How Does a Reverse Mortgage Work?

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A reverse mortgage is a special type of mortgage loan based on the equity in your home. Unlike a traditional mortgage, you don't make payments on a reverse mortgage -- in fact, the payments are made to you. This may sound a little strange, so let's take a look at how a reverse mortgage works, who can get one, and whether or not it might be a good idea for you.

How it works and who can get oneA reverse mortgage gives homeowners four ways to extract equity from their homes: via a lump sum payout, monthly payments, an open line of credit, or a combination of the three. When it comes to monthly payments, moreover, there are two ways they can be structured: "term", or payments for a set number of years, and "tenure," which means you'll continue to receive payments for as long as you own the home.

The money you receive begins to accrue interest at either a fixed or variable interest rate, depending on your loan terms, and you'll also have to pay mortgage insurance, calculated as a percentage of the loan balance. Once you die, sell the home, or vacate the home for 12 months or more, the loan becomes due and the lender recoups the outstanding loan balance from the sale of your home.

A reverse mortgage loan is a nonrecourse loan, meaning that the lender can only recoup their money upon the sale of the property, and the amount the lender collects cannot exceed the sale price of the home. Borrowers aren't responsible for any loan balance that builds up above the value of the home, and heirs cannot be held responsible for any part of the balance.

In order to be eligible to receive a reverse mortgage, you must own a home conforming to HUD standards -- a single family home, two-to-four unit property, condo, townhouse, or manufactured home built after June 1976. Co-ops or apartment buildings with more than four units are not eligible. You also must be at least 62 years of age and have enough equity in your home to justify the reverse mortgage. If there is an existing mortgage on the property, it must be paid with the reverse mortgage proceeds: the reverse mortgage lender must be in a first lien position.

As of April 27, 2015, all lenders are required to conduct financial assessments of prospective borrowers in order to determine their financial condition, since unlike a standard mortgage where an escrow account is established, borrowers are responsible for paying their own property taxes and homeowner's insurance. If it is determined that they might have trouble with these expenses, a portion of the reverse mortgage proceeds may be set aside in order to make sure they get paid.

An exampleLet's say that you own a home worth $300,000 free and clear, and decide to take out a reverse mortgage on the property. And, after considering your age and expected interest rate (we'll say a 5% total fixed interest rate, for the sake of simplicity, although monthly reverse mortgage payments tend to come with a variable rate), HUD determines you are eligible for a $140,000 reverse mortgage. You choose to receive this as equal monthly payments over a 10-year period, so $1,167 per month.

Every time you receive a check, your outstanding loan balance increases. Then, interest begins to accumulate on the money you've received, and the balance begins to rise. Here's an example of how the loan balance could increase over time.

Note: Assumes the cost of mortgage insurance is included in the 5% interest rate and that no "lump sum" is received when the loan is approved.

As you can see, a reverse mortgage can quickly eat away at your home equity. Since the lender cannot collect on the loan until your home is sold, the balance continues to climb even after the 10-year period runs out.

Reasons for and against reverse mortgagesThe reason a homeowner might want to get a reverse mortgage is simple: They'll receive money to help out with expenses or enhance their quality of life in retirement which they'll never have to pay back in their lifetime. It doesn't affect Social Security or Medicare benefits, and the borrowers retain the title to the home.

However, a reverse mortgage is not for everyone. For one thing, the initial costs of a reverse mortgage tend to be high (comparable to an FHA mortgage). According to the National Reverse Mortgage Lenders Association, a borrower can expect to pay $8,908 in fees and closing costs on a $100,000 reverse mortgage. So, if you're only planning on staying in the home for a few years, there might be cheaper options to borrow the money, such as a home equity line of credit, which you can usually obtain without any closing costs and pay just a small annual fee. According to Wells Fargo's HELOC calculator, a $100,000 HELOC on a $300,000 property comes with a variable interest rate as low as 3.675% and has just a $75 annual fee and no closing costs.

It's worth noting, moreover, that if you want to leave your home (or some of its equity) to your heirs, a reverse mortgage is usually a bad idea, for obvious reasons.

So, is it right for you?It depends. If you would rather use the equity in your home now than leave it to your heirs later, a reverse mortgage could be a great way to create an additional income stream in retirement. However, like any other major financial decision, it's important to consider all of the potential pros and cons before deciding whether or not applying for a reverse mortgage is in your best interest.

The article How Does a Reverse Mortgage Work? originally appeared on Fool.com.

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