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The Beginner's Guide To The Reverse Mortgage

By Laura Agadoni · Jan 18, 2016 · Mortgage

The Beginner's Guide To The Reverse Mortgage

Image courtesy of BeSmartee, The Beginner's Guide To The Reverse Mortgage

If a mortgage is money you borrow to get a loan, then could a reverse mortgage possibly means the opposite: the lender paying you?

The answer is "yes." That's exactly what a reverse mortgage is.

But, of course, it's not that simple. A reverse mortgage comes with rules that homeowners must first meet to qualify. And just because they can qualify doesn't mean they should get one.

If you've ever wondered what a reverse mortgage is, read on for a primer on what it is and the pros and cons involved with this financial product.

History of Reverse Mortgage

The first reverse mortgage was granted in 1961 by Deering Savings & Loan. Its inventor was Nelson Haynes of Portland, Maine, who designed this innovative loan product to help the widow of his high school football coach. His idea was to grant a loan that would not have to be paid back until after a person died, at which point the estate would then pay the loan.

The U.S. Department of Housing and Urban Development (HUD) starting insuring reverse mortgages through the Federal Housing Administration (FHA) in 1988. That was the year President Ronald Reagan signed the reverse mortgage bill and made it a law, allowing the government to insure these loans. Another name for a reverse mortgage that is insured by the FHA is Home Equity Conversion Mortgage (HECM).

People didn't really know about reverse mortgages until the 1980s when they gained national attention after the government became involved. But people still weren't taking them out on a large scale until the early 2000s. That was a perfect time, as many people saw the value of their home increase but didn't have enough retirement income to cover their expenses.

Today, most reverse mortgages are HECMs, reverse mortgages insured by the FHA. People still get these loans from private lenders, but they are regulated by HUD. The reason most people get HECMs is that they are federally insured, meaning that if the lender goes out of business, the FHA will continue to honor the reverse mortgage deal the borrower stuck. It's possible to get a reverse mortgage that is not connected with the FHA, but they are few and far between. Whether the reverse mortgage is an HECM or an in-house loan, all these loan products usually follow the same rules.

The Basic Rules

You have to be 62 or older and a homeowner with equity in the home to get a reverse mortgage. This product uses the equity in the home to provide cash to the homeowner. For this reason, a credit score is not part of the equation; it doesn't matter what the borrower's credit score is, as it does to get a regular mortgage. But the borrower can't owe any federal debt, such as income taxes or student loans, if they are getting an HECM.

If the possibility of getting a reverse mortgage doesn't apply to you, it might apply to your parents or relatives, and that could affect you down the road. Why? A reverse mortgage can use up most or all the home's equity, leaving little or nothing for the heirs to inherit.

The Purpose

Reverse mortgages were designed to help older people who had money tied up in their homes but didn't have enough income to live on or to pay for health care. The product allows people to stay in their homes without having to sell the home to pay expenses.

Note: Although the product was designed for people to pay living expenses, people who take out a reverse mortgage can use the money any way they like, even if it's to take that dream vacation they've always wanted.

Paying Back the Loan

The reverse mortgage loan doesn't become due until someone sells the home or if the home is vacant for a year, such as if the homeowner goes into an assisted living facility or a nursing home. At that point, the homeowner, the spouse, or the estate pays back the loan, and this often means selling the house to pay back the reverse mortgage. But as long as the homeowner or last surviving borrower (typically the spouse) stays in the home, the loan is not due.

Although the reverse mortgage might have eaten up all the equity in the home, leaving heirs with nothing, they at least won't owe anything more than the home's value. For example, if the balance due on the loan was $200,000, but the heirs could get only $180,000 for the house, they would need to pay only $180,000. They wouldn't have to pay the additional $20,000.

Note: You are still responsible for paying property taxes, homeowners insurance, utilities, maintenance, and homeowners association fees (if those fees apply to you) as long as you live in the home. If you fail to pay these required expenses, the lender could call in the loan or foreclose on the house.

A note on spouses: If the spouse is not on the reverse mortgage and the homeowner who took out the reverse mortgage dies, that spouse, as of August 2014, can generally remain in the home without needing to immediately pay back the loan. But that spouse won't receive any more reverse mortgage money if they weren't on the loan. This is a fairly new policy. Before August 2014, spouses typically had to immediately repay the reverse mortgage.

It's Not Free

Reverse mortgages aren't free to set up or maintain. In fact, they're usually more expensive than a regular mortgage loan. Costs vary depending on the type of loan, the amount of money you take out, and the lender you use. Figure on paying an origination fee, closing costs, servicing fees, and mortgage insurance premiums for HECMs for the life of the loan.

You also pay interest on the money you borrow. Interest rates vary depending on the lender. You can pay either a fixed rate or an adjustable rate. Whichever you choose, you'll need to pay an extra 1.25 percent. This extra is added to the interest rate to pay for the mortgage insurance. And this interest compounds. The more the loan balance accrues, the more the interest does too. All this interest gets added to the loan balance.

It pays off to shop around for the best deal. Compare all the costs of the various lenders, and choose the lender that offers the best deal overall.

How Much Can You Get?

Just how much money you can get with a reverse mortgage varies based on many factors. The lender will consider the age of the borrower, the appraised value of the home, interest rates, and whether the borrower can pay all the expenses that come with owning a home.

The best-case scenario for a lender is to receive an application from an older person (the older the better) with lots of equity in a home that's paid off or close to being paid off. This person gets the most money. The younger you are, the longer the life of the loan will probably be, which costs lenders more. However, the loan is not based on actuarial tables that life insurance companies use, tables that consider your health and lifestyle. To get an idea of how much you might get, you can enter your information into a reverse mortgage calculator.

a reverse mortgage calculator

You can use a reverse mortgage calculator like the one above to see if it make sense for your situation.

