The Complete Guide to Reverse Mortgages

If you're contemplating retirement and not sure you'll have enough to live on, your solution may be right under your kitchen table: to be precise, your home – and the equity you hold in it. Homeowners 62 and older held $6.5 trillion in home equity in the third quarter of 2017, according to the National Reverse Mortgage Lenders Association. The number marks an all-time high since measurement began in 2000, underscoring how arge a source of wealth home equity is for retirement-age adults.

The question is, how can you tap that wealth, especially if you don't feel like moving out? Home equity is only usable wealth if you sell and downsize or borrow against that equity. And that’s where reverse mortgages come into play, especially for retirees with limited incomes and few other assets.

What Is a Reverse Mortgage?

In a word, a reverse mortgage is a loan. A homeowner who is 62 or older and has considerable home equity can borrow against the value of their home and receive funds as a lump sum, fixed monthly payment or line of credit. Unlike a forward mortgage – the type used to buy a home – a reverse mortgage doesn’t require the homeowner to make any loan payments. (See Comparing Reverse Mortgages vs. Forward Mortgages.)

Instead, the entire loan balance becomes due and payable when the borrower dies, moves away permanently or sells the home. Federal regulations require lenders to structure the transaction so the loan amount doesn’t exceed the home’s value and the borrower or borrower’s estate won’t be held responsible for paying the difference if the loan balance does become larger than the home’s value. One way this could happen is through a drop in the home’s market value; another is if the borrower lives a long time.

Reverse mortgages can provide much-needed cash for seniors whose net worth is mostly tied up in the value of their home. On the other hand, these loans can be costly and complex – as well as subject to scams. This article will teach you how reverse mortgages work, and how to protect yourself from the pitfalls, so you can make an informed decision about whether such a loan might be right for you or your parents.

How Does a Reverse Mortgage Work?

With a reverse mortgage, instead of the homeowner making payments to the lender, the lender makes payments to the homeowner. The homeowner gets to choose how to receive these payments (we’ll explain the choices in the next section) and only pays interest on the proceeds received. The interest is rolled into the loan balance so the homeowner doesn’t pay anything up front. The homeowner also keeps the title to the home. Over the loan’s life, the homeowner’s debt increases and home equity decreases.

As with a forward mortgage, the home is the collateral for a reverse mortgage. When the homeowner moves or dies, the proceeds from the home’s sale go to the lender to repay the reverse mortgage’s principal, interest, mortgage insurance and fees. Any sale proceeds beyond what was borrowed go to the homeowner (if he or she is still living) or the homeowner’s estate (if the homeowner has died). In some cases, the heirs may choose to pay off the mortgage so they can keep the home.

Reverse mortgage proceeds are not taxable. While they might feel like income to the homeowner, the IRS considers the money to be a loan advance.  (See A Guide to Taxes and Reverse Mortgages.)

Types of Reverse Mortgages

There are three types of reverse mortgage. The most common is the home equity conversion mortgage, or HECM. The HECM represents almost all of the reverse mortgages lenders offer on home values below $679,650  and is the type you’re most likely to get, so that’s the type this article will discuss. If your home is worth more, however, you can look into a jumbo reverse mortgage, also called a proprietary reverse mortgage. 

When you take out a reverse mortgage, you can choose to receive the proceeds in one of six ways:

  1. Lump sum

    Get all the proceeds at once when your loan closes. This is the only option that comes with a fixed interest rate. The other five have adjustable interest rates.

  2. Equal monthly payments

    For as long as at least one borrower lives in the home as a principal residence, the lender will make steady payments to the borrower.

  3. Term payments

    The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years.

  4. Line of credit

    Money is available for the homeowner to borrow as needed. The homeowner only pays interest on the amounts actually borrowed from the credit line.

  5. Equal monthly payments plus a line of credit

    The lender provides steady monthly payments for as long as at least one borrower occupies the home as a principal residence. If the borrower needs more money at any point, they can access the line of credit.

  6. Term payments plus a line of credit

    The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years. If the borrower needs more money during or after that term, they can access the line of credit.

    (For more details on the pros and cons of each option for receiving the proceeds, see How to Choose a Reverse Mortgage Payment Plan.)

