What Is a Reverse Mortgage?

A reverse mortgage is a loan that enables homeowners aged 62 or older to convert part of their home equity into cash without selling their home. Reverse mortgages can be suitable for retirees seeking additional ongoing income or simply wanting to cash out some of their home’s equity.

We’ll explore how reverse mortgages work, eligibility requirements, pros and cons, and when they’re suitable. Notably, before proceeding, it’s crucial to seek advice from experts such as financial advisors or reverse mortgage counselors to determine if a reverse mortgage is right for you.

What is a reverse mortgage, and how does it work? 

To start, let’s explore the details of how a reverse mortgage works:

Repayment

With a traditional mortgage, the borrower must make monthly payments to a lender. Not only does a reverse mortgage require no monthly payments, but the lender pays the borrower. 

How payments to the borrower are made can vary based on the reverse mortgage, but the funds are commonly issued in a single lump sum or in incremental payments over time. 

Repayment is typically deferred until the borrower moves out of the home, sells it, or passes away. When these events occur, the mortgage balance becomes due, and the borrower or their heirs must repay the loan, usually by selling the home.

Interest and fees

Unlike a traditional mortgage, where the loan balance decreases over time, the balance of a reverse mortgage increases over time as accrued interest and fees are added to the loan balance. 

This means that the homeowner’s equity in the home often decreases as interest accrues.

Various fees may apply, including origination fees, closing costs, servicing fees, and mortgage insurance premiums. These reverse mortgage fees can vary depending on the lender and the type of mortgage.

Types of reverse mortgages

There are several types of reverse mortgages: 

• The Home Equity Conversion Mortgage (HECM) is the most common type of reverse mortgage. The Federal Housing Administration (FHA) backs this type of reverse mortgage via federal government-provided insurance.
• Private lenders may offer proprietary reverse mortgages, which aren’t insured by the federal government and may have different terms and eligibility requirements.
• Some states, local governments, or non-profit entities offer single-purpose reverse mortgages. While these mortgages are typically the least expensive option, you can only use them for a single purpose, such as making home repairs. 

Tax and insurance implications

Generally, the proceeds you receive from a reverse mortgage—either in a single lump sum or on a recurring basis—are tax-free, with no effect on your Medicare or Social Security benefits. However, the interest that accrues on the mortgage is not tax-deductible, unlike a traditional mortgage.

Additionally, borrowers must maintain homeowner’s insurance and property taxes on the home by paying these from their funds since there is no monthly payment and, therefore, no escrow account on the reverse mortgage. 

Failure to make timely property tax and insurance payments could have serious negative consequences, including the lender foreclosing on the property. 

Reverse mortgage example

Suppose a 70-year-old homeowner has a home valued at $300,000 and decides to take out a reverse mortgage. The lender determines they can borrow up to 50% of the home’s value, which amounts to $150,000. 

Let’s assume the reverse mortgage loan’s annual percentage rate (APR) is 5%, including interest and fees. The accrued interest and fees are added to the monthly reverse mortgage loan balance. 

After five years, the loan balance would be approximately $192,500 due to the monthly accrued interest. If, at this point, the homeowner decides to sell the home, they would need to repay the loan balance, which includes the initial $150,000 plus the accrued interest of approximately $42,500.

In this example, the homeowner received $150,000 in cash. However, they ended up owing more money at the end of five years due to accrued interest and fees added to the loan balance over time.

What are reverse mortgage loan eligibility requirements? 

To qualify for a reverse mortgage under the HECM program—the most common type—you must meet borrower, property, and financial requirements. The requirements for other reverse mortgages may vary. 

Reverse mortgage loan eligibility requirements commonly include: 

Borrower

To be eligible for the HECM reverse mortgage program, you must:

• Be at least 62 years of age
• Occupy the home as your primary residence
• Own the property free-and-clear or have a small existing mortgage balance you can repay with the reverse mortgage proceeds
• Not be past due on any federal debt (e.g., student loans or income taxes)
• Show you can pay ongoing property-related fees on time (e.g., taxes, insurance, HOA fees, routine maintenance)

You also must participate in a consumer counseling session about the HECM mortgage. 

Property

Only homeowners with eligible property types can use the HECM reverse mortgage program. The borrower must occupy the home as their primary residence, meet FHA standards (property and flood), and be in good condition. The most common property types include:

• One-to-four-unit residential properties
• Manufactured homes
• HUD-approved condominiums

If your property isn’t in good condition, your lender will let you know what to do to get the reverse mortgage. 

Financial

The lender will verify your ability to make property-related payments on time. Plus, the lender will check your credit history and verify your assets, income, and living expenses. 

