What is a Reverse Mortgage & How it Works?

Reverse mortgage

A reverse mortgage allows a borrower to receive money in a variety of methods such as a line of credit, a large sum, or as predetermined monthly payments over a period of time. Like a traditional mortgage, a reverse mortgage is also considered a loan. However with this type of loan, the original homebuyer is entitled to receive payments versus making them. 

Proceeds that are distributed via a reverse mortgage loan are typically due in the event of a circumstance such as a permanent relocation, resale of the home, or the death of the borrower. Since the mortgage isn’t available to borrowers who haven’t reached 62 years of age or older, federal law prohibits the proceeds to be recouped through the homeowners estate or the origination of loans that are in excess of the home’s total equity. This protects the borrower if their home should become underwater or lose a significant portion of it’s worth.

How Does a Reverse Mortgage Work?

A reverse mortgage works by providing a loan to the homeowner that requires the lender to make the required monthly payments, which is essentially the reverse of a traditional loan setup. As the borrower or homeowner receives the proceeds, they are only responsible for making payments on the interest accrued. Over the course of the loan the equity in the home also decreases causing the borrower to accumulate more debt.

The collateral used in a reverse mortgage is the borrowers home and once the home is sold the loan is repaid from the proceeds. If the homeowner passes away instead then any funds in excess of standard obligations such as the principal, insurance, fees, or interest will be turned over to the person’s estate. However, in cases where the sale of the home doesn’t cover the balance then the borrower’s beneficiaries or surviving relatives may exercise the option to repay the debt and retain the property. These transactions are also considered tax free as the Internal Revenue Service has determined that the funds from a reverse mortgage are not designated as a source of income.

What Can a Reverse Mortgage Be Used For?

Many people who find themselves in a great amount of debt as they reach their senior years may be inclined to seek out a solution such as a reverse mortgage which lets borrowers tap into the equity that their home has built up in order to receive some extra cash.

The money can be used for any purpose such as paying off the mortgage early, bulking up a retirement fund, supplemental income, vacationing, or making contributions to your grandchildren’s education.

As you consider signing up for a reverse mortgage you should also take the following things into consideration to evaluate whether it is the best decision for your circumstances:

  • Taxable Interest – The interest earned on the payments received under a reverse mortgage loan are considered taxable, meaning that the borrower will have to pay taxes on the proceeds until the loan is paid off.
  • Variable Rates – Mortgages are frequently approved with variable interest rates which may net you more money in the long term. However, as the rates adjust so does the amount of debt that you are taking on over the course of the contract.
  • Fees and Costs – Lenders charge a variety of fees and costs associated with each mortgage that is issued. Often this will require you to pay more for the origination, servicing, and insurance premiums on your reverse mortgage loan.

Types of Reverse Mortgages

Reverse mortgages can provide cash to someone who doesn’t have the income sources or credit rating to be approved for a home equity line of credit (HELOC) or other types of high quality personal loans. They also afford you the ability to choose from three different options with a variety of payment disbursement methods.

  1. Home Equity Conversion Mortgage (HECM)This type of mortgage is the most common as it is insured by federal funds via the U.S.Department of Housing and Urban Development. These loans are also subject to stricter requirements, substantial upfront costs, and are generally multi-purpose.
  2. Jumbo (Proprietary) Reverse Mortgage – These mortgages are provided by privatized loan companies and are geared towards borrowers who have homes with a much higher value than those who may have qualified for a smaller loan.
  3. Single Purpose Reverse Mortgage – This option is more widely available from governmental agencies and the costs are often much cheaper than the alternatives. The funds from this type of loan must also be used for lender specific purposes such as home repairs or other maintenance.

Each reverse mortgage option has rules and requirements that must be explained to the borrower to enter into a contract in order to comply with federally required safe lending practices and disclosures.

Reverse Mortgage Requirements

Houses or other residential structures with the exception of apartment buildings that were constructed after the first half of 1976 are generally qualified for a reverse mortgage granted that they meet other criteria. This however, does not include residential cooperatives since the buyers do not have the same ownership rights as traditional homeowners.

In order to qualify for a reverse mortgage, once the property requirement has been met, a borrower must have reached 62 years of age, have a minimum of 50% equity in their home, or have a fully paid off original mortgage loan. A loan recipient must also attend a HUD conducted counseling session due to the potential risks that may be involved to the homeowner.

Once approval has been given, there are several benefits to taking out a reverse mortgage loan as well as potential downsides.

Pros 

  • No credit scoring or income requirements
  • Loans can range from small to increasing larger amounts
  • Remaining balance cannot be taken from the borrowers estate upon death
  • Several options are available for receipt of payments

Cons

  • Certain loans disallow payments to be passed to the spouse upon the borrowers death
  • Borrowers who reside in certain geographic reasons cannot qualify for reverse mortgages
  • Unforeseen emergencies causing a change of residence could leave borrowers without funds to repay the loan

Rules Governing These Mortgages

Reverse mortgages come with very specific rules that govern the process, payments made, as well as terms that must be followed in order to protect the borrower as well as the lender authorizing the loan.

  • Mortgage insurance premiums must be paid by all borrowers
  • The maximum amount to be borrowed is just over $970,000 for HECM loans
  • Loans must adhere to an initial principal limit which is just over 50% of the equity amount
  • The full mortgage amount cannot be borrowed within the first year of the loan contract
  • A non-borrowing spouse could lose residency rights if the original ownership predates the marriage
  • Reverse mortgage borrowers are required to reside in and maintain the home at all times to avoid market value loss
  • A borrower has the right to cancel a mortgage within 3 business days of the loans closing date

Depending on the type of reverse mortgage that the homeowner enters into there may be additional lender specific requirements to be met.

Fees Involved

All home mortgages are accompanied by a myriad of fees. With a reverse mortgage loan, a borrower is expected to pay higher costs in terms of upfront premiums, interest on payments, origination fees, counseling session fees, as well as loan closing fees.

Conclusion

Reverse mortgages have been used by seniors as a tool to access cash for emergencies or other unexpected life situations. However, there can be serious risks if the contract is taken before fully evaluating the risks and benefits. By conducting the proper amount of research in terms of lenders, fees, taxes, and other financial outcomes, you can determine if this type of loan is right for you.

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