What is a Reverse Mortgage and How Does it Work?

Highlights:

• A reverse mortgage allows homeowners aged 62 and older to borrow money against the equity that they have built in their home.
• You generally do not have to repay your reverse mortgage as long as you are using your home as your primary residence. However, once you move out, sell your home or pass away, your reverse mortgage will be due in full.
• If you're considering a reverse mortgage, it's wise (and required in some instances) to meet with a HUD-approved counselor to ensure you understand the implications of your new loan.

A reverse mortgage can help older homeowners trade home equity for tax-free income. However, borrowing money against your home equity is not without financial risks.

What is a reverse mortgage?

A reverse mortgage is a type of loan that allows homeowners aged 62 and older to borrow money against the equity in their home. The income received through a reverse mortgage is typically not taxable. You may receive your funds in regular monthly payments, as a lump sum or through a line of credit.

Reverse mortgages are frequently used by older homeowners to tap into the home equity they've accumulated over many years. These funds can help cover large expenses during retirement such as in-home elder care, home upkeep and property taxes.

How does a reverse mortgage work?

Unlike traditional mortgages and other types of loans, when you take out a reverse mortgage, you don't have to immediately begin making payments. Instead, your loan balance grows over time as interest is charged each month and added back to the principal. As a result, your home equity decreases as your reverse mortgage balance increases each month.

You generally do not have to repay your reverse mortgage as long as you are using your home as your primary residence. However, it's important to note that a reverse mortgage is not free money.

If you decide to move out or sell your home, the balance on your reverse mortgage will be due in full. If you pass away before leaving your home, your estate will generally put your house on the market and use proceeds from the sale to repay your reverse mortgage debt, including the original loan amount, accrued interest, loan origination fees and other administrative costs.

Types of reverse mortgages

There are several types of reverse mortgages, each with unique features and requirements: Home Equity Conversion Mortgages (HECMs), single-purpose reverse mortgages, and proprietary reverse mortgages.

• HECMs, available only through Federal Housing Administration (FHA)-approved lenders, are secured by the federal government. The funds can be used at the homeowner's discretion, although applicants must meet with a counselor approved by the U.S. Department of Housing and Urban Development (HUD) before closing. HECMs are the most common type of reverse mortgage.
• Single-purpose reverse mortgages are backed by nonprofits and city or state governments. The funds must be used to cover a single expense — for instance, home maintenance or property taxes — that must be approved by your lender. They're generally the least common and the least expensive type of reverse mortgage.
• Proprietary reverse mortgages are offered by private lenders with no backing from federal, state or local governments. As a result, they're not subject to the same limitations as HECMs or single-purpose reverse mortgages and are often available in larger amounts.

It's also important to note that reverse mortgages are often more expensive than conventional mortgages. They come with pricey up-front costs, including loan origination fees, closing costs and — if you have an HECM — mortgage insurance premiums. That's in addition to recurring costs such as property taxes, homeowners insurance and interest.

Pros and Cons of Reverse Mortgages

Although a reverse mortgage is a viable way to tap into your home equity, these loans do have significant downsides. Before you contact a lender, consider the benefits and drawbacks of a reverse mortgage.

Pros

• Converts your home equity into cash. Many homeowners have significant wealth in the form of home equity. Tapping into that wealth through a reverse mortgage may help you to meet critical expenses that aren't covered by your savings or retirement income.
• Not taxable. The money you receive from your reverse mortgage is not taxed by the IRS. However, you can only deduct the interest you accrue on your reverse mortgage after your loan is paid.
• Keeps you in your home. A reverse mortgage can provide extra funds that allow you to live comfortably in your home, even as you age.

Cons

• Costly. With fees, interest and mortgage insurance premiums, reverse mortgages can be expensive. Other forms of credit secured by your home equity, such as home equity loans and lines of credit, have lower interest rates and may substantially reduce your borrowing costs.
• High financial risk. The balance on a reverse mortgage grows steadily over time. For this reason, they can significantly increase your debt and drain the equity from your home. Plus, if your circumstances change — for instance, if you must move into an assisted living facility — you can't sell your house without repaying your loan. This can significantly impact your future financial options.
• May threaten your estate. Over time, reverse mortgages can drain all of your home equity. When you pass away, you may have little or nothing left for your heirs after your estate sells your home and repays your reverse mortgage.

How to apply for a reverse mortgage

If a reverse mortgage makes sense for you and your family, you'll first need to make sure you meet several basic requirements. You may be eligible for a reverse mortgage if you:

• Are 62 years of age or older
• Hold considerable equity in your home
• Keep your home as your primary residence
• Maintain your home up to the appropriate property standards set by the lender
• Have no federal debt

However, before you rush to the nearest lender, make sure to consider your options. Meet with a HUD-approved counselor to make sure you understand the financial implications of a reverse mortgage on your spouse, your family and your heirs. They may also be able to guide you through other financing alternatives, including home equity loans and lines of credit.

If you do decide to apply for a reverse mortgage, compare offers from several lenders to find the loan with the lowest interest rates and fees. If you're approved, don't take your reverse mortgage for granted. You and your family must be financially prepared when payment is due.