How do reverse mortgages work, and when should someone look to obtain one? We’ve got answers to help you decide whether this commonly misunderstood product could be the best solution for you.
Reverse mortgages have been around for quite some time in various shapes and forms. Today’s reverse mortgage is very different from those of the past thanks to more safeguards (in the form of limitations) in place. Due to recent changes, reverse mortgages are making their way back into the mainstream of mortgage products nationwide. Sometimes referred to as a HECM (“heck-um”), the home equity conversion mortgage is a loan insured through the Federal Housing Administration (FHA).
At first, it’s difficult to get one’s head around a reverse mortgage because intuitively consumers are familiar only with traditional mortgages. With a traditional mortgage, money is borrowed and paid back in the future at regular intervals.
Reverse mortgages are set up in just about the same fashion with two main differences. First, they are far more flexible than traditional loans in that they can be customized to suit individual needs. Second, the timing associated with when the funds and interest must be paid back is quite different. Let’s take a closer look to gain a better understanding.
Reverse Mortgage Mechanics
A reverse mortgage is a loan where homeowners can access the equity in their home similar to a traditional mortgage or HELOC. Unlike a traditional loan, a reverse mortgage doesn’t require interest payments on a monthly basis. Rather, the interest accumulates and is simply paid at the time of a maturity event.
A maturity event is typically associated with selling the home or the borrower, or borrowers, passing. At the time of a maturity event, the FHA insurance on the loan ensures that any amount due does not exceed the value of the home at the time of sale. This feature is called “non-recourse” and is one of the main protections accompanying a reverse mortgage transaction.
As with traditional mortgages, those who take out a reverse mortgage may choose either a fixed or an adjustable rate loan. With adjustable rate programs, there are different types of disbursements that can be made. Homeowners can choose equal installments to be paid for as long as at least one of the borrowers continues to live in the property, or they can choose to receive reverse mortgage loan proceeds in equal monthly payments for a preselected period of time. They can also open a line of credit, much like a HELOC. Finally, borrowers can choose to receive a lump sum payment combined with monthly installments for as long as they occupy the property, or a combination of monthly installments and a line of credit.
With the fixed rate option, there are no installment payments or lines of credit available. Rather, a single lump sum is paid at closing.
Interest rates have historically been quite competitive on reverse mortgage loans. In most cases, both fixed rate and variable rate loan options are within 1% of the best rates on the market.
One other important note: As mentioned above, interest accrues on a reverse mortgage just like any other mortgage loan. As we will see below, qualifying for a reverse mortgage is much easier than a traditional loan – particularly in today’s tough lending environment.
It is important to point out that reverse mortgage borrowers can make payments on their reverse mortgage at any time – effectively turning them into the traditional loans we find more familiar. This means, for those who qualify, there may be an easy alternative to that traditional loan qualification process – so keep an open mind!
Anyone who is at least 62 years of age, is currently a homeowner and has sufficient equity in order to make the reverse mortgage loan work is a candidate for this product. It used to be that reverse mortgage loans were notoriously easy to qualify for. All one needed to have was sufficient equity in the home. Credit scores were not checked, and no employment or income was required.
Today, however, borrowers must be able to show they have the resources necessary to pay for annual property taxes, insurance premiums, and maintenance of the home. This change was implemented after many reverse mortgage borrowers fell behind on their property taxes and local counties began foreclosure proceedings. As an additional safeguard, reverse borrowers also complete a reverse mortgage loan counseling session, which can typically be done over the phone or in person with a non-profit counseling agency.
As long as the borrowers have sufficient equity and can demonstrate they’re able to maintain the home and to take care of housing expenses such as taxes and insurance, a reverse mortgage is an easy loan to obtain.
The amount one can be approved for is based on a set of actuary tables and takes into consideration the age of the youngest borrower on the loan application, current interest rates and the current value of the property. Loan sizes are larger for older borrowers with shorter life expectancies, when lower interest rates are available, and when the home value is higher.
If there is an existing mortgage on the property in the form of either a first or second lien, the proceeds from the reverse mortgage must go toward paying off those liens, leaving the reverse mortgage as the sole lien on the property. If the reverse mortgage is not sufficient to pay off the existing mortgage, the loan approval can be issued, but the borrowers must bring the extra money to closing to cover the difference.
When an existing mortgage is paid off, that frees the homeowners from making mortgage payments ever again as long as they own and occupy the property. For those who are “house rich” and would like to get rid of their current mortgage payment, a reverse mortgage is an ideal option.
Will the lender take my home? Do I lose ownership?
No. The homeowner does not lose ownership of the property. Similar to any other mortgage, the reverse mortgage lender simply has a lien on the property signifying there is an amount that must be paid off prior to a sale or another refinance.
What about my heirs?
Once the home is sold or no longer considered the borrower’s primary residence, the accrued interest and other finance charges must be settled. After the reverse has been paid off completely, any remaining equity will go to the homeowner’s heirs. In the event that the amount owed exceeds what the home value is at the time of sale, the non-recourse features ensures that the sale of the home fully covers any debt owed (Even if FHA must take a loss!).
Aren’t reverse mortgages expensive?
Not really. They do have origination fees like other loans, and there is a mortgage insurance premium that must be paid, but today’s reverse fees are much lower than they used to be, especially in comparison to the costs of selling. There are also options for nearly zero mortgage insurance paid up front. Similar to any other mortgage loan, there is not “one rate” and “one set of costs”. Shop around by using MortgageCS to compare – you’ll see quite a difference between lenders.
Don’t I have to pay income taxes when I take out a reverse mortgage?
Reverse mortgage proceeds are not considered income as you are simply trading one asset for another: Equity in the home for cash in hand. Generally speaking, cash received from a reverse mortgage is treated just like cash out from a traditional refinance. Due to this, it is not counted as income. To be sure, it always makes sense to contact your tax professional, as every homeowner’s situation is unique.
What if the home is sold and there isn’t enough money to pay for everything? Won’t my heirs be held responsible for my debt?
No. If the home is sold for at least the lower of the reverse mortgage balance or 95% of the current appraised value, the reverse mortgage insurance premium taken out on the loan will cover the loss. No debt is passed on to your heirs, and they are not responsible for paying any balance due.