A reverse mortgage is, in very simple words, a kind of loan that is available for people 62 years or older.
Reverse mortgages can allow the homeowner to borrow money from the loan giver, without having to pay any monthly debt. Instead, the lender gives money to the borrower. Confused? Let us explain what is a reverse mortgage and how does it work.
What Is Reverse Mortgage?
A reverse mortgage is a loan for older people, typically aged 62 and above, to borrow money against the equity of their home. This means that the homeowner gets to borrow money without having to pay any monthly payments to the lender. The money is tax-free and can be used however the borrower wishes. A reverse mortgage can be a great way for retirees to keep up with their expenses if they have only a few other valuable assets and a limited source of income.
Why is it called a ‘reverse mortgage’? A regular or ‘forward mortgage’ is when you borrow a sum of money from the lender. You then make the monthly payments to the lender so you can be the owner. Over time, the debt you owe decreases, and the value of your house increases. A reverse mortgage works in reverse – the lender makes monthly or a lump sum payment to the borrower against the value of the house. The borrower keeps the title of the house and is not required to make any loan payments to the lender. Over time, the debt the borrower owes increases, and the value of the home decreases. The entire loan becomes payable if the borrower dies, moves away permanently, or sells the home.
How Does Reverse Mortgage Work?
To be eligible for a reverse mortgage, you must be at least 62 years or older. If you live with a younger spouse, you may still become the primary borrower, though it can be very risky for your spouse. If you die, your spouse may have to sell the house or would have to pay off the entire loan to avoid selling the house.
The amount of loan you get depends on your age, home value, and current interest rate. The amount can become available to you as a lump sum payment, as monthly payments, or as a line of credit. The loan is written in such a way that the value of the house does not fall below the actual loan value. This is done to avoid burdening the estate or the heirs of the borrower from covering the difference between the loan and the house value.
The repayment of the loan becomes due when the last surviving borrower dies. Any amount remaining from the selling of the house and after repaying the loan becomes available to your heirs. However, if the borrowers wish to make a prepayment on the loan, there is no penalty. The loan can be paid off at any time after it was taken.
What Are The Types Of Reverse Mortgage?
There are three main types of reverse mortgages – single-purpose reverse mortgage, home equity conversion mortgage, and proprietary reverse mortgage.
Single Purpose Reverse Mortgage
A single-purpose reverse mortgage is, like the name suggests, available to be used for a single expense that the lender approves of, for instance, home repairs or to pay property taxes. It is the most affordable type of revere mortgage and borrowers are expected to pay a smaller amount in fees and interest. It is most suitable for people with low to moderate-income whose home equity hasn’t built yet. A single-purpose reverse mortgage ensures that the homeowner does not get evicted due to non-payment of property taxes or home insurance. Since the loan is to be used for a single purpose, the amount available to the homeowner is usually less than the amount available from other types of reverse mortgages.
A single-purpose reverse mortgage can be obtained through the local or state government, or from a not-for-profit organization.
Home Equity Conversion Mortgage (HECM)
A home equity conversion mortgage is the most popular type of reverse mortgage. It does not require a medical examination or income requirements and can be used for virtually any purpose. Given the flexibility of these mortgages, and the fact they are backed by the US Department of Housing and Urban Development, the fees and upfront costs for a HECM is also higher.
The main requirement before obtaining a HECM loan is to attend a counseling meeting with a HUD representative. The HUD representative apprises the borrower of the cost of the loan, its benefits, any pitfalls, the responsibilities of the borrower, and the payment options. The borrower also learns about the other types of reverse mortgages available that they may be eligible for. The counseling session is paid for by the borrower or through the loan proceeds.
After the counseling session, the borrower is in a better position to understand which type of reverse mortgage they would like to go for and how much would they can borrow. The amount of the loan is dependant on the person’s age, the value of the house, and the current interest rate. However, the loan amount is within $765,500, the amount set by HUD in 2020.
