Reverse Mortgage Pros and Cons
What Is a Reverse Mortgage?
A reverse mortgage is a loan for senior homeowners that uses a portion of the home’s equity as collateral. The loan generally does not have to be repaid until the last surviving homeowner permanently moves out of the property or passes away. At that time, the estate has approximately 6 months to repay the balance of the reverse mortgage or sell the home to pay off the balance.
All remaining equity is inherited by the estate. The estate is not personally liable if the home sells for less than the balance of the reverse mortgage. When you ask the question, what is a reverse mortgage, the following is the type of answer you should expect.
Eligibility For a Reverse Mortgage
To be eligible for a HECM reverse mortgage, the Federal Housing Administration (FHA) requires that all homeowners be at least age 62. If the home is not owned free and clear, then any existing mortgage must be paid off using the proceeds from the reverse mortgage loan at the closing. In addition, you must meet financial eligibility criteria as established by HUD.
When Does a Reverse Mortgage Come Due
A reverse mortgage typically does not become due as long as you meet the loan obligations. For example, you must live in the home as your primary residence, continue to pay required property taxes, homeowners insurance and maintain the home according to Federal Housing Administration requirements.
In the event of death or in the event that the home ceases to be the primary residence for more than 12 months, the homeowner’s estate can choose to repay the reverse mortgage or put the home up for sale.
If the equity in the home is higher than the balance of the loan, the remaining equity belongs to the estate.
If the sale of the home is not enough to pay off the reverse mortgage, the lender must take a loss and request reimbursement from the FHA. No other assets are affected by a reverse mortgage. For example, investments, second homes, cars, and other valuable possessions cannot be taken from the estate to pay off the reverse mortgage.
The amount that is available generally depends on four factors: age, current interest rate, appraised value of the home and government imposed lending limits. Use the calculator to estimate how much you could receive. Please note that you may need to set aside additional funds from loan proceeds to pay for taxes and insurance.
Distribution of Money From a Reverse Mortgage
There are several ways to receive the proceeds from a reverse mortgage:
- Lump sum – a lump sum of cash at closing.
- Tenure – equal monthly payments as long as the homeowner lives in the home.
- Term – equal monthly payments for a fixed period of time.
- Line of Credit – draw any amount at any time until the line of credit is exhausted.
- Any combination of those listed above
Difference Between a Reverse Mortgage and a Home Equity Loan
Unlike a Home Equity Line of Credit (HELOC), the HECM does not require the borrower to make monthly mortgage payments and any existing mortgage or mandatory obligations must be paid off using the proceeds from the reverse mortgage loan. Many seniors use the remaining proceeds to fund medical expenses, make home repairs or just keep the extra cash in case of an emergency. In addition, a HECM reverse mortgage line of credit cannot be reduced by the lender.
With a reverse mortgage the amount that can be borrowed is determined by an FHA formula that considers age, the current interest rate, and the appraised value of the home.
As stated previously, with traditional loans the homeowner is still required to make monthly payments, but with a reverse mortgage the loan is typically not due as long as the homeowner lives in the home as their primary residence, continues to pay required property taxes, homeowners insurance and maintains the home according to FHA requirements.
Pros of Reverse Mortgages
- Allows the homeowner to stay in the home.
- Can pay off existing mortgages on the home.
- No monthly mortgage payments are required, however the homeowner must live in the home as their primary residence, continue to pay required property taxes, homeowners insurance and maintain the home according to Federal Housing Administration requirements.
- The homeowner receives payments on flexible terms:
- Credit line for emergencies
- Monthly payments
- Lump sum distribution
- Any combination of the above
- A reverse mortgage can not get “upside down” so the heirs will never be personally liable for more than the home is sold for.
- Heirs inherit the home and keep any remaining equity after the balance of the reverse mortgage is paid off.
- Loan proceeds are not taxable.
- The interest rate may be lower than traditional mortgages and home equity loans.
Reverse Mortgage Cons
- The fees on a reverse mortgage are the same as a traditional FHA mortgage but are higher than a conventional mortgage because of the insurance cost. The largest costs are:
- FHA mortgage insurance
- Origination fee
- The loan balance gets larger over time and the value of the estate/inheritance may decrease over time.
- A reverse mortgage loan usually does not affect eligibility for entitlement programs, such as Medicare or Social Security benefits. However, some needs based government benefits such as Medicaid and Supplemental Security Income (SSI) may be affected by a reverse mortgage loan. You should consult a qualified professional to determine if there would be any impact to your government benefits.
- The program is not well understood by most individuals. However, the availability of independent reverse mortgage counseling helps.
Myths of Reverse Mortgages
- A reverse mortgage sells the home to the lender
- Heirs will not inherit the home
- The homeowner could get forced out of the home
- You could outlive the reverse mortgage
- Social Security and Medicare will be affected
- The homeowner pays taxes on reverse mortgage proceeds
- There are large out-of-pocket expenses
- A reverse mortgage is similar to a home equity loan
1. A reverse mortgage sells the home to the bank
Lenders are not in the business of owning homes — they wish to make loans and earn interest. The homeowner keeps the title to the home in their name. What the lender does is add a lien onto the title so that the lender can guarantee that it will eventually get paid back the money it lends.
2. Heirs will not inherit the home
The estate inherits the home as usual, but there will be a lien on the title for the amount of the reverse mortgage loan plus any accrued interest and mortgage insurance premium.
For example, let’s assume someoneone takes out a reverse mortgage and owes $50,000 after 5 years. Then the homeowner passes away and the estate sells the house for $250,000. The lender gets $50,000 and the estate inherits $200,000.
