Although they have received increased attention in recent years, many consumers still have a hard time fully understanding what reverse mortgages are, how they work and who they benefit.
Continue reading for a thorough explanation on the above topics, plus a discussion of the advantages and disadvantages of this complex financial product.
A reverse mortgage is a loan that allows senior homeowners to borrow money against their homeâ€™s equity. Instead of making monthly payments to their mortgage lender, the homeowner receives money every month from their lender â€” or receives a larger amount in a lump sum. The balance owed to the lender grows over time and isnâ€™t due until the homeowner moves out, sells the property or passes away.
Reverse mortgages are the opposite of a â€śforward,â€ť or traditional, mortgage, which allows a borrower to purchase a home and repay their lender on a monthly basis. With traditional mortgages, the balance owed reduces over time until itâ€™s completely paid off.
In both forward and reverse mortgages, the property is used as collateral for the loan. Only homeowners who are at least 62 years old can take out a reverse mortgage.
There are three types of reverse mortgages available to homeowners depending on their situation.
This is the most common reverse mortgage and is backed by the Federal Housing Administration (FHA). A HECM offers more flexibility in terms of how payments are disbursed to borrowers. Payment options include:
As the name suggests, this type of loan is used for a single purpose, such as covering home repairs or property taxes. Loan proceeds are typically distributed in a lump sum to cover the homeownerâ€™s financial need. Single-purpose reverse mortgages are offered by nonprofit agencies and some local and state governments.
This loan is offered by private lenders and usually benefits borrowers with high-value homes because they may receive bigger advances.
A reverse mortgage is a loan that takes a portion of your equity and converts it into payments made to you. The money you receive is typically tax-free, according to the Federal Trade Commission. Unlike a traditional home equity loan, you are not required to pay back a reverse mortgage on a set schedule.
Letâ€™s look at an example of how a reverse mortgage works:
John is retired, has paid off his mortgage and owns his home outright. He wants to stay in his home, but needs to supplement the monthly income he receives from Social Security and his pension.
The total amount John can borrow using a reverse mortgage is based on his age and that of his spouse, current mortgage rates and the homeâ€™s value; these limits are imposed by HUD. Hereâ€™s how the numbers could possibly work out for him, based on LendingTreeâ€™s reverse mortgage calculator:
|Value of the home||$300,000|
|Title holderâ€™s age||70|
|Lump sum estimate||$145,902|
Based on the calculator, John might qualify for as much as $145,902 if he decides to go the single disbursement route. An advantage of getting a lump-sum payment from your lender is that the interest rate will be fixed, unlike the other options which have an adjustable interest rate.
The reverse mortgage loan limit is $726,525 for 2019, which is 150% of the conforming loan limit of $484,350 for forward mortgages. Still, even if the amount of equity you have is lower than the loan limit, you wonâ€™t be allowed to borrow the full amount.
The amount youâ€™re allowed to borrow for a reverse mortgage is determined by the age of the youngest borrower, the homeâ€™s appraised value and the anticipated interest rate. Generally, the older you are, the more you can borrow.
The most common fees associated with a reverse mortgage include:
There are also additional closing costs and interest fees.
Senior homeowners who are interested in borrowing a reverse mortgage must meet the following requirements:
Most reverse mortgages have whatâ€™s called a â€śnon-recourse feature,â€ť which means if the lender takes legal action against you due to default, the lender can only use the home to satisfy the defaulted debt and canâ€™t come after you for any difference between how much you owe and the homeâ€™s value. This also applies to your heirs in the event you pass away and the home is sold to repay the debt.
Just like all other financial products, a reverse mortgage comes with its share of risks, which typically include the following:
Compared with a forward mortgage, the fees associated with a reverse mortgage are more costly. As an example, a HECM lender can charge an origination fee equal to $2,500 or 2% of the first $200,000 of your homeâ€™s value, whichever is greater, plus another 1% for any home value amount above $200,000. The maximum allowable origination fee is $6,000. By contrast, the average origination fee for a traditional mortgage is just under $1,000, according to data from Value Penguin, a LendingTree company.
You receive income from a reverse mortgage, but itâ€™s still a loan that you or your estate will be responsible for repaying. Since youâ€™re borrowing from your homeâ€™s available equity, your loan balance increases over time, which adds to your outstanding debt load.
The IRS treats the income received from reverse mortgages as loan advances, and for that reason any interest paid on a reverse mortgage isnâ€™t tax-deductible.
The majority of reverse mortgage products have an adjustable interest rate, which is subject to market fluctuations. Your rate will be at a high risk of increasing very quickly.
Consider the following benefits and drawbacks before applying for a reverse mortgage:
The timeline varies by lender, but the lending process could take two months or longer. Be sure to ask your loan officer for a rough idea.
No, interest paid on reverse mortgage balances is not tax-deductible.
When you pass away, your reverse mortgage becomes due and payable. If you have a surviving spouse or heirs, they will be responsible for paying back the loan, which might involve selling your house.
For HECM loans, you can find an FHA-approved lender through HUDâ€™s website. For other types of reverse mortgages, a quick online search will reveal public and private lenders in your area.
A reverse mortgage isnâ€™t the best option for every senior homeowner. If you need money to fund renovations, repairs or other expenses, here are some alternative options.
If you have a sizeable amount of equity in your home, you might qualify to take out a home equity loan or home equity line of credit (HELOC). You borrow a lump sum of cash with a home equity loan and youâ€™re granted a line of credit, similar to a credit card, with a HELOC. Either of these products might work better if youâ€™re still employed, as they require you to make monthly payments after borrowing the funds.
For those borrowers who still have a mortgage balance, you could refinance your loan by extending the term and lowering your monthly payment amount, which frees up some cash in your budget. You could take advantage of a cash-out refinance, which allows you to borrow a new mortgage thatâ€™s larger than what you actually need for your house and pocket the difference.
Empty-nesters with more home space than they actually need might benefit from renting out one of their bedrooms either through short- or long-term rentals. This generates extra income that can be used for remodeling, traveling or other expenses.
As long as youâ€™re old enough to tap your 401(k), IRA or other retirement account without any early withdrawal penalties, going this route is a less costly way to supplement your income. Generally speaking, you can withdraw from your retirement accounts without penalty starting at age 59 Â˝.
Reverse mortgages come with additional considerations that may not always be a concern for forward mortgages, but they may provide relief for some older homeowners who want to supplement their income and also age in place.
If you can comfortably manage your insurance, tax and other obligations related to homeownership, maintain your property and keep it in good condition, and are confident that your heirs will take care of your home after your passing, a reverse mortgage could work well for you.
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