How Does a Reverse Mortgage Work?

Reverse mortgages are special types of home loans that allow homeowners age 62 and older to convert a portion or all of the equity they have in their homes into cash, to be used for any purpose they choose. Unlike a traditional home equity loan or second mortgage, where monthly payments have to be made, a reverse mortgage does not have to be repaid until the borrowers no longer use the home as their principal residence.
These loans are called reverse mortgages because they work the opposite way from traditional or forward mortgages. With a traditional mortgage the borrower pays back the lender, but with a reverse mortgage, the lender pays the borrower. The relation between the homeowner's debt and equity is reversed. When you take out a mortgage to buy a home, you may make a down payment and pay the balance with the loan proceeds. So you start out with a substantial amount of debt and little or no equity in the home. As you make your mortgage payments, over time you are reducing your debt and increasing your equity in the home. With a reverse mortgage the opposite is the case - you start out with substantial equity in your home and no debt. As you receive money from the lender you are increasing your debt and decreasing your equity in the home. But your debt under a reverse mortgage can never be more than your home's value. It should be noted that with a reverse mortgage you are reducing the equity you have in your home. But if the market value of your home is increasing faster than the rate at which you are receiving money through the reverse mortgage, your equity could continue to increase. On the contrary, if the market value of your home is decreasing, you will have less equity that you can take out in cash through a reverse mortgage. The amount of equity you have in your home will therefore depend on how much you are receiving through the reverse mortgage, and how the market value of your home is changing. When you take out a mortgage to buy a home you have to show that you have sufficient income to be able to make the mortgage payments each month. But since a reverse mortgage is based on the equity you already have in your home, you don't need to have any minimum amount of income to qualify. With a traditional or forward mortgage, you could lose your home if you don't make the monthly payments, but with a reverse mortgage you cannot lose your home because you don't have to make any monthly payments. Reverse mortgages do not require any repayment for as long as you live in the home. And the lender never takes title to your home. Who Qualifies for a Reverse Mortgage?The only requirements for applying for a reverse mortgage are that you must be at least 62 years of age, you must own your home outright or have a low mortgage balance that can be paid off at closing, and you must live in the home. Your home can be a single-family home, a 2-4 unit property that you own and occupy, a townhouse, condominium, or manufactured home built after June 1976. When you still owe money on your existing mortgage you may still qualify for a reverse mortgage. But since the reverse mortgage must be in a first lien position, you will need to pay off your existing loan first. You could pay it off with the proceeds from the reverse mortgage, with money from savings, or from some other source. If according to your age, the value of your home, and the interest rate, you qualify for a reverse mortgage for more than the amount you still owe on your traditional mortgage, you can pay off the balance on your traditional mortgage with the proceeds from the reverse mortgage and use the additional amount any way you choose. If you qualify for less than the amount you still owe, you will have to finance the difference. In this case you would have to consider whether it is worthwhile applying for a reverse mortgage, taking into account your overall financial situation, such as the fact that you may have to deplete your savings to pay off your traditional mortgage, and weigh the closing costs and interest involved in a reverse mortgage compared to the cost of the interest you are currently paying on your traditional mortgage. How Much Money Can You Get?The amount you can borrow with a reverse mortgage depends on your age, the appraised value of your home, and the interest rate. Generally, the higher the value of your home, the older you are, and the lower the interest rate, the more you can borrow. What Can the Money Be Used For?The proceeds from a reverse mortgage can be used for any purpose, such as supplementing your social security and other retirement benefits and paying your living expenses, covering the costs of health care, for travel and vacation, for repairing or renovating your home, or paying off debts. What are the Payment Options? You can receive the money from a reverse mortgage all at once in a lump sum, in fixed monthly amounts either for a specified term or for as long as you live in the home, as a line of credit that allows to decide when and how much cash to take, or a combination of these methods. Line of Credit: A line of credit gives you the flexibility to access the funds as you need them. This option has a growth feature in the sense that the unused balance grows as the value of your home appreciates and as you get older. The growth feature does not mean that you are earning interest. You have to submit a written request to access the funds, and your available balance could eventually be exhausted, depending on the fund requests you make. Term: With fixed amounts over a specified term, you can have the funds deposited directly into your account, and your monthly payments can be larger than they would be when you receive monthly payments for life. The payments you receive are not indexed for inflation. Tenure: With a tenure plan, you receive monthly payments as long as you live. Even if the total amount you receive exceeds the value of your home, you will never owe more than the value of your home. Depending on the type of reverse mortgage, the financial institution or the federal government makes up the difference. Since these payments