    It’s also possible to use a reverse mortgage called an “HECM for purchase” to buy a different home than the one you currently live in.

    In any case, you will typically need at least 50% equity – based on your home’s current value, not what you paid for it – to qualify for a reverse mortgage. Standards vary by lender.

    Would You Benefit from One?

    A reverse mortgage might sound a lot like a home equity loan or line of credit. Indeed, similar to one of these loans, a reverse mortgage can provide a lump sum or a line of credit that you can access as needed based on how much of your home you’ve paid off and your home’s market value. But unlike a home equity loan or line of credit, you don’t need to have an income or good credit to qualify, and you won’t make any loan payments while you occupy the home as your primary residence.

    A reverse mortgage is the only way to access home equity without selling the home for seniors who don’t want the responsibility of making a monthly loan payment or who can’t qualify for a home equity loan or refinance because of limited cash flow or poor credit. (For more on this topic, see Reverse Mortgage or Home Equity Loan?)

    If you don’t qualify for any of these loans, what options remain for using home equity to fund your retirement? You could sell and downsize, or you could sell your home to your children or grandchildren to keep it in the family – perhaps even becoming their renter if you want to continue living in the home. (For more, see Top 5 Alternatives to a Reverse Mortgage.)

    Pros and Cons

    Once you’re 62 or older, a reverse mortgage can be a good way to get cash when your home equity is your biggest asset and you don’t have another way to get enough money to meet your basic living expenses. A reverse mortgage allows you to keep living in your home as long as you keep up with property taxes, maintenance and insurance and don’t need to move into a nursing home or assisted living facility for more than a year. (For more, see 5 Signs a Reverse Mortgage Is a Good Idea.)

    However, taking out a reverse mortgage means spending a significant amount of the equity you’ve accumulated on interest and loan fees, which we will discuss below. It also means you likely won’t be able to pass your home down to your heirs. If a reverse mortgage doesn’t provide a long-term solution to your financial problems, only a short-term one, it may not be worth the sacrifice. 

    What if someone else, such as a friend, relative or roommate, lives with you? If you get a reverse mortgage, that person won’t have any right to keep living in the home after you pass away. (For further reading, see 5 Signs a Reverse Mortgage Is a Bad Idea.)

    Another problem some borrowers run into with reverse mortgages is outliving the mortgage proceeds. If you pick a payment plan that doesn’t provide a lifetime income, such as a lump sum or term plan, or if you take out a line of credit and use it all up, you might not have any money left when you need it. (See How to Avoid Outliving Your Reverse Mortgage.)

    Rules Governing These Mortgages

    If you own a house, condo or townhouse, or a manufactured home built on or after June 15, 1976, you may be eligible for a reverse mortgage. Under Federal Housing Administration (FHA) rules, cooperative housing owners cannot obtain reverse mortgages since they do not technically own the real estate they live in but rather shares of a corporation. In New York, where co-ops are common, state law further prohibits reverse mortgages in co-ops, allowing them only in one- to four-family residences and condos.

    While reverse mortgages don’t have income or credit score requirements, they still have rules about who qualifies. You must be at least 62, and you must either own your home free and clear or have a substantial amount of equity (at least 50%). Borrowers must pay an origination fee, an up-front insurance premium, ongoing mortgage insurance premiums, loan servicing fees and interest. The federal government limits how much lenders can charge for these items. (Learn about the fees in A Look at Regulation of Reverse Mortgages.)

    Lenders can’t go after borrowers or their heirs if the home turns out to be underwater when it’s time to sell. They also must allow any heirs several months to decide whether they want to repay the reverse mortgage or allow the lender to sell the home to pay off the loan. (Learn more in Rules for Obtaining an FHA Reverse Mortgage.)

    The Department of Housing and Urban Development (HUD) requires all prospective reverse mortgage borrowers to complete a HUD-approved counseling session. This counseling session, which usually costs around $125, should take at least 90 minutes and should cover the pros and cons of taking out a reverse mortgage given your unique financial and personal circumstances. It should explain how a reverse mortgage could affect your eligibility for Medicaid and Supplemental Security Income. The counselor should also go over the different ways you can receive the proceeds. (See Find the Right Reverse Mortgage Counseling Agency.)

