A reverse mortgage is a great tool for converting home equity into cash in retirement. What is a reverse mortgage? How does a reverse mortgage work? An experienced and successful industry veteran offers the inside scoop.
You’ve probably seen the reverse mortgage commercials with Henry Winkler and Tom Selleck. They make reverse mortgages sound pretty good, don’t they? But are they as good as they sound?
I’ve helped many seniors get reverse mortgages over the years – including a close relative. There is a lot of misinformation out there about reverse mortgages. Many of the negative rumors you’ve heard are actually misunderstandings about how a reverse mortgage works.
My goal is to set the record straight about how a reverse mortgage works for real. No hype, no rumors. We’ll cover the basics, then we’ll dig under the hood and reveal the stuff that many lenders don’t tell you. Once we’re done, you may know more about how a reverse mortgage works than many industry professionals.
Table of Contents
What is a Reverse Mortgage?
A reverse mortgage is a unique mortgage product that offers homeowners 62 and older access to home equity without giving up ownership of their homes or taking on a mortgage payment.
The most popular reverse mortgage in the United States is the home equity conversion mortgage, or HECM (commonly pronounced heck-um by industry professionals). If you know somebody who recently got a reverse mortgage, it was likely a HECM.
The HECM program was created when President Reagan signed the Housing and Community Development Act of 1987 into law.
The HECM is regulated and insured by the Federal Housing Administration (FHA) and the Department of Housing and Urban Development (HUD).
Around 50,000 HECM reverse mortgages are written in the United States every year. That number will likely grow as more seniors and financial professionals learn how a reverse mortgage works.
Why Do People Get Reverse Mortgages?
So, what is a reverse mortgage used fo? What do people usually do with the money?
The HECM can accomplish many different things because it’s so flexible and customizable. There are multiple payout options available, including lump sum, line of credit, term/tenure income, or some combination thereof. Your lender can tailor the reverse mortgage to your specific goals and needs.
Homeowners commonly use the proceeds to:
- Eliminate existing mortgage payments
- Eliminate consumer debt payments (credit cards, auto loans, personal loans, etc.)
- Pay for home improvements and repairs
- Cover medical bills or pay for in-home care
- Supplement existing retirement income
- Help protect and preserve existing retirement assets for longer
- Plan for long-term care
You can use the funds for pretty much whatever you like. You can even change up the payout options years after the reverse mortgage is complete.
How Does a Reverse Mortgage Work?
So, how does a HECM work?
First of all, the minimum qualifying age is 62. If you’re married, only one of you needs to be at least 62. The younger spouse can qualify as a non-borrowing spouse.
No mortgage payments are required as long as at least one borrower (or non-borrowing spouse) lives in the home and pays the required property charges. The loan becomes due and payable when the last borrower or non-borrowing spouse permanently leaves the home.
You remain the owner of your home and you’re free to leave it to your heirs. Your heirs can keep the home by paying off or refinancing the reverse mortgage balance. If your heirs don’t want the home, they can sell it, repay the reverse mortgage, and keep the remaining equity.
Your heirs can also let the lender sell it if they don’t want to keep the home or mess with selling it.
The HECM is a non-recourse loan, which means the most that will have to be repaid is the value of your home. If your home isn’t worth enough to pay off the entire balance, FHA will cover the shortage.
Proceeds have no impact on income taxes, Social Security retirement benefits, and Medicare.
Proceeds can sometimes impact Social Security Disability, Medicaid, and other government assistance programs. If you receive government assistance, be sure you thoroughly understand how a reverse mortgage could impact your benefits.
How a Reverse Mortgage Works Under the Hood
Now that we’ve covered some basics, let’s get into how a reverse mortgage works under the hood. This will be a little more technical, but it’s stuff that lenders usually don’t explain. In fact, many industry professionals don’t completely understand what we’re about to cover.
First of all, a reverse mortgage works opposite of what you’re used to. With a traditional “forward” mortgage, you borrow a large amount and pay it back on a monthly basis over time. Your loan balance decreases and your home equity increases over time.
A reverse mortgage works in the opposite direction. You borrow over time and pay it back in one lump sum when you’re no longer living in the home. The idea is to convert home equity into cash that can be used to fund your retirement. The balance grows over time as you extract equity out of your home.
How Proceeds Are Calculated
How much you can get from a HECM reverse mortgage depends on your home’s value, the age of the youngest borrower (or non-borrowing spouse), current interest rates, and the HECM program you select (fixed-rate or variable-rate). There’s no set amount that applies to everybody.
To determine how much you qualify for, your lender first establishes the maximum claim amount, which is equal to the lesser of the appraised value of your home or the FHA loan limit.
A principal limit factor (PL factor) is determined based on the age of the youngest borrower (or non-borrowing spouse) and the current expected interest rate.
The PL factor is multiplied by the maximum claim amount to determine the principal limit (PL), which is the total pool of cash available.
