Considering a Reverse Mortgage? Read This First.
Retirees who’ve built significant equity in their home but are short on cash for living expenses have a few options to generate cash flow: including obtaining a home equity loan or line of credit, selling their home and downsizing, or taking in a monthly renter if the situation allows. Yet, one additional option that has garnered plenty of publicity over the last several years is a reverse mortgage. Let’s explore this option in more detail.
What is a reverse mortgage?
A reverse mortgage is a loan that allows homeowners to convert a portion of their home equity into cash. Unlike a traditional mortgage wherein the borrower makes monthly payments to the lender, the lender actually makes payments to the borrower in this case: which is precisely how these types of loans—reverse mortgages—earned their name.
How does a reverse mortgage work?
Akin to a regular mortgage, anyone interested in a reverse mortgage needs to apply, receive approval from a lender, and pay for closing costs. Once approved, you’ll receive funds—tax-free—often as a fixed monthly payment, line of credit, or lump sum.
Reverse mortgages don’t require any loan payments to the lender (although this is still an option); instead, the entire loan balance (principal plus interest) is due when you sell your home, when the home is no longer your primary residence, or when you pass away (with heirs then assuming this responsibility). If the co-borrower is your spouse, you generally don’t need to pay back reverse mortgage loans until both parties satisfy any of the above requirements.
How to qualify for a reverse mortgage
Not everyone can take out a reverse mortgage loan. Typical qualification requirements include the following provisions:
· You must be at least 62 years of age
· The home must be your primary residence
· You can’t be delinquent on any federal debt
· Your home must be in good condition (per specific property standards)
· You must typically have at least 50% equity in your home (though the amount varies by lender)
While no minimum credit score requirements exist, lenders do consider your debt history as part of the approval process.
Types of reverse mortgages
There are three types of reverse mortgages, which are in fact all quite similar:
Home equity conversion mortgage (HECM)
Issued by the U.S. Federal Government, an HECM is the most common type of reverse mortgage. You can use these loans for any purpose—including bill payments, home renovations, or even vacations—and will likely pay a high mortgage premium and face limited mortgage amounts as they’re insured by the Federal Housing Administration. Borrowers must also receive counseling from a HUD-approved reverse mortgage counselor before receiving this type of loan.
Proprietary reverse mortgage
These types of reverse mortgages aren’t federally regulated and are offered by private lenders. Because they aren’t regulated or insured by the government, they generally summon higher loan amounts and higher interest rates than HECM loans. You can typically use these loans for any purpose.
Single-purpose reverse mortgage
Some local and state governments as well as nonprofit organizations offer these types of reverse mortgages, which—as their name implies—are designed for one purpose only as specified by the lender. These loans aren’t federally insured, so lenders don’t need to charge mortgage insurance premiums, but they usually reflect smaller dollar amounts than other types of reverse mortgages.
How reverse mortgage loan amounts are calculated
The amount you’re eligible to receive from a reverse mortgage is typically based on three factors: your age, the value of your home, and expected interest rates.
Other factors sometimes considered include any other financial obligations you have (debt) and the distribution type: meaning how you want to receive your funds (a lump sum will typically result in the lowest dollar amount you qualify for).
With regard to age, lenders often use the age of the youngest borrower or eligible non-borrowing spouse: because if the older homeowner dies, the loan won’t come due until the younger homeowner passes. As a result, more interest can accrue (which is better for the lender). What’s more, the younger the borrower, the less he or she qualifies for (meaning the lender faces less risk).
Common reverse mortgage fees
Generally speaking, a reverse mortgage loan is more expensive than a traditional home loan: especially with respect to fees.
While some upfront costs you may encounter resemble those of a traditional mortgage—including origination fees (reverse mortgage lenders can charge up to 2% of your home’s value but cannot exceed $6,000), third-party inspection and title search fees, and ongoing expenses such as interest and servicing fees—others do not.
For example, HECM loans charge an initial mortgage insurance premium (MIP) that is either 2% of your home’s appraised value or the current maximum lending limit ($1,089,300): whichever is less. This fee is due at closing. In addition, HECM loans charge an annual insurance premium (0.5% of the outstanding mortgage balance) that can be financed into the loan.
While expensive, initial and ongoing HECM loan insurance premiums provide several provisions that benefit borrowers. For example, this insurance guarantees the borrower will receive loan proceeds per agreed-upon terms. It also offers non-recourse protection; if the sale price of your home doesn’t cover the full amount owed, the lender is unable to go after any other assets you may have.
When reverse mortgages are worth considering
For a retired couple, healthcare expenses alone can top out at $315,000 (according to Fidelity); and that doesn’t even include long-term care! Add in housing, transportation, food, and utility expenses, and retirement costs accumulate quickly. In fact, the average retiree household (led by someone age 65+) spends $57,818 annually according to the most recent Bureau of Labor Statistics (BLS) data. That said, a reverse mortgage is sometimes a viable option if you’re struggling to keep up with these expenses during retirement.
When to NOT consider reverse mortgages
If you plan on moving in the near future, a reverse mortgage isn’t a sensible option: because when you move, your reverse mortgage loan will come due. You should therefore only consider a reverse mortgage if you plan on remaining in your home for an extended period of time.
It is in fact possible for your home to appreciate more than your reverse mortgage loan balance. However, if you’re looking to maximize the value of your estate for your heirs, a reverse mortgage would likely be too risky as the opposite can also hold true: meaning your heirs would need to hand ownership of the home back to the lender.
Finally, if you can’t afford to pay ongoing property maintenance expenses, the lender can require you to immediately pay back the loan.
In sum: are reverse mortgages worth it?
Reverse mortgages are controversial, especially when you consider high-pressure sales tactics and false claims some private lenders make with respect to the same (e.g., claiming you can’t lose your home). However, these are sometimes a good option for those who are house rich and cash poor and struggling to make ends meet during retirement—but only after they’ve considered all other available options.
FAQs
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Yes. In considering this possibility, it's important to understand that refinancing this type of mortgage does come with some risk. Age plays a role in determining how much equity you can access when refinancing, so as you get older, the amount of equity available may be limited. Breaking a reverse mortgage contract in order to refinance can also often result in prepayment penalties; it’s therefore crucial to thoroughly evaluate potential risks and implications before deciding to refinance a reverse mortgage.
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When you’re approved for a reverse mortgage, you can receive your funds in several ways. One option is to receive a single lump-sum payment, a method suitable if you have a specific major expense to cover—such as a home renovation or family vacation—or if you want to consolidate debt. That said, this loan structure is very risky: especially for early-age retirees lacking other retirement resources (retirement funds can dry up very quickly). Other options include:
· Line of credit: You can generally access up to 60% of your available principal limit in the first year, with the unused portion of your line of credit growing annually—irrespective of your home’s value—at the same adjustable rate you’re charged on any money you borrow.
· Term payment plans: These provide equal monthly payments with a predetermined end date.
· Modified term reverse plans: You’ll receive monthly payments for a predetermined period as well as a line of credit that’s accessible until you’ve exhausted the funds.
· Tenure payment plans: These provide equal monthly payments for life, so long as one borrower still lives in the home as his/her primary residence. While these payments are smaller, there is less risk since you won’t outlive your retirement savings.
· Modified tenure plans: You’ll receive both fixed monthly payments for life and have access to a line of credit, with more modest payments than a regular tenure plan.
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Yes, the amount of borrowed funds can dry up in this case. However, you can in fact remain in your home should this happen, provided you continue to live there, maintain it, and stay current on required taxes and insurance.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual or business.
