What is a Reverse Mortgage and How Does it Work?

If you’ve lived in your current home for many years, you may reach the point where you’ve made your final mortgage payment or are very close to paying off the house. Congratulations – this is a major accomplishment in the journey of homeownership.

Your home now represents pure equity; funds that could come in handy to pay for unexpected major expenses, medical bills, or any kind of financial emergency. But how do you gain access to some of that hard-earned equity from your home? These situations could be ideal for a reverse mortgage.

You may have heard the term “reverse mortgage.” But what exactly does it involve, and why would you want to pull money out of your home in the form of another mortgage? Keep reading to find out.

What is a reverse mortgage?

A reverse mortgage is a loan based on the current paid-up value or equity in your home. Instead of making a monthly mortgage payment, your lender can use your equity to pay you a set monthly amount, provide a credit line for you to draw upon as needs arise, or pay out a lump sum to you.

While gaining access to this money sounds great, it’s essential to understand how a reverse mortgage works to avoid any pitfalls.

How does a reverse mortgage work?

When you have a regular mortgage, you pay the lender every month so you can eventually own your home outright. With a reverse mortgage, you get a loan in which the lender pays you. Reverse mortgages use part of the equity in your home and convert it into payments to you.

You do not need to pay back this loan until you move, sell the home, or pass away. When you (or your heirs) sell the home, the reverse mortgage loan balance is deducted from the proceeds of the sale. Any balance remaining from sale proceeds reverts to you or your heirs.

What can you pay for with a reverse mortgage?

Here is a shortlist of expenses you can pay for with funds from a reverse mortgage:

Medical debt
Living expenses
Debt consolidation
Home improvements
College tuition
Another home purchase
Or, you can use it as supplemental income

There are no stated constraints for how you use the money. But that doesn’t mean you should run right out and get one. Be sure to read the pros and cons to understand if this financial tool makes sense for your situation.

How do I qualify for a reverse mortgage?

Prepare to shop around for the right type of reverse mortgage to suit your situation. If you meet all of these qualifications, a reverse mortgage might meet your needs:

The primary loan holder must be age 62 or older – your spouse may be younger.
You must own your home outright or have just one mortgage which you are the borrower.
You’ll be required to pay off the existing mortgage using the proceeds from your reverse mortgage.
The home must be your primary residence.
You must be current on all property taxes, homeowners’ insurance, and other mandatory legal obligations (like HOA dues).
You must attend a consumer information class led by a HUD-approved counselor.
Your home must be maintained and in good condition.
The home must be a single-family home, condo, townhouse, manufactured home built after June 1976, or a multi-unit property with up to four units.

There are 3 reverse mortgage types

Single-purpose reverse mortgages

These are offered by some state and local government agencies and nonprofits. For a single-purpose reverse mortgage, the lender specifies how loan proceeds must be spent. For example, you may only be able to use the funds for property taxes or home repairs. This is the least expensive type of reverse mortgage, and low and moderate-income homeowners can often qualify.

Home Equity Conversion Mortgages (HECMs)

HECMs are reverse mortgages backed by the Department of Housing and Urban Development (HUD). You can use proceeds from a HECM for any purpose. This type of loan will be more expensive than a single-purpose reverse mortgage or traditional home loan, including high closing costs. If you plan to stay in your home for a long time, the upfront costs are less of an issue.

Proprietary reverse mortgages

These loans are offered by private lenders. You may be able to get a larger loan from a private lender if you own a high-value home over $500,000. These loans are more expensive than single-use loans and similar to HECMs.

How much money can you get from a reverse mortgage?

The amount of money you can access from a reverse mortgage will vary with the amount of equity you have in your home, your age, the home’s current market value, current interest rates, and the specific type of reverse mortgage.

If you have another loan, lien, or outstanding balance on your home equity line of credit, you will be required to pay the outstanding balances first with any funds you received from a reverse mortgage. The obligation includes any property tax liens, or contractor, or other private liens.

How much does a reverse mortgage cost?

The costs and terms for a single-purpose reverse mortgage and a proprietary reverse mortgage can vary. You’ll want to shop around with different agencies and mortgage lenders to find the most favorable terms. Costs for HECM loans are well-documented since the government backs such loans. However, you will not need to pay loan costs out of pocket because the costs can be covered by loan proceeds, which will reduce the net loan amount available for expenses.

HECM costs include:

Mortgage Insurance Premium (MIP): This mortgage insurance guarantees that you will receive expected loan advances. You can finance the MIP as part of your loan. Initially, you will be charged 2% of the loan amount for MIP at closing. This is followed by an annual MIP equal to 0.5% of the mortgage balance over the loan’s life.
Third-party Charges: Third-party costs include an appraisal, title search and insurance, surveys, inspections, recording fees, mortgage taxes, credit checks, and other fees. These costs are paid at closing.
Origination Fee: Like any mortgage, the lender gets paid to process your loan. A lender can charge the greater of 2% of the first $200,000 of your home’s value + 1% of the amount over $200,000 or $2,500. All origination fees are capped at $6,000.
Servicing Fee: Service fees over the term of the loan cover services that include sending the account statements to you, paying property taxes and insurance on your behalf, and disbursing loan proceeds. If the loan has an annual adjusted interest rate or a fixed interest rate, the service fee caps $30 per month. If your interest rate adjusts monthly, the monthly service fee caps at $35.

At loan closing, the lender deducts the first servicing fee from your available funds and then adds each monthly servicing fee to your loan balance. Alternatively, lenders may include the servicing fee in the mortgage interest rate by charging a higher rate.

Reverse mortgage pros and cons

Pros:

A reverse mortgage can give you financial options and additional income during retirement.
If the primary loan holder passes away, the spouse can stay in the house and continue to receive payments from the loan.
You don’t have to make monthly mortgage payments.
Depending on the type of reverse mortgage, your funds can be used for any expense.
It can be used as a way to stop or prevent foreclosure and loss of the home.

Cons:

You will owe more over time due to interest on the loan.
You could lose your home if you don’t maintain payments for property taxes and insurance.
You reduce the equity in your home because you are, in effect, lending it to yourself.
The upfront cost of a reverse mortgage can be thousands of dollars.
Your heirs may not be able to keep the home if they can’t afford to pay off the loan.

Is a reverse mortgage a good idea?

While a reverse mortgage involves certain complications, it can be an excellent way to supplement your income during retirement, pay for medical expenses, or home improvements that allow you to age in place. As with any loan, it makes good sense to shop around for the best terms and fees. Guidance from a HECM counselor can help you make the best choice.

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