    Your responsibilities under the reverse mortgage rules are to stay current on property taxes and homeowners insurance, and keep the home in good repair. And if you stop living in the house for longer than one year – even if it’s because you’re living in a long-term care facility for medical reasons – you’ll have to repay the loan, which is usually accomplished by selling the house.

    Fees Involved

    The Department of Housing and Urban Development adjusted the insurance premiums for reverse mortgages in October 2017. Since lenders can’t ask homeowners or their heirs to pay up if the loan balance grows larger than the home’s value, the insurance premiums provide a pool of funds that lenders can draw on so they don’t lose money when this does happen.

    One change was an increase in the up-front premium from 0.5% to 2.0% for three out of four borrowers and a decrease in the premium from 2.5% to 2.0% for the other one out of four borrowers.  The up-front premium used to be tied to how much borrowers took out in the first year, with homeowners who took out the most – because they needed to pay off an existing mortgage – paying the higher rate. Now, all borrowers pay the same 2.0% rate.  The up-front premium is calculated based on the home’s value, so for every $100,000 in appraised value, you pay $2,000. That’s $6,000 on a $300,000 house.

    All borrowers must also pay annual mortgage insurance premiums of 0.5% (formerly 1.25%) of the amount borrowed. This change saves borrowers $750 a year for every $100,000 borrowed and helps offset the higher up-front premium. It also means the borrower’s debt grows more slowly, preserving more of the homeowner’s equity over time, providing a source of funds later in life or increasing the possibility of being able to pass the home down to heirs.

    Reverse Mortgage Lenders

    To obtain a reverse mortgage, you can’t just go to any lender. Reverse mortgages are a specialty product, and only certain lenders offer them. Some of the biggest names in reverse mortgage lending include American Advisors Group, One Reverse Mortgage and Liberty Home Equity Solutions. (Learn more about these lenders in Find the Top Reverse Mortgage Companies.)

    It’s a good idea to apply for a reverse mortgage with several companies to see which has the lowest rates and fees. Even though reverse mortgages are federally regulated, there is still leeway in what each lender can charge. (Learn how to find a reputable lender in Picking the Right Reverse Mortgage Lender.)

    Interest Rates

    Only the lump-sum reverse mortgage, which gives you all the proceeds at once when your loan closes, has a fixed interest rate. The other five options have adjustable interest rates – which makes sense, since you’re borrowing money over many years, not all at once, and interest rates are always changing. Variable-rate reverse mortgages are tied to the London Interbank Offered Rate (LIBOR).

    In addition to one of the base rates, the lender adds a margin of one to three percentage points. So if LIBOR is 2.5%  and the lender’s margin is 2%, your reverse mortgage interest rate will be 4.5%. In early 2018, lenders’ margins ranged from 1.08% to 3.38%.  Interest compounds over the life of the reverse mortgage, and your credit score does not affect your reverse mortgage rate or your ability to qualify.

    How Much Can You Borrow?

    The proceeds you’ll receive from a reverse mortgage will depend on the lender and your payment plan. For an HECM, the amount you can borrow will be based on the youngest borrower’s age, the loan’s interest rate and the lesser of your home’s appraised value or the FHA’s maximum claim amount, which is $679,650 for 2018.

    You can’t borrow 100% of what your home is worth, or anywhere close to it, however. Part of your home equity must be used to pay the loan’s expenses, including mortgage premiums and interest. Here are a few other things you need to know about how much you can borrow:

    • The loan proceeds are based on the age of the youngest borrower or, if the borrower is married, the younger spouse, even if the younger spouse is not a borrower. The older the youngest borrower is, the higher the loan proceeds.
    • The lower the mortgage rate, the more you can borrow.
    • The higher your property’s appraised value, the more you can borrow.
    • A strong reverse mortgage financial assessment increases the proceeds you’ll receive, because the lender won’t withhold part of them to pay property taxes and homeowners insurance on your behalf.

    The amount you can actually borrow is based on what’s called the initial principal limit.  In January 2018, the average initial principal limit was $211,468 and the average maximum claim amount was $412,038.The average borrower’s initial principal limit is about 58% of the maximum claim amount.

