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There are many financial benefits to homeownership including accruing wealth that you can pass onto future generations, controlling your living costs, and the ability to build equity in your property over time.
Equity is the value of your home minus any loan balances you have against the property. As you age, equity can be a particularly valuable financial resource since it can be tapped to provide a reliable stream of income in the form of a reverse mortgage. This can be a helpful source of funds during retirement in later years—or if you’re facing some other financial emergency.
What is a reverse mortgage?
A reverse mortgage is a type of loan that converts your home equity into cash that you can receive in the form of periodic payments—all without having to sell the property. These payments will come from the lender either on a monthly basis or you can opt to open a line of credit that’s used as needed.
An increasing number of homeowners are using reverse mortgages to generate a stream of tax-free income. The total number of reverse mortgage originations increased from 43,000 to 59,000 between 2020 to 2021, an increase of more than 36%, according to the Consumer Financial Protection Bureau (CFPB).
How do reverse mortgages work?
This loan arrangement is called a reverse mortgage because of the way the loan is structured. With a traditional mortgage, you borrow money to buy the home and you’ll make payments to a lender each month. However, with a reverse mortgage, the lender pays you.
Perhaps one of the most important points is that when taking out a reverse mortgage loan, the title to your home remains in your name. What you will be relinquishing however, is some of the equity you’ve accumulated in the home.
When you take out a reverse mortgage, the interest and fees associated with the loan are added to your reverse mortgage balance each month. And that means the loan balance grows month after month.
And here’s the key point: Your home equity decreases as a result, because you’re borrowing against the equity in your home.
“The difference between a forward mortgage and a reverse mortgage is that you’re accessing a bit of your available equity on your primary residence and you’re not having to pay a monthly mortgage payment,” explains Jennifer Fraser, of GreenPath Financial Wellness, a certified reverse mortgage counseling company. “But your home equity is going down because the lender is giving you the equity in advance.”
Some other important points about how reverse mortgages work:
- In most cases, you must be 62 or older to apply for a reverse mortgage. Though some lenders provide mortgages to applicants as young as 55.
- You must still pay property taxes on your home and homeowners insurance.
- You are also required to maintain the condition of your home.
- Reverse mortgages are repaid when the borrower no longer lives in the home. Typically the homeowner, or their heirs, will sell the home to repay the loan.
Different types of reverse mortgages
There are three different types of reverse mortgage options and some notable differences between them.
Home equity conversion mortgages (HECM)
Perhaps the most common type of reverse mortgage is the home equity conversion mortgage—or HECM. The only reverse mortgage insured by the federal government,
HECMs are backed by the U.S. Department of Housing and Urban Development (HUD). And as a result, these loans are available only through lenders that have been approved by the Federal Housing Administration (FHA).
When using a HECM, borrowers are able to choose how they receive funds—either through a fixed monthly payment or a line of credit or even some combination of both of those options. The money can be used for any purpose.
Proprietary reverse mortgages
Proprietary reverse mortgages are backed by the individual lenders offering them instead of the government. And unlike HECMs, these loans are typically available to borrowers younger than 62. Some lenders provide reverse mortgages to applicants who are as young as 55, says Steve Irwin, president of the National Reverse Mortgage Lenders Association (NRMLA).
In addition, proprietary reverse mortgages are known for offering higher loan amounts than HECMs. That means if you own a home worth $1 million or $2 million or more, you’ll be able to access more of the equity through a proprietary reverse mortgage than when using a HECM.
“The FHA lending limit for a HECM is $970,800 currently, so that means only $970,800 of home value is considered. If you have a home over $1 million that extra value is not calculated,” explains Irwin. “Some proprietary mortgages go as high as $4 million to $6 million, so it’s more of a jumbo product.”
Single-purpose reverse mortgages
Perhaps the least common and in some cases, least expensive option, single-purpose reverse mortgages are offered by state and local government agencies. In some cases, non-profits also offer these mortgages.
“Single-purpose reverse mortgages can only be used for a single approved purpose specified by the lender,” says Fraser. “That purpose can include such things as property taxes or home repairs.”
These types of reverse mortgages typically provide access to a more limited amount of home equity, meaning the loans are smaller, Fraser explains. In some cases, single purpose reverse mortgages may also be limited to homeowners with low to moderate income.
Reverse mortgage requirements
While the qualification requirements for a reverse mortgage may vary slightly between the three loan options and the lenders offering them, the criteria generally includes:
Age requirements
In the case of the HECM, borrowers must be at least 62 years old. For proprietary reverse mortgages, the age minimums may vary but in some cases borrowers may be as young as 55 to 60, says Irwin.
