Reverse Mortgages: What They Are and How They Work

Updated: 28th Dec 2021 Written by Elijah Bishop
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You may have come across TV adverts featuring well-spoken individuals adorned in tailored suits telling senior citizens that they can unlock their home equity through a reverse mortgage.

But if you’re like most senior citizens approaching retirement or already in retirement, you may wonder what reverse mortgage is and how it works. 

Also known as a home equity conversion mortgage, a reverse mortgage is a loan that allows senior citizens to exchange the equity in their home for cash during their retirement years.

But while reverse mortgage may seem like an excellent option, there are still plenty of risks to the process and even potential scams. 

In this article, we’ll reveal some never-seen information about reverse mortgages, how it works, and what homeowners considering one should know before applying. 

What Is a Reverse Mortgage?

A reverse mortgage is a type of loan that lets people aged 62 and older borrow against a part of their home’s equity.

Unlike with a traditional mortgage, instead of making monthly mortgage payments to the lender, the borrower receives money from the lender to cover their personal needs. 

Introduced in 1961, a reverse mortgage allows you to access your home equity in the form of a lump sum, a line of credit, or even in the form of monthly payments that you only repay when you sell the house or pass away.

The good news is that you don’t have to make monthly payments, unlike other forms of mortgages. 

Most reverse mortgages are guaranteed by the Federal Housing Administration (FHA) and administered by the Department of Housing and Urban Development (HUD).

Reverse mortgages backed by the FHA can also be referred to as home equity conversion mortgages (HECM). 

How Does a Reverse Mortgage Work?

Before applying for a reverse mortgage, you must understand the term home equity. In real estate and mortgage terminology, home equity refers to the current market value of your home minus your current mortgage principal balance. 

For example, if the appraised value of your home is $250,000 and you still have a mortgage balance of $100,000, then you have an equity of $150,000.

In another scenario, let’s say your home market value is $250,000, and you have paid off the entire mortgage, then your equity in the property is $250,000. 

Now when you apply for a reverse mortgage, you’re simply borrowing against that equity you have in your home.

Like any other home equity loan, your lender will check your credit, evaluate the property condition, title, and conduct a home appraisal.

If approved, the money you’ll receive from your lender is tax-free, and you can decide to accept it as a lump sum, a line of credit, or in small monthly payments depending on your needs and the type of loan you opt for. 

You may decide to make monthly payments on your mortgage during this time, but it isn’t compulsory.

However, your mortgage lender will request that you continue making payments on your property taxes and insurance premiums to avoid foreclosure.

With a reverse mortgage, you start paying for the loan when you pass away (your heir becomes responsible for the loan), sell the home, or permanently move out. 

What Can a Reverse Mortgage be Used For?

Reverse mortgages can be a life-saver for elderly citizens. Whether you need money for personal or home improvement needs, taking advantage of your home equity through a reverse mortgage can be your best bet. Below are some of the common and acceptable uses of a reverse mortgage for: 

  • Supplement your retirement income
  • Pay for an out-of-pocket medical expense
  • Pay for essential home improvements (repairs)
  • Consolidate debts
  • Create an emergency fund

While there are several other acceptable uses of a reverse mortgage, you should consider discussing your potential needs with your lender for proper guidance. 

Reverse Mortgage Requirements

To qualify for a reverse mortgage, you must meet specific requirements. One of the basic requirements is that the primary homeowner must be age 62 or older. Other requirements include: 

  • You must own the property outright or have at least paid a substantial amount of your mortgage. Most online mortgage lenders will request that you have at least 50% equity in the home. 
  • The property must be occupied as your primary residence. Investment properties or vacation homes do not qualify. 
  • You cannot be delinquent on any federal debt.
  • You must have the financial capability to continue making payments on property taxes, homeowners’ insurance, and homeowners association dues.
  • You must participate in an information session provided by a U.S. Department of Housing and Urban Development (HUD)-approved reverse mortgage counselor.

Before applying for a reverse mortgage, you should evaluate your income to ensure that you have the necessary cash inflow to cover the cost of your property taxes and mortgage insurance

Reverse Mortgage Borrowing Limits

The borrowing limits on each type of reverse mortgage differ. If you are applying for a proprietary reverse mortgage, there is no standard limit on how much you can borrow.

