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You’ve sweated blood to make decades of mortgage payments and now you’ve finally reached your goal: owning your own home (or, at the very least, building substantial home equity). While many people are still dreaming about it, you might already have that property tile in your hands. However, there is a dark reality that stands as a background to this scene: like many homeowners in their 60’s, you’re still operating on a very tight budget.
So, you chance upon a commercial extolling the value of a reverse mortgage as your financial messiah, convincing you that while you live in your house, you can convert your equity to cash. It’s a good idea, right? After all, what good is all that equity if you have no plans of selling your house? Well, read on.
Reverse mortgages might appear heaven-sent for cash-strapped seniors, but they are also expensive and financially hazardous.
We will discuss the basics of reverse mortgage here, including how they work, the interest rates and fees, and of course, its pros and cons. We will also give you some alternatives you should understand before you sign the contract.
What is a Reverse Mortgage?
It is a type of home equity loan that lenders reserve for older homeowners and does not require monthly mortgage payments. Instead, the full loan repayment takes place after the borrower moves out or dies.
Reverse mortgages are popular as a last-resort source of income, but nowadays, they have become a decent retirement planning tool for many homeowners.
Let’s assume that you have a house worth $400,000 free and clear and you decide to take out a reverse mortgage on your home. After factoring in your age and expected interest rate (for simplicity, we’ll peg it at 5% fixed rate) HUD declares that you are eligible for a $180,000 reverse mortgage. Note that in reality, reverse mortgage payments usually come with a variable rate. You opt to receive this as equal monthly payments spread over 10 years so you’ll receive $1,500 each month.
Every month that you receive a check, your outstanding loan balance increases. Afterward, interest begins to build upon the amounts you’ve received and the balance rises even more. This is how the loan balance could increase over time.
Features of a Reverse Mortgage
In a reverse mortgage, the homeowner always retains the title or ownership of the home. The ownership never transfers to the lender at any point even after the last surviving spouse permanently leaves the property.
The amount of funds that a borrower can get will depend on the person’s age (or age of the younger spouse in the case of couples), home value, interest rates and upfront costs. The rule is, the older the borrower is, the more proceeds he/she may get.
A borrower can only access funds up to a certain limit during the first 12 months after closing. For example, a borrower who is eligible for a $100,000 loan can only access a maximum of $60,000 – or 60% of the loan. After that, on month thirteen onwards, he can take as much or as little of the remaining balance as he wishes.
However, there are exceptions to the 60% rule. A borrower can withdraw a little bit more if there is an existing mortgage or other liens on the home that he should pay off. He can withdraw enough money to settle these obligations plus 10% more of the maximum allowable amount. That adds up to an additional $10,000 or 10% of $100,000.
Lenders must conduct a financial assessment of every reverse mortgage applicant. They need to make sure that the person can afford to live in the property and continue to pay property tax and homeowners insurance over the term of the loan. Lenders will check all of the borrower’s income streams, including Social Security, pensions, and investments.
The borrower must provide the lender a copy of his tax returns and bank account statements to help establish his actual income and expenses. He should also be able to explain any credit trouble (ex. Late payments). The lender will evaluate the explanation to see if it qualifies as an ‘extenuating circumstance’ and so sways the application for approval.
Reverse Mortgage Costs
If you decide to go ahead with the loan, brace yourself to pay higher-than-average closing costs based on the value of your home. You must prepare yourself to pay origination fees, upfront mortgage insurance, and appraisal fees.
Here’s another thing to consider: the interest rate is also generally higher than that for a traditional mortgage.
Never forget that anyone who takes out a reverse mortgage still remains responsible for paying the property taxes, insurance, and repairs on the home. If for some reason, you fail to comply with this, the lender may require you to repay your reverse mortgage early.
Using the equity in your home also lessens the value of your estate. What this does is to lessen the value of the inheritance that you can pass along to your heirs when you’re gone.
It is a good idea to explore all other sources of income first before you touch your home equity. For example, you might liquidate your portfolio and cut down on your expenses. If you have done this and still don’t have enough, a reverse mortgage may be a justifiable move.
What are the Types of Reverse Mortgages?
Basically, there are two main types of reverse mortgages: a home equity conversion mortgage and a proprietary reverse mortgage.
1. Home Equity Conversion Mortgage
HECM (pronounced as ‘Hekum’) is the popular acronym used for a Home Equity Conversion Mortgage. It is a mortgage that the U.S. Department of Housing and Urban Development created and currently regulates.
Let me explain that the HECM is NOT a government loan but a loan that a mortgage lender has issued. However, the Federal Housing Administration, which is part of the HUD, insures it, which accounts for the association.
Here’s how it goes: A borrower has to pay upfront a Mortgage Insurance Premium (MIP) to the FHA at closing time. It’s equal to two percent (2%) of the home’s appraised value or FHA’s lending limit ($679,650) whichever is less. The FHA will also charge the borrower an annual premium equivalent to 0.5 percent of the outstanding loan balance.
Therefore, your loan balance will increase by an amount equal to this fee every year. FHA protects the borrower through this insurance in two major situations. First, if the company servicing the loan fails to meet its obligations and is not able to make a payment, the FHA provides the borrower continued access to the remaining loan proceeds. Second, in a case when the value of the home upon selling is not enough to pay off the loan balance.
In this case, the government, through the FHA, pays off the remaining balance of the mortgage.
By and large, HECMs make up the majority of the reverse mortgages in the United States. Among the many rules and regulations that govern HECMs is a requirement that the borrower receives third-party counseling. This allows the borrower to get all the information they need so they can make the right decision whether to take the loan or not.