    The government lowered the initial principal limit in October 2017, making it harder for homeowners, especially younger ones, to qualify for a reverse mortgage. On the upside, the change helps borrowers preserve more of their equity.  The government lowered the limit for the same reason it changed insurance premiums: because the mortgage insurance fund’s deficit had nearly doubled over the past fiscal year. This is the fund that pays lenders and protects taxpayers from reverse mortgage losses.

    To further complicate things, you can’t borrow all of your initial principal limit in the first year when you choose a lump sum or a line of credit. Instead, you can borrow up to 60%, or more if you’re using the money to pay off your forward mortgage. And if you choose a lump sum, the amount you get up front is all you will ever get. If you choose the line of credit, your credit line will grow over time – but only if you have unused funds in your line.

    Reverse Mortgages, Your Spouse and Your Heirs

    Both spouses have to consent to the loan, but both don’t have to be borrowers, and this arrangement can create problems. If two spouses live together in a home but only one spouse is named as the borrower on the reverse mortgage, the other spouse is at risk of losing the home if the borrowing spouse dies first. A reverse mortgage must be repaid when the borrower dies, and it’s usually repaid by selling the house. If the surviving spouse wants to keep the home, he or she will have to repay the loan through other means, possibly through an expensive refinance.

    Only one spouse might be a borrower if only one spouse holds title to the house, perhaps because it was inherited or because its ownership predates the marriage. Ideally, both spouses will hold title and both will be borrowers on the reverse mortgage so that when the first spouse dies, the other continues to have access to the reverse mortgage proceeds and can continue living in the house until death. The nonborrowing spouse could even lose the home if the borrowing spouse had to move into an assisted living facility or nursing home for a year or longer. (For more details, see Reverse Mortgage: Could Your Widow(er) Lose the House?)

    Avoiding Reverse Mortgage Scams

    With a product as potentially lucrative as a reverse mortgage and a vulnerable population of borrowers who may have cognitive impairments or be desperately seeking financial salvation, scams abound. Unscrupulous vendors and home-improvement contractors have targeted seniors to help them secure reverse mortgages to pay for home improvements – in other words, so they can get paid. The vendor or contractor may or may not actually deliver on promised, quality work; they might just steal the homeowner’s money.

    Relatives, caregivers and financial advisors have also taken advantage of seniors by using a power of attorney to reverse mortgage the home, then stealing the proceeds, or by convincing them to buy a financial product, such as an annuity or whole life insurance, that the senior can only afford by obtaining a reverse mortgage. This transaction is likely to be only in the so-called financial advisor’s best interest. These are just a few of the reverse mortgage scams that can trip up unwitting homeowners.  (Learn about what to look for in Beware These Reverse Mortgage Scams.)

    Do This to Avoid Foreclosure 

    Another danger associated with a reverse mortgage is the possibility of foreclosure. Even though the borrower isn’t responsible for making any mortgage payments – and therefore can’t become delinquent on them – a reverse mortgage requires the borrower to meet certain conditions. Failing to meet these conditions allows the lender to foreclose.

    As a reverse mortgage borrower, you are required to live in the home and maintain it. If the home falls into disrepair, it won’t be worth fair market value when it’s time to sell, and the lender won’t be able to recoup the full amount it has extended to the borrower. Reverse mortgagees are also required to stay current on property taxes and homeowners insurance. Again, the lender imposes these requirements to protect its interest in the home. If you don’t pay your property taxes, your local tax authority can seize the house. If you don’t have homeowners insurance and there’s a house fire, the lender’s collateral is damaged. About one in five reverse mortgage foreclosures from 2009 through 2017 were caused by the borrower’s failure to pay property taxes or insurance, according to an analysis by Reverse Mortgage Insight.

    The Bottom Line

    A reverse mortgage can be a helpful financial tool for senior homeowners who understand how the loans work and the trade-offs involved. Ideally, anyone interested in taking out a reverse mortgage will take the time to thoroughly learn about how these loans work. That way, no unscrupulous lender or predatory scammer can prey on them, they’ll be able to make a sound decision even if they get a poor-quality reverse mortgage counselor and the loan won’t come with any unpleasant surprises.

    Even when a reverse mortgage is issued by the most reputable of lenders, it’s still a complicated product. Borrowers must take the time to educate themselves about it to be sure they’re making the best choice about how to use their home equity.

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