Borrowing limits on proprietary reverse mortgages are set by individual lenders and are open to changes. 

However, suppose you’re applying for an FHA or other government-backed reverse mortgages.

In that case, you are prohibited from borrowing beyond 80% of your home appraised value or the FHA maximum claim amount of $765,600.

This is because lenders want a safeguard in case the market value of the property falls. More importantly, borrowing limits may change due to a homeowner’s age, credit, and existing loan interest rate. 

>> More: Review the Different Types of Government Home Loans

Types of Reverse Mortgages

Like other types of home loans, there are different types of reverse mortgages with unique offerings.

And like traditional mortgages, these loan types can either have a fixed-rate or adjustable-rate interest rate. 

Home Equity Conversion Mortgage (HECM)

Home equity conversion mortgages (HECMs) are backed by the U.S. Department of Housing and Urban Development and can be more expensive than conventional mortgages.

If you’re 62 and above with enough equity in your home, you can easily qualify for a HECM loan and use it for just anything. 

Like other types of reverse mortgages, HECM loans also allow borrowers to choose how they want to get paid, such as a lump sum, fixed monthly payments, or a line of credit.

Since the FHA offers HECM, borrowers must meet its strict requirements and undergo HUD-approved counseling.

More importantly, since the FHA provides HECM loans, borrowers must pay for mortgage insurance premiums (PMI). 

Proprietary Reverse Mortgage

Proprietary reverse mortgages aren’t federally regulated like the HECM ones. They’re offered up from privately owned or operated companies.

Also, referred to as jumbo reserve mortgages as they can exceed the borrowing limits set by the FHA for HECM loans.

As of the time of writing this article, the maximum amount that can be borrowed under a HECM loan is $822,375. The limit for a jumbo reverse mortgage, on the other hand, can be as high as $4 million.

While proprietary reverse mortgage offers several benefits like no mortgage insurance premium and a bigger loan amount, it comes with a pretty high-interest rate and mortgage origination fees.

Also, proprietary reverse mortgages attract fraudulent lending companies who use reverse mortgages to scam unsuspecting older citizens. 

Single-Purpose Reverse Mortgage 

Government agencies offer a single-purpose reverse mortgage at the state and local level and by nonprofit groups.

It’s a type of reverse mortgage that puts rules and restrictions on how you can use the money from the loan.

Usually, single-purpose reverse mortgages can only be used to make property tax payments or pay for home repairs.

And since money coming from a single-purpose reverse mortgage is expected to be used in a specific way, they are usually lower than HECM and proprietary reverse mortgages.

However, you don’t have to pay for mortgage insurance or deal with high-interest rates compared to the other types of reverse mortgages. 

Does Reverse Mortgage Have Any Fees?

Like a conventional mortgage, several fees are associated with reverse mortgages, specifically the Home Equity Conversion Mortgage (HECM).

One important thing to note is that these fees are a little higher than those associated with a traditional mortgage. Below are some of the fees you can expect when you apply for a reverse mortgage.  

  • Origination fees
  • Servicing fees
  • Third-party fees

How Much Does a Reverse Mortgage Cost?

Reverse mortgages come with several costs, which aren’t cheap. However, one of the upsides to getting a reverse mortgage is that most HECM mortgages allow you to roll these costs into your loans. But doing this reduces the amount you’ll receive from your lender.

According to HUD, here is a breakdown of some of the costs associated with getting a reverse mortgage. 

  • Mortgage Insurance Premium: When you take out an FHA reverse mortgage, you’ll need to pay an upfront MIP and annual FHA MIP when you close on the loan. Typically, the upfront MIP protects you and the lender by ensuring the loan doesn’t end up as a non-recourse loan. For an FHA reserve mortgage, the initial MIP is pegged at 2% and an annual MIP equal to 0.5 percent of the outstanding loan balance. The MIP can be financed into the loan.
  • Origination fee: A mortgage origination fee is the amount of money your lender charges for processing your HECM loan. To avoid lending discrepancies, the FHA has set a minimum and maximum cost of origination fees. So, regardless of your home value, you won’t pay less than $2,500 or more than $6,000. It is common for lenders to charge the greater of $2,500 or 2 percent of the first $200,000 of your home’s value, plus 1 percent of the amount over $200,000. 
  • Servicing fee: It is common for lenders to charge a monthly fee to cover the cost of maintaining and monitoring your loan over its lifetime. This fee can cost up to $35 monthly.
  • Third-party fees: Aside from lender-related fees, you may need to pay for the services offered by third-party service providers. These fees entail appraisal, home inspection, credit check, title check, and title insurance.
  • Interest Rates: The interest rate a lender charges you is determined by the lender you work with, the type of reverse mortgage loan, and whether you opt for a fixed-rate or adjustable-rate mortgage. More importantly, it is common for borrowers with excellent credit scores to receive a lower interest rate. 

