How reverse mortgages work:
- Loan for homeowners age 62+
- No monthly mortgage payments are required.
- Funds are tax-free and may be used for virtually anything.
- Loan is repaid when you pass away or sell your home.
- Any remaining equity belongs to your heirs.
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 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.
In the following video I will explain how a reverse mortgage works in comparison to traditional loan types.
Let us jump right into it!
With a traditional mortgage, you make structured monthly payments (usually over 15 or 30 years). The amount you owe is reduced by each payment you make and therefore the equity you have in your property increases over time. On the other hand, with a reverse mortgage you have the option to make NO monthly mortgage payments. Instead of writing a payment back to the bank, that interest payment is simply added to your loan balance and your equity position may decrease over time. While mortgage payments are not required, you may choose to make payments to keep your loan balance from rising. Now, let us look at a couple different approaches to having a reverse mortgage and compare them to traditional loans.
Alex, Jane, and Jack all took out a $250,000 starting loan balance. Alex got his $250,000 as a 30-year mortgage and will be paying principal and interest payments for the next 30 years. As he makes his payments, the loan balance (the amount he owes the bank), decreases over time. His home value increases… And so does his remaining home equity. His line of credit however remains zero as traditional loans are closed end and do not allow for you to reborrow funds in the future.
Now let us look at Jane.
Jane, who took a reverse mortgage, decides to make some repayments to keep her balance from rising. Because reverse mortgages are OPEN ENDED loans, the lender is required to increase Jane’s available line of credit by each payment she applies to her loan balance. Over time, Jane will have preserved her home equity all while growing a sizeable line of credit reserve. These funds may be borrowed later to fund long term care or other related retirement expenses. Just like Alex, Jane’s home value increases over time. And in turn she retains much of her home’s equity.
This ultimately yields to an increase in her equity that she will pass to her family, and the financial security of a flexible line of credit to fund unexpected retirement expenses.
Finally, we have Jack, who took a reverse mortgage, but has decided to make no repayments for his lifetime in the home. As a result, his loan balance increases…But over time his home value rises, increasing his remaining home equity, albeit at a lesser rate than his counterparts. At the end of the day, or in this case- at the end of the 30 years, both Jane and Jack have
benefitted from their reverse mortgages in different ways. Jane, by making payments of her choice, afforded her heirs a great margin of inheritance and retired in confidence with a line of credit reserve for the unexpected. And while Jack may not be passing on as much equity to his heirs, he afforded himself the freedom of not making any mortgage payments on the $250,000 tax free release of his home’s equity.
Reverse mortgages can seem complicated but in reality, it is simply a loan against your home that can be repaid at any time, whether that be at the end of life when your home sells, or by making voluntarily repayments while you’re alive. Repayments may be made as interest only, interest plus principal, or any amount you choose. You’re in the driver’s seat! As with all mortgages, you will receive a monthly statement that will outline the interest charges, loan balance and line of credit activity. One thing to keep in mind is with a reverse mortgage you own your home and are responsible for maintaining future property charges such as your taxes and homeowner’s insurance.
How it’s 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 can 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 2021 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 your amount using ARLO’s Reverse Mortgage Calculator
How 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.
Flexible 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.
Unique credit line growth feature
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.
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.
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 homes appraised value, where an 80-year-old will receive closer to 70%.
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.
What is the downside to a reverse mortgage?
Reverse mortgages do not come without cost. It is a loan against your home, and it does accrue interest unless you decide not to make voluntary repayments. The longer you keep a reverse mortgage balance, the higher the interest charges become as interest itself compounds over the life of the loan. If you wish to pass your home and all its equity to your heirs, the reverse mortgage might not be suitable for you.
How is a reverse mortgage paid back?
The reverse mortgage balance can be repaid at any time without penalty. You can choose to either repay the loan voluntarily or defer interest until you later sell your home. When the loan balance will be paid in full any remaining equity will belong to your heirs or estate.
Can you lose your home with a reverse mortgage?
Yes. When taking a reverse mortgage, you agree to maintaining your property charges such as taxes and homeowner’s insurance and occupying 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.
Hopefully you now know how reverse mortgages work and are on your way to determining if a reverse mortgage is right for you!
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