are fixed amounts each month, if you need additional funds, you would have to change plans. Payments under a tenure plan are not indexed for inflation. Modified Term and Modified Tenure: These payment options combine a fixed monthly payment, either for a certain term or for life, with access to a line of credit. These plans provide you with two sources of funds. Your fixed monthly payment would be smaller because a portion of your equity has been allocated to the line of credit. How is the Reverse Mortgage Loan Repaid?Your reverse mortgage loan balance is paid when you eventually sell your home or no longer live in your home. At that time, you or your estate repays the balance of the reverse mortgage plus interest and fees, either from the proceeds from the sale of the home or by using other funds. Any remaining amount from the sale of your home after repaying the balance of the reverse mortgage belongs to you or your heirs. What is the Interest on a Reverse Mortgage?You are charged interest only on the money you receive. Reverse mortgages may charge a variable interest rate that is based on 1-year Treasury Bills or the London Interbank Offered Rate (LIBOR) plus a margin that is usually an additional one to three percentage points, or a fixed rate. The interest compounds over the life of the reverse mortgage until it is repaid. The interest is not deducted from your proceeds from the loan. Property Taxes and InsuranceWhen you have a reverse mortgage you are responsible for paying the property taxes and insurance, and must keep the home properly maintained. If you are unable to pay the property taxes and insurance, a special amount can be set aside from your proceeds from the reverse mortgage to pay these expenses. When a Reverse Mortgage is Not in Your Best InterestsA reverse mortgage can be a convenient way to cash out the equity you have in your home in order to have that money available for other purposes once you reach age 62. But there are situations in which a reverse mortgage may not be to your advantage. If You Plan to Leave Your Home to Someone ElseIn order to repay your reverse mortgage, the home may have to be sold once you no longer live there. So if you are planning to leave your home to your children or someone else, a reverse mortgage is probably not for you. Closing CostsThere are up-front closing costs involved in obtaining a reverse mortgage, much like the case of refinancing an existing mortgage. These include an origination fee, up-front mortgage insurance premium, an appraisal fee, and other standard closing costs such as a credit report fee, flood certification fee, escrow fee, document preparation fee, recording fee, courier fee, title insurance, pest inspection, and survey. The appraisal is done in order to place a value on your home, and also to make sure there are no major structural defects. In order to take out a reverse mortgage, federal regulations require that your home be structurally sound and that it complies with all home safety codes. If the appraiser detects any defects, you will be responsible for making the necessary repairs. You may be able to finance the repairs with the reverse mortgage loan. You could also be charged a service fee set-aside, which is an amount of money that is deducted from the proceeds of the reverse mortgage loan to cover the costs of servicing your account. The company that services the loan is allowed to charge a monthly fee that ranges between $30 and $35. There is normally a cap on the closing fees, and they may be financed as part of the reverse mortgage. But they nevertheless represent a cost, and if you plan to stay in your home for only a relatively short time, such as 2 or 3 years, it may not be worthwhile to take out a reverse mortgage. Effects on Government BenefitsA reverse mortgage does not affect your regular Social Security or Medicare benefits. But if you are on Medicaid, the proceeds you receive from a reverse mortgage and that you retain could be counted as an asset and could affect your eligibility for Medicaid. If you use the proceeds to pay for some expense the same month you receive them, there should be no problem. But if the proceeds remain in your bank account from one month to another, they would be counted as an asset, and if your total liquid assets including bank accounts and savings bonds exceeds $2,000 for an individual or $3,000 for a couple, you would be ineligible for Medicaid. Counseling One of the requirements for obtaining a reverse mortgage is that you receive counseling. This is intended to protect you and help you make a wise decision. An independent third party will make sure you understand the program, and will review your alternative options with you before you apply for a reverse mortgage. This counselor will also explain the financial implications of taking out a reverse mortgage, the tax consequences, and the effect on your estate. Steps Involved in Obtaining a Reverse MortgageOnce you are interested in a reverse mortgage, you would contact a reverse mortgage lender. You would then receive counseling, as mentioned above, from a HUD-approved counseling agency, or a national counseling agency such as AARP, the National Foundation for Credit Counseling, or Money Management International. The next step would be to fill out a loan application and choose the type of payment plan you prefer. The lender must disclose the estimated total cost of the loan. The lender then orders an appraisal, at your cost. Once the appraisal is completed, the lender will finalize the conditions with you and send the loan package for final approval. Once the loan package is approved, the closing date is scheduled, the interest is calculated, figures are finalized, and the closing documents are prepared. After closing, the loan funds are disbursed to you according to the payment option you have chosen. A new lien is placed on your home and the loan is managed by the loan servicing company, which may be the same lender. The loan is repaid when you no longer occupy the home as your principal residence. It may be repaid by you, or by your heirs or estate, with or without selling the home.