One of the upsides to getting a reverse mortgage is that it allows you to roll most of the above-listed costs into the loan.

However, you are free to pay any of them out of pocket if you want to avoid adding them to your loan.

Please speak with your lender for an update on the latest costs associated with a reverse mortgage.   

>> More: What Is Prepaid Interest Charged on a Mortgage?

What Are the Advantages of Reverse Mortgages?

Here are some advantages of getting a reverse mortgage. 

  • The borrower doesn’t need to make monthly payments toward their loan balance.
  • You can access your home equity without having to sell the property or make monthly mortgage payments.
  • Proceeds can be used for living and healthcare expenses, debt repayment, and other bills.
  • Funds can help borrowers enjoy their retirement.
  • You are protected from declining home values since it is a non-recourse loan. That is, even if the value of your home falls, you are only responsible for what you borrowed.
  • Non-borrowing spouses not listed on the mortgage can remain in the house after the borrower dies
  • Borrowers facing foreclosure can use a reverse mortgage to pay off the existing mortgage, potentially stopping the foreclosure.

What Are the Disadvantages of Reverse Mortgages?

Here are some disadvantages of getting a reverse mortgage.

  • If you have an existing mortgage, funds obtained from a reverse mortgage must be used to pay it off.
  • You must pay mortgage insurance premiums and homeowners insurance for the life of the loan on federally backed loans.
  • If you move out of the home for more than 12 consecutive months and have no eligible co-borrower living in the house, the loan could become due.
  • Other expenses associated with reverse mortgages, like fees and closing costs, will reduce the amount of cash you get
  • If you and your co-borrowing spouse die before paying back the loan, your heirs must pay off the total loan balance or 95% of the home’s appraised value (whichever is less) if they wish to keep the house from foreclosure.
  • Falling behind on property taxes or insurance payments could trigger default and foreclosure, which could cause you to lose your home. 

How Much Money Do You Get from a Reverse Mortgage?

The amount of money you can receive from a reverse mortgage will depend on several factors. Some of these factors may include: 

  • Your age
  • Current interest rates
  • The current market value of your home
  • Type of reverse mortgage
  • Your chosen reverse mortgage and its related costs 

Also, the amount you receive will be impacted if your current home is linked to an existing mortgage or liens.

If your home is serving as collateral for an existing home equity loan or home equity line of credit (HELOC), they will have to be paid with the proceeds of the reverse mortgage before any of your personal needs.

More importantly, you’ll only receive a portion of your home equity and not the entire equity of your home. 

Who Owns the House in a Reverse Mortgage?

Like any other type of traditional mortgage, you’re still the owner of the house even when you take out a reverse mortgage.

However, when you pass away or move from the home, you must pay the loan in full. If you or your heir cannot pay the loan, your lender will have to sell the house to recoup the money you owe.

More importantly, you or your heir are responsible for any additional costs if your home is sold less than the amount you owe the lender. 

Can You Lose Your House with a Reverse Mortgage?

Just like with any other loan option, there are several conditions associated with reverse mortgages.

Failing to adhere to these conditions may result in you losing your home to the lender. The ways you could violate the conditions of a reverse mortgage include:

The house is no longer your primary residence

One of the requirements of reverse mortgages is that the home must be your primary residence. This means that you cannot stay away from your home for more than 12 consecutive months.

While this rule doesn’t stop you from embarking on business trips or vacations, you can, however, not vacate your home for 12 straight months. By failing to adhere to this rule, the loan becomes due for collection. 