Proprietary Reverse Mortgage
A proprietary reverse mortgage, or jumbo reverse mortgage, is for borrowers whose houses have a higher value and who are eligible for a loan that exceeds the $765,500 limit set by the HUD. Generally, it is also required that you should have paid off the original mortgage or have a small amount left to pay. This type of reverse mortgage is not government-backed and is available only through private lenders.
Reverse Mortgage Explained
For some people, a reverse mortgage may seem like an extra income. However, the reality couldn’t be far from this. Here are a number of things you should consider before you opt for a reverse mortgage.
- Excessive Fees and Cost of Loan: The cost of obtaining a reverse mortgage can climb fast. It is also usually payable from the loan amount, which means you end up losing thousands from your home equity even before you get access to it. For instance, lenders charge origination costs, mortgage insurance premiums, closing costs, servicing fees over the life of the loan, etc.
- Your debt increases over time: Interest rates increase every year. The more you borrow over the years, the more the interest on it adds up, This means the debt increases with time as the interest adds up.
- Interest rates are variable: Reverse mortgages are usually based on variable interest rates, except for a HECM that has a fixed rate, but it will require you to take out a lump sum which will be less than what you would get with a variable loan.
- All the costs for your home are your responsibility: In a reverse mortgage, the borrower keeps the title of the home. Hence, you are responsible for paying the homeowner’s insurance, property taxes, utilities, fuel, maintenance, and any other costs related to your house. The lender may cancel your loan and ask you to repay it if you cannot keep up with the costs of your house. This means that you can potentially lose your home as well. The lender may require you to keep a set-aside amount that will pay towards your housekeeping expenses, taxes, and insurances. This set aside amount is not available to you from the loan amount.
Reverse Mortgage Payment Options
There are a number of ways the lender can make the reverse mortgage payments to you. You may also choose to use a combination of these payments.
- Lump-sum: Get the entire loan amount at loan closing. The interest rate is fixed.
- Tenure Plan: The borrower gets equal monthly payments or annuities until they live on the property.
- Line of Credit: The borrower can take the money as and when they need it. They only pay back the amount that they used from the loan, with interest.
- Term Payment: The homeowner gets a certain amount of money each month for a fixed period of time, like 10 years. The loan ends after that and the loan payment becomes due on the borrower.
- Term Payment or Tenure Plan Plus a Line of Credit: You can go for monthly payments for a fixed number of years or until you occupy your house, with the option of withdrawing extra money from the loan when you need it.
You should choose a plan that is the most closely matched to your needs. Do not withdraw more than is necessary – you will have to pay it all back with accrued interest.
How Does A Reverse Mortgage Work When You Die
A reverse mortgage is probably the last loan that the borrower will take. The loan is dependant on the primary borrower occupying the home that the reverse mortgage is taken for. When the borrower dies, the payments from the reverse mortgages stop. The loan becomes payable. The heirs or the spouse left behind has two options to pay off the loan. If they wish to keep the house, they can pay it off or they may sell the house to make up for it. Any amount leftover from the sale of the house and after paying off the loan is inherited by the heirs.
Reverse Mortgage Example
A reverse mortgage might cost more than the value of the house at the end of the term or after you pass away. For example, if the value of your home is set at $200,000, and you take a reverse mortgage for 25 years at a rate of 5% and withdraw a lump sum of $100,000, the total interest that accrues is $238,635. This brings the total debt owed at the end of the term to $338,635.
An example to illustrate the cost of the reverse mortgage is given below:
- Cost of the house = $200,000
- Origination fee = 2% of house value = 2% of $200,000 = $4000
- Mortgage Insurance Premium = 2% of $200,000 + 0.5% of $200,000 annually
= $4000 + $1000 per year
- Closing Costs
This means that you will have to pay thousands in costs from the home equity even before you get access to the usable loan!
A reverse mortgage may seem like a very appealing prospect for people above 62 years old. However, you may want to look at other options available and compare costs before you sign up for it. A reverse mortgage can potentially cost you your hard-earned home and evict your spouse or dependents, if not properly drafted.