program options available.
  8. Scams: Sadly, older people are often targeted by financial scams, often by family members, caregivers, or financial advisors. For example, family members or caregivers may use their power of attorney to take out a reverse mortgage, then pocket the loan proceeds. Or financial advisors may sell them products like annuities that the senior can only afford by taking out a reverse mortgage — potentially even taking an illegal kickback from the mortgage lender.

When Reverse Mortgage Lenders Can Foreclose

Although borrowers don’t actually make monthly payments to the lender in most cases, nonpayment isn’t the only reason a lender can foreclose.

Borrowers must continue paying for property taxes and homeowners insurance. Failure to do so constitutes a breach of the mortgage note. Although lenders typically just buy it for you in these cases and then pass the costs along by charging you on top of your principal and interest payments, if the borrower fails to repay the lender for these, the lender files foreclosure.

Moving out of the property without paying off the reverse mortgage balance in full also constitutes a breach of contract that can trigger foreclosure. While you may have every intention to age in place, your health could mandate that you move into a nursing home or other extended care facility. Moving out would trigger your reverse mortgage loan to become due.

Borrowers must also keep their home in good repair. Failing to keep up with maintenance and repairs also violates the terms of reverse mortgage loans, and can lead to foreclosure.

Other Options to Pull Out Equity from Your Home

Reverse mortgages aren’t the only game in town for house-rich but cash-poor retirees.

Before taking out a reverse mortgage, consider these alternatives as well.

Home Equity Loans

Although they are usually second mortgages, technically a home equity loan could be a first mortgage if you take out a loan on a property you own free and clear.

You can take out a much higher LTV for a traditional “forward” mortgage — as high as 80% to 100% of the property value. That means more cash for you — but you’ll have to pay proportionate monthly payments on that debt as well.

Home Equity Line of Credit (HELOC)

A home equity line of credit is a line of revolving credit in an amount up to the equity value, usually with an adjustable interest rate, so payment amounts vary from month to month.

Like other loans, the terms of the loan and the amount of credit that may be available is subject to negotiation between borrower and lender. Read more on HELOCs versus home equity loans to make an informed decision.

Cash-Out Refinance

Rather than take out a second mortgage in addition to your first, you could refinance your first mortgage entirely. With a cash-out refinance, you take out a new mortgage loan for more than you currently owe on the home and keep the excess cash.

A new mortgage loan means restarting the amortization schedule, which in turn means more of your monthly payment goes toward interest. It also means a longer debt payoff horizon, and for older people, that can mean for life. But it also means higher LTV than second mortgages.

Read more about the pros and cons of refinancing versus other ways to pull equity out of your home before you decide.

Downsizing and Reverse Mortgages

Want to downsize to move to a smaller, more affordable home for retirement, but like the idea of a reverse mortgage?

The FHA offers a purchase version of its HECM loan program, so you don’t have to go through two settlements (a purchase settlement and a refinance settlement).

You must come up with enough cash to cover the difference between the purchase price of the new home and the HECM loan amount at closing. For example, if the new home purchase price is $300,000 and the net loan amount after settlement costs is $140,000, the borrowers must have $160,000 in cash to close.

While a conventional mortgage on the new property might require less cash on the loan closing than the HECM, it also requires making monthly payments to the mortgage company. Funding with an HECM mortgage instead requires more cash upfront but eliminates any future mortgage payments and avoids the risk of a decline in the future market value of the home. Potential borrowers need to run the numbers to determine the best approach for their situation.

The other loan requirements all still apply, including the age requirements and HUD-approved counseling session. Like all reverse mortgages, the owner or their heirs can pay off the loan balance at any time, or their heirs can pass the property to the bank upon the homeowner’s death.

Final Word

Like a stock that does not pay a dividend or a zero-coupon bond, equity in a home provides no cash to its owner. Any increase in equity value lies dormant until you sell or borrow against the asset.

Worse, older people still making mortgage payments continue adding to the amount tied up as equity in their home. In many cases, those funds could better serve them in the form of available cash.

Reverse mortgages can make a valuable tool in helping you achieve financial security and peace of mind in your golden years. Still, they come with their own risks and disadvantages. Make sure you understand the obligations and rights associated with a reverse mortgage before moving forward.

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.