What is a Reverse Mortgage and How Does it Work?
Reverse mortgages can be confusing. Here are some straightforward answers about what they are, how they work, who qualifies and much more…
What is a Reverse Mortgage?
Let’s start with the basics: what is a reverse mortgage anyway?
A reverse mortgage is a really unique type of loan against your home. When you get a reverse mortgage, you are borrowing your own home equity. (Home equity is the difference between what your home is worth and the amount you owe on your home.) So if your home is appraised at $300,000 and you still owe $50,000 on the mortgage, then you have $250,000 in home equity.
What makes reverse mortgages unique (and very different from a home equity loan) is that you do not have to pay back the reverse mortgage for as long as you live there. There are absolutely no ongoing monthly loan payments (although you must continue to pay for taxes and insurance on the property.)
So, How Does a Reverse Mortgage Work?
A reverse mortgage is essentially a mortgage — in reverse.
When you originally purchased your home, you probably borrowed money (got a mortgage) and you have been making monthly payments to pay down the balance ever since. Over time, your debt (the amount you owe on the mortgage) has decreased and your home equity has increased. Maybe even you own your home outright by now — meaning you no longer have a mortgage on your home.
A reverse mortgage is almost the opposite of a mortgage. Instead of paying a lender, the lender pays you but here is where it gets a little complicated.
Here are the basics of how does a reverse mortgage work:
Get Money: When you get a reverse mortgage, you are eligible to access — and use (in anyway you like) a portion of your home equity.
Eliminate Mortgage Payments if You Have Them: The only caveat is that if you still have a mortgage on your home, the money from your reverse mortgage must be used to pay off that original loan and any other loans against your home. This alone is actually a HUGE benefit. The reverse mortgage completely eliminates having to pay ongoing monthly mortgage payments. You will have a lot more freedom without the burden of that bill.
Accumulate Interest: Instead of paying down the loan and the interest on the loan as you do with a traditional mortgage, you are accumulating interest on your reverse mortgage proceeds — but only on the money you receive. So, your loan amount grows over time. However, you will never ever owe more than the home’s value at the time the loan becomes due.
Pay Back the Loan: Reverse mortgages are paid back plus interest when you die, sell your home, or permanently move out of your home.
However, as stated above, with a reverse mortgage, you will never owe more than the value of your house. In this regard, a reverse mortgage is part loan and part insurance product – the reverse mortgage lenders are pooling their risk across many customers and making a calculated bet that most will pay back the loan in full with proceeds from the future sale of their home.
Who Is Eligible for a Reverse Mortgage? What Are the Qualifications?
If you are asking about what is a reverse mortgage and how does it work, then you probably want to know if you qualify for this loan.
Borrowers must be at least 62 years of age for most reverse mortgages and have sufficient home equity. Furthermore, you must occupy the home as your principal residence (you must live there the majority of the year).
Single family one-unit dwellings are eligible properties for reverse mortgages. Some programs may also accept 2-4 unit owner-occupied dwellings, along with some condominiums, planned unit developments, and manufactured homes. Generally homes that are less than a year old are not eligible.
How Much Money Can I Get from a Reverse Mortgage?
Your benefits will be determined by the following factors:
- The appraised value of your home
- The amount of home equity you have
- The maximum lending limit
- Your age — The older you are, the more money you are eligible to borrow.
- The current interest rate — The lower the interest rate, the more money you can borrow.
It is important to note that you will never be able to borrow an amount equal to the full value of your home or even all of your home equity. In order to maintain home ownership, you actually need to retain home equity. This ownership stake also gives you more flexibility and options for the future.
If you want to know how much you personally are eligible to borrow, you can get an estimate with a good reverse mortgage calculator.
How is Money Paid to Me from a Reverse Home Mortgage?
Depending on the type of reverse mortgage you choose, you can take cash out of your home:
- In a single lump sum
- As a regular monthly cash advance, similar to an annuity for retirement income planning
- As a credit line account that lets you customize when and how much is paid to you – changing over time as your needs change
- As a combination of these payment methods
What Are the Risks of a Reverse Mortgage?
Reverse mortgages do not generally affect Social Security, Medicare or pension benefits.
However, if you are currently eligible for Medicaid or other low-income help from the government, you need to be careful that income from a reverse mortgage does not eliminate your eligibility for these public programs.
What Are the Costs of a Reverse Home Mortgage?
There is good news and bad news about these costs:
The Bad News: These costs can be significant although not too different from the costs associated with other types of home equity loans. However, generally speaking, if you don’t think that you will remain in the house for longer than another five years, a reverse mortgage is probably not be the most financially advantageous decision.
The Good News: These costs can usually be financed from the proceeds of your loan.
Costs of a reverse mortgage include:
- Origination fee
- Closing costs
- Servicing fee
- Mortgage insurance premium
- Interest expense
- Insurance or maintenance costs to bring the home up to FHA standards
You can review a full case study of these costs in this article: reverse mortgage rates and fees.
How Can I Use My Reverse Mortgage Money?
Generally, there are no restrictions on how you use money from a Reverse Mortgage. AARP and the U.S. Department of Housing and Urban Development (HUD) conducted a survey of reverse mortgage borrowers to learn how they used the proceeds from their reverse mortgages. They found that households used reverse mortgages in the following ways:
- Hospital/healthcare costs
- Repay existing mortgages
- Reduce the financial burden on children supporting them
- Home repair/improvement
- Pay property taxes
- Daily expenses
- Travel, something special
Additionally, using a reverse mortgage as an estate and retirement planning tool is particularly advantageous – see Innovative Uses for a Reverse Mortgage for more information.
Is a Home Equity Conversion Mortgage (HECM) Different from a Reverse Mortgage?
HECM is an acronym for Home Equity Conversion Mortgage. The HECM is the most popular type of reverse mortgage — by far. It is the federally insured reverse mortgage – and currently the only reverse mortgage program widely available.
How Else Can You Use Your Home Equity to Help Fund Retirement? What Are Alternatives to a Reverse Mortgage?
If you want to use your home equity to help fund retirement, you have a couple options besides getting a reverse mortgage:
Downsizing: You could sell your home and move to another residence. Downsizing is considered to be the most efficient way to access your home equity.
Home Equity Loan: You could borrow against your home and receive a lump sum in the form of a home equity loan or establish a home equity line of credit.
However, it can be very hard for seniors to qualify for a home equity loan because of income requirements and the fact that you need to start repaying home equity loans as soon as they come into effect.
Is a Reverse Mortgage Right for Me?
Now that you hopefully have a better idea of “what is a reverse mortgage and how does it work,” it is time to assess whether or not it is right for you and your retirement.