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A reverse mortgage can be a great way for retirees to create an extra stream of income without having to make any loan payments. However, a reverse mortgage is a major financial decision, and like any major financial decision, it's important to know exactly what you're getting into before you commit. Here's what you need to know about reverse mortgages and the pros and cons of this option.
What is a reverse mortgage?
The reverse mortgage, or Home Equity Conversion Mortgage (HECM), has been in existence since 1988, and is an FHA-insured program. They were created in order to give retirees an additional option to create income. The guidelines I'll discuss throughout this article are applicable to this type of reverse mortgage.
There are also proprietary reverse mortgages, which are privately insured by the companies that offer them. While these aren't technically subject to the same regulations and qualifications as the HECM, most companies stick to them anyway.
So, what is a reverse mortgage? Unlike a traditional mortgage where a homebuyer makes payments to a lender over time, a reverse mortgage is the exact opposite arrangement, where a lender makes payments to a homeowner in exchange for equity in the home. In other words, a bank is lending a homeowner money so it can acquire equity in a home, as opposed to a traditional mortgage where the borrower's goal is to acquire equity over time.
Who can get a reverse mortgage?
Reverse mortgages aren't available to everybody. In order to obtain one, four specific conditions need to be met.
- You need to be at least 62 years old.
- Your home must conform to HUD standards. This means that co-ops and buildings with more than four housing units are ineligible, as are manufactured homes built before July 1976.
- The equity in your home must be sufficient to justify the reverse mortgage.
- The reverse mortgage lender must be the first lien holder. Any existing mortgages must be paid off with the proceeds from the reverse mortgage.
How it works
When you obtain a reverse mortgage, there are a few different ways it can work in regards to how you'll get paid. Here are the six types of payment plans offered for HECM reverse mortgages:
- Tenure: Equal monthly payments for as long as at least one borrower continues to live in the property.
- Term: Equal payments for a fixed number of months.
- Line of credit: Similar to a home equity line of credit (HELOC), borrowers who select this option can use their reverse mortgage borrowing ability when and if they need it.
- Modified tenure: A combination of a line of credit and the tenure option.
- Modified term: A combination of a line of credit and the term option.
- Single disbursement lump sum: A single payment made to the borrower(s) at closing.
Lump sum payments are generally made at a fixed interest rate, while the other options typically come with variable rates.
The amount of money you can get depends on your age, the current market interest rates, and the appraised value of the home. Currently, FHA-backed reverse mortgages are limited to $625,500 regardless of how much the home is worth, but proprietary reverse mortgage lenders may have higher limits. Additionally, before the loan process can be started, prospective borrowers need to take an approved counseling course explaining how reverse mortgages work, financial and tax implications, and other considerations.
Once the lender starts paying the borrower, interest begins to accumulate on the loan, as well as mortgage insurance costs, which the borrower pays.
However, you don't actually have to pay anything to a reverse mortgage lender. The loan is repaid when the borrower sells the home or dies. Most reverse mortgages are "nonrecourse" loans, meaning that the lender has no other way to collect what is owed other than through the sale of the home. This is a very important point, because as we'll see in a minute, reverse mortgage balances can increase rapidly, especially if the loan is held for a long period of time.
Unlike traditional mortgages, reverse mortgage borrowers still have to pay their own taxes and insurance each year. However, lenders are legally required to conduct financial assessments of borrowers to determine their financial condition, which involves an income analysis and a credit review. If the lender is concerned with the borrower's ability or willingness to keep up with these expenses, a portion of the reverse mortgage proceeds can be set aside for this purpose.
How the balance grows
For simplicity, let's consider a reverse mortgage obtained as a lump sum amount with a fixed interest rate. Let's say that you're 62, and obtain a $100,000 reverse mortgage at 5% interest (including mortgage insurance), and that your home's current value is $300,000. Here's how the balance can climb over time.
Note: Assumes monthly compounding
Here's the thing to notice. Over time, the balance you owe can climb pretty rapidly, especially in the latter years. However, because of the nonrecourse nature of reverse mortgages, you never actually "owe" more than the value of your home. In this example, if after 30 years your home's value had only grown to $400,000, that's all the lender could legally collect.
In general, the IRS doesn't consider proceeds of a reverse mortgage to be taxable income, rather, it is considered to be a loan advance. Unlike a traditional mortgage, borrowers can't deduct the interest charged on a reverse mortgage each year, as interest isn't deductible until it's actually paid. However, the mortgage insurance premium charged is deductible for taxpayers who itemize deductions.
Because proceeds from a reverse mortgage aren't taxable income, they'll have no effect on Social Security or Medicare benefits. However, proceeds are considered to be liquid assets, and therefore can affect Medicaid and SSI eligibility.
Beware of the costs
Reverse mortgages aren't cheap. According to the National Reverse Mortgage Lenders Association, the average borrower can expect to pay more than $8,900 in fees and other closing costs on a $100,000 reverse mortgage.
Before you decide on a reverse mortgage, it's a good idea to compare its costs to other forms of borrowing. For example, as of this writing, a home equity line of credit (HELOC) can be obtained with a variable interest rate of less than 4% and with no closing costs. However, the drawback is that unlike a reverse mortgage, you'd actually have to make loan payments. Even so, it's a good idea to take a close look at your options.
The bottom line on reverse mortgages
A reverse mortgage can be a great way for retirees who don't have sufficient income from other sources to get extra cash to cover expenses and live the lifestyle they want to live. While a reverse mortgage does have its benefits, the drawbacks need to be considered, such as the long-term loss of equity in your home and the costs of obtaining the reverse mortgage. If the pros outweigh the cons, a reverse mortgage could be a smart move for you.
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