Borrowers also have three choices on how they get their money: in one lump sum, as a line of credit, or as a monthly payout.

  • Lump sum: If you choose to get the money in one lump sum, you must have a fixed interest rate. You would also get less total money this way than if you chose another option.
  • Line of credit: The line-of-credit option lets you draw against your account any time you wish, like using a credit card. You can continue doing this until you use up all the money. You pay interest only on the money you take out.
  • Monthly payout: You have two choices here. You can get fixed monthly cash payouts for a specific time, or you can get fixed monthly cash payouts as long as you live in the home.

Is Income Received Taxed?

A reverse mortgage is not considered income, even though you're receiving money. It's considered to be a loan advance. Therefore, the money you receive is not taxable. Reverse mortgages usually have no effect on Medicare or Social Security benefits, either.

However, you cannot claim deductions for the interest that builds up on a reverse mortgage as you can on the interest you pay for a regular mortgage loan. The only time you can deduct the interest is when the reverse mortgage loan is paid.

Make Sure You'll Live in the Home for Awhile

Just as it's good advice to not buy a home if you don't plan to stay in it for about five years, you shouldn't take out a reverse mortgage unless you plan to live in the home for five years or more. The reason is the same for both scenarios: the costs associated with a mortgage or a reverse mortgage are high enough as to not make them worthwhile unless you plan on staying put awhile.

This is even truer with a reverse mortgage. In addition to the upfront costs, the continuing mortgage insurance required (that extra 1.25 percent) will probably be for nothing. This insurance is to cover the lender if your loan balance grows to more than the home's worth, which is unlikely if you move shortly after taking out the loan.

Counseling Is Required

Before you take out an HECM, you must meet with a financial counselor.

housing of urban development HECM counseling agencies

The HUD's counselor search system is a bit clunky. It tends to work better when you sort by "State" and enter your desired state, then press "send".

The counselor explains all the costs involved and goes over all the ins and outs of the loan product. They answer any questions you might have, and they present other options that might suit you better, options that you might not even know about, such as government programs that you might qualify for.

If you still decide that a reverse mortgage is the right choice for you, the counselor will help you choose the best product. Make sure that the counselor goes over all this with you to your satisfaction; you must pay the counselor for this service, so you should get value from the meeting.

Tip: Ask for an explanation of the Total Annual Loan Cost (TALC) rate. This gives you an accurate idea of just how much this loan costs you.

Concern for Heirs

Many seniors who could use the money a reverse mortgage provides are reluctant to take one out for fear of having nothing to leave their children. Although this could be the case, many times a borrower can take a reverse mortgage and still have a house to leave for their children.

If the value of the home appreciates, for example, or if the borrower doesn't use all the reverse mortgage money, the children simply need to pay off what was spent. It's true that they might need to sell the house to pay back the reverse mortgage money, but they get to keep anything over the amount borrowed. And that is still a great legacy. For example, if $100,000 was borrowed through a reverse mortgage, but the house sells for $200,000, the heirs would pay $100,000 and still get to keep $100,000.

Remember that a reverse mortgage is a non-recourse loan, meaning that the lender cannot collect more than the home's value. That's the reason the borrower pays mortgage insurance premiums.

Reverse Mortgage Scams

Be careful with people who try to push this loan product on you (or your parents) or try to make you think you need to spend money that a reverse mortgage provides when you really don't.

Home improvements: One way that people scam older homeowners is convincing them they need expensive home improvements that they don't really need. This homeowner might then think the only way to get this (unnecessary) home improvement is to take out a reverse mortgage.

Investments: Another scam involves a pushy salesperson trying to get an older homeowner to invest money they don't have now but could get if they would only take out a reverse mortgage.

Misrepresentation: Sometimes reverse mortgage brokers are misleading with seniors, telling them they will never lose their home, for example. And that is simply untrue. Some actions would trigger the loss of the home:

  • If the property is transferred or sold
  • If the borrower moves out for 12 months or more
  • If the borrower doesn't keep up with their obligations of paying taxes and insurance and maintaining the home

If you (or your loved ones) do happen to sign a reverse mortgage agreement only to realize later that you really shouldn't have, you have three days after you close on the deal to get out of it. If you want to do that, tell your lender in writing, sent certified mail, return receipt requested. The lender must then cancel the deal and return any money you paid within 20 days.

Different Uses for Reverse Mortgages

Probably the best use for a reverse mortgage today is the same as it was when it was first created back in 1961: to help cash poor but house rich homeowners meet their daily financial needs. Here are some other ways people use reverse mortgages:

  • To pay off an existing mortgage on the home
  • To make improvements that allow a borrower to remain in the home, such as installing a wheelchair ramp, widening doorways, and lowering countertops and light switches
  • To pay off major debts, such as credit card debt or a car loan
  • To have some fun, such as traveling and being able to go out to dinner
  • To buy a vacation home (If the borrower chooses this option, the vacation home cannot become the primary residence.)
  • To use as a safety net in case an emergency arises
  • To pay for someone to come in to care for the borrower so they can remain at home instead of going to a facility

A reverse mortgage, although not a solution for everyone, can work for many older people who have a home and now wish to use the equity in it. As long as the borrower knows all the rules and plays by the book, a reverse mortgage can be a great financial tool. All potential borrowers should understand completely what they are signing up for with a reverse mortgage by meeting with a counselor and speaking about this option with people they trust.

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