How does a reverse mortgage work?
A reverse mortgage works by allowing homeowners age 62 and older to borrow from their home’s equity without having to make monthly mortgage payments. The most common type of reverse mortgage is the Home Equity Conversion Mortgage (HECM), a program insured by the Federal Housing Administration since 1988.
The amount of funds available from a reverse mortgage are based on the age of the youngest borrower, home value, and current interest rates. You may choose to take funds in a lump sum, a line of credit, monthly payments, or a combination thereof.
Funds received are tax-free and may be used for virtually anything. The repayment of the loan is required when the last surviving borrower vacates the home permanently or fails to maintain property taxes and homeowner’s insurance.
When the loan is repaid, any remaining equity is passed to heirs or however your will or trust dictates. If the loan balance exceeds the home value at time of maturity, no debt will pass to the borrowers’ heirs as reverse mortgages are non-recourse loans.
How reverse mortgages are different
A reverse mortgage is different from a traditional or “forward” loan, in that it operates exactly in reverse. The traditional loan is a falling debt, rising equity loan. A reverse mortgage is a falling equity, rising debt loan.
In other words, as you make payments on a traditional loan, the amount you owe is reduced and therefore the equity you have in the property increases over time. With the reverse mortgage you make no regular payments. So as you draw out funds and as interest accrues on the loan, the balance grows and your equity position in the property becomes smaller.
There is never a payment due on a reverse mortgage and there is never a prepayment penalty of any kind. You can make a payment at any time, up to and including payment in full, without penalty. Many borrowers choose to repay some or all the accruing interest, or whatever amount they desire.
How much you are eligible to receive
The amount of money you can receive from a reverse mortgage generally ranges from 40-60% of your home’s appraised value. The older you are, the more you can receive, as loan amounts are based primarily on your life expectancy and current interest rates.
With a reverse mortgage, several factors dictate the loan amount, including:
- The age of the youngest borrower
- Value of the home or the 2022 lending limit (whichever is less)
- The interest rates in effect at the time
Also factoring into the loan amount are:
- Costs to obtain the loan (which are subtracted from the Principal Limit)
- Existing mortgages and liens (which must be paid in full)
- Any remaining money belongs to you or your heirs.
-Calculate how much you can get by using ARLO’s Reverse Mortgage Calculator
How your age affects the amount available
You must be at least 62 years of age for a reverse mortgage. The Principal Limit of the loan is determined based on the age of the youngest borrower because the program uses actuarial tables to determine how long borrowers are likely to continue to accrue interest.
If there are multiple borrowers, the age of the youngest borrower will lower the amount available because the terms allow all borrowers to live in the home for the rest of their lives without having to make a payment.
Of course there will always be exceptions, but the premise is that a 62-year-old borrower will be able to accrue a lot more interest over his or her life than an 82-year-old borrower with the same terms. Therefore, HUD allows the 82-year-old borrower to start with a higher Principal Limit.
Reverse mortgage payment options
There are several ways borrowers can receive funds from a reverse mortgage:
- Cash lump sum at closing
- Line of credit that you can draw from as needed
- Payment for a set amount and period, known as a “term payment”
- Guaranteed payment for life (known as a “tenure payment”) which lasts if you live in your home.
In addition to these options, you can use a modified version of each and “blend” the programs, if you will. As an example. A married couple in California, born in 1951 and own outright a $500,000 home, may decide it is time to get a reverse mortgage.
The couple would like $100,000 at closing to make some improvements to their property and fund a college plan for their grandchild. They have a larger social security benefit that will begin in four years, but until then, would like to augment their income by $1,000 per month.
They can take a modified term loan with a $100,000 draw at closing and set up the monthly payment for four years of $1,000 per month. That would leave an additional $125,000 in a line of credit that would be available to use as they need.
In addition, they would receive a guaranteed growth rate on their unused line of credit funds.
Line of credit growth rate
In the past, many considered the reverse mortgage loan a last resort. Let us consider a borrower who is savvy and is planning for her future needs. She has the income for her current needs but is concerned that she may need more money later.
So, she obtains her reverse mortgage and — after the costs to obtain the loan — has the same $200,000 line of credit available to her.
Her line of credit grows at the same rate on the unused portion of the line as what would have accrued in interest and mortgage insurance premiums had she borrowed the money.
As the years go by, her credit line increases, meaning if she one day needs more funds than she does now, they will be there for her.
If rates do not change, here is what her access to credit looks like over time:
- 10 years: $350,000
- 15 years: $500,000
- 20 years: $660,000
Remember, that is if rates do not change. If interest rates go up 1% in the third year and one more percent in the 7th, after 20 years her available line of credit would be more than $820,000.
Now of course this is not income, and if you do borrow the money you owe it and it will accrue interest. You or your heirs would have to pay it back when the property sells. But where else can you ensure that you will have between $660,000 and $800,000 available to you in 20 years?