2. Proprietary Reverse Mortgage
With proprietary reverse mortgages, it is the mortgage companies that privately insure the mortgages. The law does not require them to have the same regulations as HECMs. However, most companies that offer proprietary reverse mortgages adopt the same consumer protection features in the HECM program. These include the mandatory counseling for borrowers.
If your property is not eligible for FHA financing, then a proprietary reverse mortgage is your next best option. You will not qualify for FHA financing if your property is a non-FHA approved condominium, a planned unit development (PUD), or if the home value exceeds the $679,650 maximum loan limit.
Finance people call these loans as “jumbo” reverse mortgages because borrowers are usually eligible for higher proceeds than they would be with an FHA-insured HECM.
How Much Can I Get With a Reverse Mortgage?
In order to be eligible for a reverse mortgage, a prospective borrower must be at least 62 years old and has title to his or her residence. They should submit an application to the lender who will then arrange an inspection of the property. In some cases, the lender might require the borrower to make certain repairs on the property before they grant approval.
Many factors will affect the size of the reverse mortgage, while most of them are similar to the factors that determine your maximum amount in a conventional mortgage . These will include the borrower’s age, the type of mortgage they want, the value and location of the property, the homeowner’s equity and the prevailing interest rates. Similar to a traditional mortgage, lenders will also charge an origination fee, an appraisal fee, and other applicable miscellaneous charges to the borrower.
Here’s what affects the mortgage amount:
- Age of the borrower – the younger he is, the less he can receive
- Value of the property – with a HECM, you can only borrow a maximum of $636,650
- They type of reverse mortgage program you pick – some types can give more
- The interest rate – will have an impact on your debt-to-income ratio
How Lenders Set The Rate With a Reverse Mortgage?
It is common nowadays for reverse mortgages to have variable interest rates. Typically, lenders will tie the interest rate to a certain rate index such as the one-month LIBOR that goes up and down with the market (similar to adjustable rate mortgage). On top of the LIBOR, the lender will add their margin, which usually ranges from two to three percentage points to determine your interest rate.
A reverse mortgage lender will not earmark a portion of the payment to cover interest. Instead, they will let it compound until the date of repayment when it becomes due along with the principal.
According to the FTC, there are fixed-rate reverse mortgages out in the market but in all probability, it will also come with a condition for you to take a lump-sum payout. It may also limit and lower the amount you could receive than what you could get from a variable-rate reverse mortgage.
Reverse Mortgage Pros & Cons
Now, when you understand the basics of a reverse mortgage, we can move to the next step.
Getting a decision and choose the right type of mortgage isn’t an easy task. However, understanding the big picture may help us to get the right decision.
In order to consider the big picture, you have to know the pros and cons of each mortgage type, in this case – the reverse mortgage. Let’s start with the benefits:
Advantages of a Reverse Mortgage
- It will help you if you are a homeowner or a homebuyer aged 62 (or older) to live a more comfortable retirement through a loan facility.
- You can continue to live in your home and retain ownership of it. By the same token as any mortgage, you must meet your loan obligations, keep your property taxes current as well as other expenses such as insurance, maintenance, and homeowners’ association dues.
- You have several options on how to take your funds. You can get a lump sum, a line of credit that you can draw from as needed, a stream of monthly releases set for a determined length of time or as long as you live in the home or a combination of these. But if you elect a fixed-rate loan, you will automatically receive a single disbursement lump sum payment. The other payment options are available only for adjustable-rate mortgages.
- You can use the funds from your reverse mortgage to pay off the existing mortgage on your home. Although there will be a lien on your home on account of the outstanding amount of your reverse mortgage, you will not be required to make monthly principal and interest payments. This will free you from the monthly mortgage payment expense. However, you still need to pay back your loan as well as other expenses in relation to it and to ownership of your property.
- You won’t have to pay monthly mortgage payments as long as you live in the home and continue to pay your property taxes, homeowner’s insurance, et.al. and maintain the property.
- You can finance closing costs and ongoing fees, such as the FHA Mortgage Insurance Premium (MIP) with your reverse mortgage. This ensures that your out-of-pocket expenses are minimal.
Disadvantages of a Reverse Mortgage
- The loan balance increases over time as interest on the loan and fees accumulate.
- Your loan balance eventually increases because of the accumulation of loan interest and fees.
- Your reverse mortgage will become due because of several possible scenarios leading to a “maturity event” when you have to repay the loan. These happen when the last surviving borrower (or non-borrowing spouse meeting certain conditions) passes away, the home is no longer your primary residence, or you vacate the property for an extended period of time. For medical reasons, it’s more than 12 months and for non-medical reasons, more than 6 months (see CFPB Guidelines). If you fail to meet your other loan obligations such as paying property taxes, insurance, homeowner’s association dues or if you fail to maintain the property, the loan will also become due.
- The more home equity you use, the fewer assets become available to leave to your heirs. Of course, you can still leave the home to them but they will have to repay the balance of the loan. Normally, borrowers sell their homes to pay off the loan. However, you can still repay the loan by using other funds or by refinancing through a traditional mortgage.
- Fees for reverse mortgages may be higher than with a traditional mortgage. (You may inquire about our lower cost options.)
- It may affect your eligibility for other needs-based government programs such as Medicaid or Supplemental Security Income (SSI). Consult a benefits specialist if you want to find out more about this.
Is It The Right Thing For You?
Well, it depends. If you want to use the equity now rather than leave it to your heirs later, a reverse mortgage is a great option to have an additional income stream in retirement.
The key is this: this is an important financial decision and you should consider all the potential pros and cons before you decide whether or not applying for a reverse mortgage is the best choice for you.