Residency requirements
The home must be your primary residence. This means you must live there the majority of the calendar year.
Housing counseling requirements
Reverse mortgage applicants are required to meet with an independent housing counselor to discuss their finances and the implications of a reverse mortgage. Whether it’s proprietary reverse mortgage or an FHA-insured HECM, independent, third-party counseling is required, says Irwin.
Mortgage balance
Most reverse mortgages require that applicants either own the home outright or have at least paid off a substantial portion of the mortgage.
Debt
Most lenders require that applicants not have any federal debt, especially in the case of HECMs. This includes such things as federal income taxes and federal student loans.
Condition of the home
Typically, the home must be in good shape to qualify for a reverse mortgage. If not, the lender may require repairs before proceeding with the loan.
Benefits and downsides of a reverse mortgage
There are pros and cons to reverse mortgages that should be weighed carefully before proceeding. This type of loan may not be right for everyone depending on your short and long-term financial goals.
Pros: Reliable flow of income
Whether you choose ongoing payments or a line of credit from your reverse mortgage, these loans can provide a steady source of income, which can be particularly important for those on a fixed income.
Pro: Eliminating mortgage payments
When you take out a reverse mortgage, the lender pays you and you cease making mortgage payments. This too is a key benefit and one that can be helpful for individuals who have a limited income as they age. Or for individuals who simply want to have additional money available to travel, pay for their children’s education expenses or other needs as they arise.
Pro: Avoid using other retirement accounts
Using a reverse mortgage can make it possible for borrowers to avoid tapping retirement investment accounts. This can be especially helpful during market downtowns that impact retirement savings accounts.
Pro: Reverse mortgage income is not taxed
The income generated by a reverse mortgage is not taxed under any circumstances. The IRS considers the money a loan advance.
Con: You eat away at the equity in your home
As your reverse loan balance increases, the equity in your home decreases. If your goal is to transfer the home with equity to your heirs, you should carefully consider this ramification before proceeding.
Con: Fees and interest
Like any loan, there’s interest and fees on a reverse mortgage. Many lenders charge an origination fee or closing costs—or both. There may also be servicing fees during the course of the loan. And depending on whether you open a HECM or a proprietary reverse mortgage, there may also be insurance premiums that are added to your loan balance each month.
Con: You must still pay taxes and insurance
The reverse mortgage arrangement requires that borrowers still pay property taxes on the home out of their own pocket and homeowners insurance. This means you must have the financial capability to stay abreast of these costs.
When does a reverse mortgage make sense?
Reverse mortgages are not for everyone. There are expenses and requirements involved with maintaining this type of loan. The most important of which is that borrowers must have the means to continue paying property taxes and home insurance out of their own funds.
“It is terribly important that borrowers understand that they must stay current on their property taxes, and homeowners insurance,” explains Irwin. Failing to do this could cause the loan to be called due.
Still, for the right person, in the right circumstances, Irwin says the loans can provide a helpful source of income.
“We’re seeing the majority of consumers pursue a reverse mortgage so that they may be relieved of the monthly mortgage obligation they have on their current home,” says Irwin. “We know the majority of senior homeowners want to age in place. And maintaining a monthly mortgage obligation through retirement has been a challenge.”
A reverse mortgage can also be a good choice for those who want to modify their homes as they age without having to take a typical personal loan that would require making principal and interest payments.
Finally, there are also individuals who want to avoid using retirement accounts, particularly if those accounts have taken a hit in a down market.
“Increasingly there are individuals who are just simply building reverse mortgages into a broader financial plan,” says Irwin. “This includes the strategic use of home equity if there are retirement savings accounts and retirement investment accounts that have taken a hit. Then people may turn to strategic use of home equity in the meantime.”
How to avoid scams related to reverse mortgages
It’s important to be aware of scams linked to reverse mortgages, according to the CFPB. This may include contractors who pressure you to use a reverse mortgage to pay for repairs to your property that you may not want or need. Or these scams may include advertisements falsely promoting special deals for veterans and no-payment reverse mortgages.
“Unfortunately seniors are often a target,” says Fraser. “One of the benefits of the requirements of a reverse mortgage is that prior to closing on a reverse mortgage, applicants must go through an educational session with a certified counselor. When we conduct those sessions we’re on the lookout for signs of duress or for someone who is potentially being asked to cash in equity and use it for something other than what they had planned.”
Before proceeding with a reverse mortgage, be sure you understand all of the implications and have carefully reviewed the costs and requirements associated with this type of loan.