Pros and cons of a reverse mortgage

While a reverse mortgage can offer flexibility for seniors, it’s essential to weigh the pros and cons carefully. Consider how it fits into your long-term financial and estate planning goals before proceeding. 

Pros

• Access to cash

  Provides a source of one-time cash or recurring cash flow for retirees without requiring them to sell their home or get a new loan.

• No payments

  With a reverse mortgage, the borrowers aren’t required to make monthly payments, freeing up cash flow.

• Flexible payment options

  Offers various disbursement options, including a single lump sum or monthly payments.

• No income tax requirements

  The cash proceeds (one-time and ongoing) from a reverse mortgage are typically free of income taxes.

• Ability to remain in the home

  Ability to remain Borrowers can continue to live in their home until they permanently move out or pass away.in the home

• Protection against market declines

  Reverse mortgages are commonly non-recourse loans, meaning borrowers won’t owe more than the home’s value. 

Cons

• Accrued interest

  Interest accumulates over time, potentially reducing the homeowner’s equity and the inheritance left for heirs.

• Fees and closing costs

  Reverse mortgages come with fees, such as application or origination fees, closing costs, and mortgage insurance premiums.

• Impact on heirs

  Upon the borrower’s death, the estate or heirs may need to repay the loan or sell the home to pay off the mortgage.

• Limited loan amount

  The amount that can be borrowed is based on factors like the borrower’s age, home value, and current interest rates.

• Risk of foreclosure

  Failure to meet ongoing obligations, like paying property taxes or maintaining homeowner’s insurance, can lead to foreclosure.

• Complexity

  Reverse mortgages can be complex financial products, requiring borrowers to understand the terms, risks, and potential implications thoroughly.

Consider the reasons you need the reverse mortgage and the requirements to qualify. Then, consult a financial professional or counselor to weigh the pros and cons. 

Erin Kinkade

CFP®

Is a reverse mortgage right for you? 

Determining whether a reverse mortgage is suitable involves considering personal financial circumstances and goals. Here are some questions to ask yourself:

• Do I plan to stay in my home for the long term? Reverse mortgages are designed to allow you to stay in your home. If you plan to move soon, there may be better options than a reverse mortgage. 
• Do I have sufficient home equity? To qualify for a reverse mortgage, you must have a lot of equity in the property. You likely won’t be eligible for a reverse mortgage if you can’t meet this eligibility requirement. 
• Can I afford to pay property tax, insurance, and maintenance costs? Your lender will verify you can afford to pay these on time. You likely won’t qualify for a reverse mortgage if you can’t afford these costs. 
• Am I willing to reduce my heirs’ inheritance? A reverse mortgage lowers your home equity. You should avoid getting a reverse mortgage if you don’t want to reduce your heirs’ inheritance. 

By honestly answering these questions, borrowers can gauge whether a reverse mortgage aligns with their financial needs and objectives, helping them make an informed decision about this financial product.

Reverse mortgage alternatives

Home equity loan 

A home equity loan could be a valuable alternative to a reverse mortgage. It allows homeowners to borrow a fixed sum using their home’s equity as collateral. Unlike a reverse mortgage, which provides income, a home equity loan offers a lump-sum payment. 

The upfront cash may be attractive, but the loan must be paid back with interest over a period. The total amount repayable increases the longer it takes to pay off the loan, posing a potential financial risk. 

Home equity line of credit (HELOC)

A HELOC operates much like a credit card, offering a revolving line of credit based on the home’s value. This flexibility could make it an attractive choice over a reverse mortgage. 

However, with fluctuating interest rates and a requirement to make minimum payments, a HELOC can become a challenging financial burden over time.

Cash-out refinance

With a cash-out refinance, you can refinance your mortgage for more than you owe, and then pocket the difference. 

This choice may appeal to you if current mortgage rates are lower than when you first got your loan. One significant drawback is the need to pay closing costs, which could offset potential savings.

Home sale-leaseback

A home sale-leaseback presents an alternative wherein you sell your home and use the funds as you wish while renting back the property. 

It is attractive to those who no longer want to manage home ownership costs but want to stay in their homes. However, you will need to adjust to the reality of being a tenant in your own home.

Home equity sharing agreement 

A home equity sharing agreement is a contract where you agree to share your home’s value increase with a company or an individual. 

This allows you to access some of your home’s equity without accruing debt, but you could end up owing a significant amount of money if your home appreciates. The terms of these agreements can also be complex, requiring careful understanding. 

Sell your home 

Selling your home outright can provide you with the most significant lump sum. However, it would mean leaving your home, which may not be ideal for many seniors who would prefer to age in place. 

Also, once the home is sold, the money you receive is taxable and could affect eligibility for certain benefits.

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