Ronald Reagan signed a law in 1987 that created a brand new type of loan called the Home Equity Conversion Mortgage (HECM), which is known as a reverse mortgage. Even though it’s been around for almost three decades, many people aren’t familiar with it and don’t understand how it works.
In this post, I’ll explain what a reverse mortgage is, the different types, who can have one, and how much you can borrow. Plus, I’ll give you the main pros and cons to consider before getting a reverse mortgage, which is a question that came in recently from a Money Girl podcast listener named Steve B.
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What Is a Reverse Mortgage?
A reverse mortgage is a home loan that allows you to convert a portion of your equity into cash without having to make any payments. To get one you must be at least 62 years old, own and occupy your home, and have some amount of equity in it.
Equity is the difference between your home’s appraised market value and how much you owe on it. For instance, let’s say your home is worth $250,000. If your mortgage balance is $100,000, then you have $150,000 ($250,000—$100,000) in equity, which equals 60% ($150,000 / $250,000 = 0.60).
The main difference between a reverse mortgage and a regular mortgage or home equity loan is that the lender pays you, instead of you paying a lender. That’s the “reverse” part.
It’s an advance on the equity you’ve already built up in your home. To qualify, you typically need at least 40% equity. And if you already have a mortgage, you also need enough equity to pay it off using the loan proceeds so the reverse mortgage is the only debt on your home.
See also: Should You Get or Pay Off a Home Mortgage?
How Is a Reverse Mortgage Paid Off?
Since you don’t have to make payments, you may be wondering how a reverse mortgage is paid off. The amount you owe grows as interest on the loan accumulates over time. And just like with a regular mortgage, you eventually have to pay it back what you borrowed plus interest.
You or your heirs will have to settle up with a reverse mortgage lender when you move out of the home or die.
You or your heirs will have to settle up with a reverse mortgage lender when you move out of the home or die—typically by selling the property.
Heirs have a minimum of six months to satisfy the debt, but they can request a 90-day extension, if needed. If a reverse mortgage isn’t paid off by that time, the lender could begin foreclosure.
But your heirs are not legally responsible for your debt. So if the house sells for less than what you owe, the bank takes a loss, not you or your heirs. And if it sells for more than what you owe, any remaining equity belongs to you, your heirs, or your estate.
See also: The Truth About Debt and Death
Types of Reverse Mortgages
There are 3 main types of reverse mortgages homeowners can choose from:
Type #1: Home Equity Conversion Mortgage (HECM)
The HECM that I previously mentioned is the most popular reverse mortgage because it’s backed by the Federal Housing Administration (FHA), gives you multiple payment options, and allows you to use the money for anything you want.
With an adjustable-rate HECM you can be paid:
a single lump sum
fixed amounts over a specific period of time
fixed amounts as long as you live in your home
a line of credit that allows you to tap any amount of funds at any time (until you’ve used up your available credit line)
a combination of fixed payments and a credit line
Fixed-rate HECMs offer a lump sum payment only. The total amount you can borrow on a reverse mortgage is called the principal limit. It’s calculated based on factors such as your age, home equity, and interest rate—but is capped at $625,500, as of 2016.
The amount you can borrow is typically in the range of 50% to 60% of your equity, but could be more or less depending on your situation. As interest rates rise, homeowners qualify for less money; however, older homeowners can typically borrow more since having a shorter life expectancy makes you less risky.
One unique feature of an HECM is that you have to complete financial counseling with an independent government-approved agency in order to apply. The counselor must explain the loan’s costs, your obligations for repayment, and possible alternatives to tap your home’s equity.
There is no income or credit requirement to be approved for a reverse mortgage; however, lenders do assess your overall financial situation.
There is no income or credit requirement to be approved for a reverse mortgage; however, lenders do assess your overall financial situation. They want to make sure that you’re willing and able to maintain your home after the loan is funded.
Type #2: Proprietary Reverse Mortgage
The second type of reverse mortgage is offered by private companies and is called a proprietary reverse mortgage. These loans make up a small portion of the reverse mortgage market, but offer unique features because the federal government does not insure them. In other words, they don’t come with as many restrictions as HECM products.
For instance, if your home is worth more than the government’s lending limit of $625,500, you can get a much larger loan. That’s why proprietary products are also called jumbo reverse mortgages. Similar to an HECM, you can take funds as a lump sum or a line of credit and spend them any way you like.
Unlike an HECM, proprietary reverse mortgages don’t come with upfront or monthly mortgage insurance premiums, but may come with higher interest rates. Another big difference is that the lender can, but doesn’t have to require you to get mortgage counseling.
Type #3: Single-Purpose Reverse Mortgage
The last type of reverse mortgage is not widely available, but is the least expensive. It’s called a single-purpose reverse mortgage because it can only be used for a specific, lender-approved reason, such as making home repairs or paying property taxes.
Single-purpose reverse mortgages may be offered by local and state government agencies and non-profits. They often go by another name, such as a property tax deferral program, and may be limited to low- to moderate-income homeowners.
See also: 5 Ways to Get a Loan With Bad Credit
5 Pros of Getting a Reverse Mortgage
Now that you understand what a reverse mortgage is, I'll summarize the benefits of the HECM product only, since it's the most popular type. Here are five main pros to consider before getting one:
Pro #1: There are no restrictions on how you spend reverse mortgage money.
As I previously mentioned, getting a reverse mortgage means that you can quickly tap the equity in your home and spend it any way you like. That’s a lifesaver if you’re cash poor, but equity rich, and need to supplement your retirement income to meet everyday living expenses and bills.