You decided to move or sell your home: 

Another rule associated with reverse mortgages is that a reverse mortgage loan becomes payable upon the sale or relocation of the parties involved in the loan.

So, if you decide to put up your home for sale as part of your relocation process, you’re still required to live in the property for 12 consecutive months. But if you vacate the house for this period or sell the property, the loan becomes payable. 

You default on the payment of your property taxes and insurance premiums: 

While you don’t need to make monthly mortgage payments, you are expected to continue paying your property taxes and insurance premiums.

And failure to make the necessary payments as at when due may lead to violation of your loan terms and even foreclosure. 

Alternatives to Reverse Mortgages

If you’re not moved by the enticing ads by reverse mortgage companies or not up to 62 years, other alternatives allow you to cash out on your home equity. If you need to tap into your home equity for your retirement years, below are other options. 

Downsize

If you’re all about moving to a new location, selling your home instead of taking out a reverse mortgage can be a better alternative.

Selling your home and moving to a less expensive house allows you to tap into your home’s accumulated equity.

More importantly, you can use the proceeds from your home sale to purchase a smaller house and pay off your mortgage balance. 

Refinance

If you plan on staying in your home, doing a traditional mortgage refinance could be your best option.

You could either do a cash-out refinance or take out a second mortgage to cash out on your home equity.

One of the upsides to refinancing your current home loan is that it reduces your monthly mortgage payments, interest rates and free up some cash for your personal use.

However, make sure to weigh the closing costs and new loan terms to see how they will impact your finances in the long run. 

>> More: How to refinance Your Mortgage

Loan or HELOC

Instead of taking out a reverse mortgage, you can also borrow against your home equity using a home equity loan or line of credit.

When you take out a home equity loan, you can receive a lump sum upfront which you’ll need to pay back in installments.

With a line of credit, you can quickly draw from the loan anytime until you hit the maximum amount. 

How to Avoid Reverse Mortgage Scams

Government-backed reverse mortgages are generally safe, thanks to the strict guidelines set by the Federal Housing Administration.

But the majority of tv ads and social media ads are from private lending companies, which are mostly bogus and untruthful.

Before opting for a reverse mortgage program or lender, you should look out for the following things. 

  • Don’t respond to unsolicited mailers or other ads
  • Don’t sign documents if you don’t understand them—consider having them reviewed by an attorney
  • Don’t accept payment for a home you don’t own
  • Be wary of anyone who says you can get something for nothing (i.e., no down payment)

Also, intending reverse mortgage borrowers should look out for these two major types of reverse mortgage scams. 

  • Contractor loans: It is common for some contractors to try to convince unsuspecting elderly citizens to take out a reverse mortgage when searching for home improvement services. 
  • Veteran loans: The U.S. Department of Veterans Affairs (VA) doesn’t provide reverse mortgages. But it is common for borrowers to see ads promising unsuspecting senior citizens with special deals for veterans. 

Who Are Reverse Mortgages Best For?

Reverse mortgages aren’t designed for every homeowner. Only homeowners that meet the requirements can take advantage of a reverse mortgage. A reverse mortgage is designed for the following set of people: 

  • Senior citizens who have no desire to pass down their house to their children
  • Senior citizens faced with multiple expenses in their retirement years
  • Individuals who have little or no savings but have a considerable amount of equity in their home. 

Bottom Line: What Is a Reverse Mortgage

A reverse mortgage offers an excellent opportunity for senior citizens to finance their needs and supplement their income while in active retirement.

It is also one of the easiest ways for older homeowners to tap into their home equity to cover significant financial expenses.

However, like traditional mortgages, there are several eligibility requirements, borrowing limits, and conditions guiding reserve mortgages. 

Before opting for a reverse mortgage, you should consider speaking to a HUD counselor or experienced lender for proper guidance.

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Elijah Bishop
Elijah Bishop

Elijah A. Bishop is a Senior Personal Finance Writer who has been writing about real estate and mortgages for years. He has a degree in English, Media and Creative writing from the University of Georgia. He also holds a realtor license and has been in and out of the US mortgage industry as a loan officer. Bringing over 15 years of experience, Elijah produces content that analyzes ethnicities, race, and financial well-being. His areas of expertise are mortgages, real estate, and personal loans.