A reverse mortgage is a “non-recourse” loan which means that the HECM borrower (or his or her estate) will never owe more than the loan balance or value of the property, whichever is less; and no assets other than the home must be used to repay the debt. Non-recourse means simply that if the borrower (or estate) does not pay the balance when due, the mortgagee’s remedy is limited to foreclosure and the borrower will not be personally liable for any deficiency resulting from the foreclosure.
3. The homeowner could get forced out of the home
The HECM reverse mortgage was created specifically to allow seniors to live in their home for the rest of their lives. The homeowner will not be evicted or foreclosed on as long as the borrower meets the obligations of the loan. For example, the borrower must live in the home as their primary residence, continue to pay required property taxes, homeowners insurance and maintain the home according to Federal Housing Administration requirements.
4. Someone can outlive a reverse mortgage
The reverse mortgage becomes due when all homeowners have moved out of the property for 12 consecutive months or passed away.
5. Social Security and Medicare will be affected
Government entitlement programs such as Social Security and Medicare are usually not affected by a reverse mortgage. However, need-based programs such as Medicaid can be affected. It’s best to consult with a qualified financial advisor to learn how a reverse mortgage could impact eligibility of some government benefits.
6. The homeowner pays taxes on a reverse mortgage
The proceeds from a reverse mortgage are not considered income and are not taxable. Consult a tax advisor for more information.
7. There are large out-of-pocket expenses
Typically, the majority of lender closing costs and fees can be financed into the reverse mortgage loan.
8. A reverse mortgage is similar to a home equity loan
A reverse mortgage and a home equity loan both use the home’s equity as collateral; however, there are also some differences. For example,
- Any homeowner can apply for a home equity loan. A homeowner must be at least age 62 to be eligible for a reverse mortgage.
- A home equity loan typically must be repaid in monthly payments over 5 or 10 years. A reverse mortgage is typically not paid back until the homeowner moves out of the property for 12 consecutive months or passes away.
- A home equity loan that charges no closing costs may have a higher interest rate over the life of the loan. A reverse mortgage charges upfront closing costs but generally has lower interest over the course of the loan.
The three largest closing costs are the FHA mortgage insurance, the origination fee, and escrow fees. However the only cost that is typically paid out of pocket is counseling.
FHA Mortgage Insurance
With a HECM, the borrower is required to pay an initial Mortgage Insurance Premium (MIP), as well as an annual MIP of 1.25 percent. (Please see chart below for more details regarding the initial MIP).
The mortgage insurance premium provides the following safeguards:
- The HECM is a “non-recourse” loan. If you sell the home to repay the loan, you or your heirs will never owe more than the loan balance or the value of the property, whichever is less; and no assets other than the home must be used to repay the debt
- If the lender becomes insolvent or otherwise fails to make payments due the borrower; MIP ensures that the borrower will continue to receive their payments
The origination fee is what the reverse mortgage lender earns on the loan. The FHA uses a formula to determine what the lender can charge. The formula is:
- 2% of the first $200,000 of the property’s value and 1% of the amount over $200,000
- A maximum of a $6,000 origination fee
- A lender can charge a HECM origination fee up to $2,500 if your home is valued at less than $125,000
Title is required for all mortgages whether reverse or conventional. The largest part of title fees is title insurance. Title fees are usually broken down into:
- Title insurance (varies by state and with property value)
- Title settlement
- Title search/exam
- Payoff (if a mortgage is being paid off)
- Doc prep
An appraisal is required to determine your home’s value. A reverse mortgage appraisal is conducted by an FHA-approved appraiser and follows specific FHA guidelines that require more documentation than a typical appraisal. The cost of the appraisal can vary.
Other Closing Costs
- Wire Fee
- Flood Cert
- Credit Report
Interest and annual mortgage insurance premium accumulates on a reverse mortgage loan. However, instead of paying down the balance like you would on a traditional mortgage, the loan balance increases over time.
Interest Rate and Mortgage Insurance
The true interest rate is one and a quarter percentage points above the quoted rate because the total rate includes the FHA’s ongoing Mortgage Insurance Premium (MIP) charges. For example, if the quoted rate is 4.51%, with the MIP charges of 1.25%, the total rate would be 5.76%.
In general, to be eligible for a reverse mortgage the youngest homeowner must be 62 years old or older and have sufficient home equity. You must also meet financial eligibility criteria as established by HUD.
Determining whether or not there is sufficient equity in the home is an FHA calculation that takes into account:
- Current interest rate
- Whether the rate will be variable or fixed
- Age of the youngest homeowner
- FHA lending limits
- Appraised value of the home
You may need to set aside additional funds from loan proceeds to pay for taxes and insurance.
Frequently asked questions:
- If a homeowner is not 62 but they are permanently disabled, can they qualify?
- No. The FHA use age as a criteria to determine reverse mortgage eligibility and makes no exceptions for disability or Social Security status.
- Can someone qualify if they have a mortgage?
- Yes, as long as they have sufficient equity. Many homeowners who take out a reverse mortgage use it to pay off their existing mortgage, so they can stop making monthly mortgage payments.
- Do all 62-year olds who own their home qualify?
- No. Some homeowners who want to get a reverse mortgage are not eligible because they don’t have enough equity built up in their home. In addition, some types of homes are not eligible and the borrower must also meet financial eligibility criteria as established by HUD.
- What happens if there isn’t enough home equity to qualify?
- This is called a “shortfall.” This means that the reverse mortgage would not provide enough money to pay off the existing mortgage on the home — it is coming up “short.” In this situation, some homeowners may choose to make up the difference by paying down the balance on their mortgage by the amount of the shortfall so that they can qualify for the reverse mortgage. However, most people who want a reverse mortgage and have a shortfall don’t have enough money to do this.