Lump sum restrictions
The fixed rate requires you to take a lump sum draw. This means that you must take the full draw of all the money available to you at the close of the loan. You cannot leave any funds in the loan for future draws as there are no future draws allowed with the fixed rate.
Since borrowers experienced a much higher default rate on taxes and insurance when 100% of the funds were taken at the initial draw, HUD changed the method by which the funds would be available to borrowers which no longer allows all borrowers access to 100% of the Principal Limit at the close of the loan.
Tip #1 – Shop interest rates & closing costs
As for pricing, reverse mortgage lenders are more willing now than ever to help pay costs whenever they can on reverse mortgages. If there is an existing mortgage balance to payoff, there is often room in the value of the loan for the lender to make back money they spend on your behalf when they sell the loan.
Lender credits are allowed by HUD, so shop around and see what is available. Education is key. Knowing your goals will help you procure a loan that is best for you. A very low margin will accrue the least amount of interest once you start using the line, but if you are looking for the greatest amount of line of credit growth, a higher margin grows at a higher rate.
Getting the least amount of fees on your loan will not help if you plan to be in your home for 20 years, because in that 20 years the interest will cost you tens of thousands of dollars more, thus ruining your goal to preserve equity.
Knowing what you want out of your reverse mortgage will help you choose the best option to meet your long and short term goals.
Tip #2- Weigh the costs vs benefits
As I stated earlier, we do not recommend reverse mortgages for everyone. If the loan does not meet your needs and you are still going to be scraping to get by, you will need to face that fact before you choose to use your equity.
If the loan doesn’t make your life easier and you’re thinking that you are just going to have to sell in a few years anyway, consider making that move now before you begin to erode your equity and the next move becomes that much more difficult.
The reverse mortgage is supposed to be the last loan you ever need. If you know you are not in your forever home, consider using your reverse mortgage to buy the right house instead of using it as a temporary solution — one that is not a true solution at all.
By and large, most borrowers can benefit when they do their research and plan carefully. You need to know how these loans work, what your plans are, and which options will best achieve your goals.
How much can you get from a reverse mortgage?
The amount of money you can receive from a reverse mortgage loan is based on the youngest borrower’s age, current interest rates, and your home’s appraised value. Reverse mortgage principal limit factors are based on actuarial tables. On average a 62-year-old will receive approximately 50% of the home’s appraised value, whereas an 80-year-old will receive closer to 70%.
Who owns the house in a reverse mortgage?
You always own your home when you have a reverse mortgage. You are not selling your property to the lender in order to obtain a reverse mortgage, and are just taking out a loan that works differently than a traditional or “forward” loan.
How does a reverse mortgage get paid back?
A reverse mortgage does not require monthly mortgage payments and therefore the loan is paid back when the loan reaches a maturity event or if the homeowner decides to sell their home or pay it off through other means. When a reverse mortgage borrower passes away, the heirs to their property can either pay off the balance to keep the property or sell the home in order to pay off the balance of the loan. The reverse mortgage is non-recourse so you can never owe more than the value of the home. If an heir inherits the property with a balance that exceeds the current market value, they are not required to pay back the loan balance or even attempt to sell the property if they do not choose to and can sign the property over to the servicer to handle from there and any loss on that sale is covered by the mortgage insurance fund.
Can I sell my house if I have a reverse mortgage?
Yes, you can sell your house at any time when you have a reverse mortgage and there is no prepayment penalty to do so.
Can you lose your home with a reverse mortgage?
Yes. When taking a reverse mortgage, you agree to maintain your property charges such as taxes and homeowner’s insurance and occupy your home as your primary residence. (Defined by not leaving longer than a 6-month period). Should you fail to maintain the loan agreement the servicer is required by HUD to call the loan due and payable.
Is a reverse mortgage a good idea?
Reverse mortgages are not inherently good nor bad. The decision to take a reverse mortgage should always be looked at as an individual approach weighing long-term suitability. If you can stay in your home for the foreseeable future and the reverse mortgage allows you to live more comfortably, the reverse can be a great idea! If you have plans to move later in retirement you should look at alternatives such as the reverse mortgage for home purchase, or other home equity loans.
Why should you not get a reverse mortgage?
You should not get a reverse mortgage if you are looking at selling your home in the near future. The reverse mortgage is not intended to be a short-term financing instrument, and the upfront costs for mortgage insurance, etc. make it less appealing to use in that manner.
What are disadvantages of a reverse mortgage?
There are a couple disadvantages of a reverse mortgage loan compared to other loan products. With a reverse mortgage, the property must be your primary residence. If you obtain a reverse mortgage and then want to move out of the property and retain it as a rental property you have to refinance or pay off the reverse mortgage. Another downside to the reverse mortgage is that the closing costs are higher than a traditional loan because of the mortgage insurance on the HUD-insured HECM product.
Hopefully you now know how reverse mortgages work and are on your way to determining if a reverse mortgage is right for you!
What is a Reverse Mortgage & How Does it Work – Explained by ARLO™