For example, let’s assume your home’s value is $400,000 and the PL factor is 0.50. Because the home value is less than the lending limit, we calculate proceeds based on the home value:
$400,000 (maximum claim amount) * 0.50 (PL factor) = $200,000 (principal limit)
In this case, the principal limit is $200,000. This is the total pool of cash available to pay off existing mortgages balances, closing costs, and other mandatory obligations.
Once the mandatory obligations are paid, the remaining funds can be allocated to term or tenure income, lump sum, and line of credit.
Older borrowers tend to qualify for higher PL factors, which means they qualify for more proceeds than younger borrowers.
PL factors also tend to increase as interest rates decrease. In other words, you tend to qualify for more when rates are low versus when rates are high.
How Interest Accrues
The HECM reverse mortgage is a home loan, so it has an interest rate like any other home loan. HECM rates are usually comparable to traditional “forward” mortgage interest rates.
HECM interest is calculated exactly the same way as it is for a “forward” mortgage. The interest rate is an annual rate, but the interest accrues monthly.
To calculate the interest for a given month, you take the annual interest rate, divide it by 12, and multiply it by the loan balance. For example, if the loan balance is $100,000 and the annual interest rate is 4%, the interest due for the current month would be calculated as follows:
$100,000 (loan balance) * 0.33% (4% annual rate/12 months) = $333.33
No mortgage payments are required, so the outstanding interest is simply added to the loan balance. The starting loan balance for the following month would be $100,333.33.
MIP also accrues onto the loan balance over time. Like interest, MIP is based on an annual rate, but it accrues monthly.
FHA changes the MIP rate from time to time, but as of this writing, it’s an annual rate of 0.50%. For the latest MIP rates, go here.
The closing costs for a HECM reverse mortgage typically fall into three categories:
- IMIP – A one-time fee charged at closing by FHA to insure the HECM. IMIP helps make the HECM non-recourse.
- Origination fee – A one-time fee charged by lenders. The origination fee can be negotiable, particularly if your starting loan balance is relatively large.
- Third-party costs – One-time fees are charged to cover third-party services necessary to complete your loan. Common third-party costs include title insurance, appraisal, government recording, credit report, etc.
Most or all of the closing costs are typically rolled into the new loan, which means they’re not out of pocket. The exception is a HECM for purchase; you’ll need to cover the closing costs out of pocket along with your down payment.
How a Reverse Mortgage Is Settled Up
Let’s cover how a reverse mortgage works when the last borrower (or non-borrowing spouse) passes away. This is a common topic raised by reverse mortgage applicants. How does a reverse mortgage work when it’s time to settle up? What happens to the home?
Once the servicer learns that all borrowers and/or non-borrowing spouses have passed away, it will issue a Due and Payable notice to the heirs. The servicer may also order an appraisal to determine the current market value of the home.
The heirs can also request their own appraisal at their own expense.
The heirs will have a few different options to settle the reverse mortgage balance:
- Pay the lesser of the loan balance or 95% of the appraised value to keep the home. The heirs can settle the loan balance by refinancing or using other assets such as savings or life insurance proceeds.
- Sell the property, repay the balance, and keep the remaining equity. The sale process works just like it would with any other type of mortgage. You hire a real estate agent (or sell it yourself, if you prefer), sell the house, and repay the loan balance once the sale closes. Any remaining equity goes into the estate.
- Give the lender a Deed in Lieu of foreclosure. The heirs sign the deed over to the servicer and the servicer sells the property and repays the loan balance.
- Do nothing. The lender uses the foreclosure process to sell the property and repay the loan balance.
HUD requires the lender to begin foreclosure proceedings if the heirs do not repay the balance in response to the Due and Payable Notice. Foreclosure must begin within 90 days, but no sooner than 30 days after the issuance of the Due and Payable Notice.
If the heirs plan to sell the home, they have an initial time window of six months to do so. If the heirs are diligently trying to sell the home, but are unsuccessful, they can request up to two 90-day extensions to push back foreclosure. In other words, the heirs could have as long as a year to sell the home before HUD requires the lender to foreclose.
It’s important to understand that the heirs do not lose out simply because the lender begins foreclosure proceedings. HUD requires lenders to being foreclosure by a certain date, but it doesn’t mean foreclosure is a done deal. The foreclosure process stops once the heirs repay the loan balance or sell the home.
A Few Final Thoughts
So, what is a reverse mortgage and how does it work? It’s simply a home loan that allows retirees to tap into home equity without a mortgage payment or giving up ownership of their home.
No mortgage payments are required, so any interest simply accrues onto the loan balance over time. Essentially, the home is paying the mortgage “payment” so you don’t have to out of your pocket.
What is a reverse mortgage used for? At the most fundamental level, it’s used to provide lifestyle and financial security in retirement. Instead of living on just Social Security, pensions, 401(k)s and IRAs, retirees can also live on the home equity they’ve built up over the years they’ve lived in their homes.
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