Even if you have plenty of income, you could use a reverse mortgage to pay off a first or second mortgage so you don’t have to make monthly payments anymore. That helps cut costs so you can stretch your income every month.
Even if you have plenty of income, you could use a reverse mortgage to pay off a first or second mortgage so you don’t have to make monthly payments anymore.
Or you could use the money to take a dream vacation, make home improvements, buy a second home, a boat, or to start a business. No matter how you use the money from a reverse mortgage, it’s a great source of tax-free income after you reach age 62.
Pro #2: You don’t need income to qualify for a reverse mortgage.
One of the problems with getting a regular mortgage or home equity loan when you’re in retirement is that you may not have enough income to qualify—even if you have plenty of home equity.
But with a reverse mortgage you can qualify even if you have little or no income. That means you don’t have to sell your home to get your equity out of it. You can keep your home, maintain your lifestyle, and take income from the equity you’ve accumulated.
Pro #3: You can take money from a reverse mortgage in a variety of ways.
Depending on the reverse mortgage product you choose, you can access your home equity in different ways.
Getting an adjustable rate product that comes with a line of credit gives you the most flexibility. You can tap it if you need money for any reason, or you can leave it alone.
Pro #4: A reverse mortgage line of credit can grow over time.
Another huge advantage with a reverse mortgage credit line is that your unused balance actually grows at the current interest rate. That means you could end up with more cash over time than when you originally got the credit line.
This is how a reverse mortgage can be part of a smart retirement plan. For instance, let’s say you don’t need to tap your equity at age 62, but you take out an HECM line of credit anyway.
If an unexpected tragedy occurs—like getting Alzheimer’s, needing an assisted living facility, or having expensive home repair bills—you’ll have a growing balance to leverage if you need it. You may not need it, but knowing it’s there can give you terrific peace of mind.
Pro #5: You can never owe more for a reverse mortgage than the value of your home.
Regardless of how much you borrow, reverse mortgages are designed so you can never owe more than what your home is worth. That protects you in case your property value declines.
As I previously mentioned, if you or your estate can't sell your home for enough to pay off your reverse mortgage balance, the lender takes a loss, not you.
See also: Got Cash? What to Do With Extra Money
5 Cons of Getting a Reverse Mortgage
Now let’s cover the cons of getting a reverse mortgage through the HECM program:
Con #1: Reverse mortgages come with higher-than-average costs
The major downside of getting a reverse mortgage is that they come with fees, closing costs, and interest rates that are higher than for traditional mortgages or home equity loans. Because your ability to get a reverse mortgage is not based on your income or credit score, lenders offset the unique risks of the loan by charging you higher fees.
Because your ability to get a reverse mortgage is not based on your income or credit score, lenders offset the unique risks of the loan by charging you higher fees.
The longer you have a reverse mortgage the less it costs you over the long run. So, if you just need money for a short period of time or plan to sell your home after just a few years, you’ll probably come out ahead getting a home equity loan or a line of credit instead.
But, as I previously mentioned, those types of traditional loans require you to have sufficient income, credit, and to make monthly payments.
Con #2: You’re still responsible for all of your home’s expenses.
With any type of reverse mortgage, you keep the title to your home. That means that you’re still responsible for maintaining it, keeping it insured, and paying the property taxes.
If you don’t comply, you could be required to repay your reverse mortgage early. But the good news is that you can pay for these expenses using the money you get from the loan or line of credit (if you have enough equity).
Con #3: You or your heirs have to eventually repay a reverse mortgage.
As I previously mentioned, if you can’t stay in your home you have to begin repaying the debt. If you have to relocate or go into a medical facility due to an illness, you have 12 months before you have to pay back the balance. This could be a time in your life when money is already tight.
In some situations a surviving spouse who didn’t sign the loan, because he or she was younger than 62 at the time, may be able to stay in the home. However, your spouse wouldn't be allowed to take any money from the reverse mortgage and would be responsible for maintaining the property and paying insurance and property taxes.
Remember that spending any amount of equity in your home reduces the value of your estate, which leaves less for your heirs. So, if leaving a financial legacy is important to you, consider other ways to accomplish that goal, such as purchasing life insurance.
Con #4: You won’t be able to deduct home mortgage interest.
A huge benefit of a traditional mortgage is the home mortgage interest deduction, which allows you to deduct the interest you pay from your taxable income, reducing the amount of tax you owe.
But you can’t deduct interest for a reverse mortgage because you don’t make principal or interest payments on the loan until it’s paid off. At that time you can take the deduction, if you’re still alive.
Con #5: Getting extra income affects your eligibility for certain benefits.
Getting money from a reverse mortgage could affect your eligibility for federal or state benefits that are based on assets. For instance, if you believe you might need to rely on Medicaid for long-term care, having a reverse mortgage might substantially delay when you can qualify.
But getting income from a reverse mortgage doesn’t affect regular benefits like Social Security or Medicare in any way.
Should You Get a Reverse Mortgage?
A reverse mortgage can be a quick way to turn your home equity into cash without having to sell the property, give up ownership, or make monthly payments. When used wisely it can be a valuable financial planning tool, a solution for cash-strapped retirees, or icing on the cake for those who just want to upgrade their lifestyles.
But a reverse mortgage isn’t for everyone, so be sure to weigh all the pros and cons, compare interest rates and fees of different types of loans, and consider alternatives to tap your equity, such as a traditional home equity line of credit (HELOC) or home equity loan.
Here are some tools to help you learn more:
One Reverse Mortgage Calculator
AAG Reverse Mortgage Calculator
Liberty Reverse Mortgage Calculator
Mortgage Professor Reverse Mortgage Calculator
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