How reverse mortgages work: A comprehensive guide to a tricky financial product

Most Americans aren't prepared as they head into retirement — the news isn't all bad, though. With home equity at an all-time high, more homeowners have options for securing cash. You may be wondering, "how do reverse mortgages work?" or whether a reverse mortgage alternative is a better fit. In this post, we'll take a deep dive into the workings of reverse mortgages.

Point Editorial Team
February 10, 2022
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How do reverse mortgages work?

Remember when you first took out your mortgage? You started with a substantial loan and each month chipped away at it bit by bit. You sent monthly payments to your lender, and the balance decreased over time. Eventually, you may have even paid it off entirely.

With a reverse mortgage, the lender gives you money. It’s essentially the bank repurchasing your house from you. 

Reverse mortgages can be paid as a lump sum, kept open as a line of credit, or paid out in monthly installments over time. Your reverse mortgage balance will continue to grow as interest charges and fees pile up, and monthly payments are paid out to you (if you opt for this method).

Who’s eligible for a reverse mortgage?

Reverse mortgages aren’t available to just anyone. You’ll need to meet the following criteria to be eligible:

  • Applicants can’t owe any federal debts
  • Must be at least age 62 or older
  • The home must be your primary residence
  • Mortgage holders must own 50% equity in the home 
  • The home can’t be a mobile home or a manufactured home
  • You must have the financial means to keep up with repairs, homeowners insurance, and property taxes

How much does a reverse mortgage cost?

Between closing costs and service fees, taking out a reverse mortgage can get expensive. Typical upfront and continued costs associated with a reverse mortgage include:

  • Origination fees: These are paid to the lender and can’t exceed $6,000.
  • Real estate closing costs: Paid to third parties, these costs consist of credit checks, mortgage taxes, recording fees, inspections, surveys, a title search, an appraisal, and other fees.
  • Fees and interest: Like any loan, you can expect to accumulate interest over the life of the loan. 
  • Property taxes and homeowners insurance: These are continued costs paid to third parties by the homeowners.
  • Initial mortgage insurance premium: Your lender will charge initial and annual mortgage insurance premiums you’ll pay to the Federal Housing Administration. This insurance guarantees you’ll receive the cash advances you are expecting. These premiums differ from homeowners insurance, which you are still responsible for.

Depending on the type of reverse mortgage you choose, you can pay expenses using the money from the reverse mortgage, your personal cash reserve, or roll it into your monthly payments. 

What types of reverse mortgages are available?

There are three main types of reverse mortgages, each of which serves a different financial purpose:

1. Home Equity Conversion Mortgages (HECMs)

HECMs are federally insured and backed by HUD — only FHA-approved lenders can offer them. These types of reverse mortgages offer the most flexibility and allow you to use the proceeds for any purpose. 

Initial mortgage insurance premiums on HECMs are limited to 2% of the property value or the maximum claim amount, whichever is less. Before closing, borrowers must undergo a HUD-approved counseling session, paying roughly $125.

2. Single-purpose reverse mortgages 

Need money to cover a single home-related expense? If so, a single-purpose reverse mortgage may be a good option for you. Not as common as the other types of reverse mortgages, they're primarily offered by state and local government agencies or non-profit organizations. Single-purpose reverse mortgages are the cheapest option but also the most restrictive. For example, you can only use proceeds to pay for a specific lender-approved item, such as property taxes or home repairs.

3. Proprietary reverse mortgages

If you live in a high-cost-of-living area like San Francisco or New York, you know that your home may be worth far more than the maximum amount allowed by HEMCs. In that case, a proprietary reverse mortgage offered by a private company may be a better option for you. Homeowners with high-value homes can receive a larger loan using this product. 

These types of reverse mortgages are private loans that are not government-backed. They're not as restrictive, but they lack some of the protections you get with a government-backed loan. Proprietary reverse mortgages — also called jumbo reverse mortgages — aren't subject to the financial safety measures that HECMs provide and may come with higher interest rates.

A personal finance professional can help you determine which type of reverse mortgage is right for your needs.

The pros and cons of a reverse mortgage

Reverse mortgages have many advantages and disadvantages that should be considered when deciding if it's right for you.

Pros of a reverse mortgage

  • The IRS typically does not tax the funds you receive in a reverse mortgage because they treat it as a loan.
  • A reverse mortgage shouldn’t affect your Medicare or Social Security benefits.
  • You can remain in your primary residence and continue to own your home.
  • You can pay off your existing mortgage and not have monthly mortgage payments.
  • You can finance fees and closing costs with your reverse mortgage, which lowers your out-of-pocket expenses.
  • Your heirs are generally not responsible or personally liable for any amount of the mortgage that exceeds your home’s value when the loan is repaid.
  • After you repay the loan, any remaining equity will belong to you or your heirs.

Cons of a reverse mortgage 

  • Not everyone will qualify for a reverse mortgage.
  • Due to accumulating interest and fees, your loan balance will increase as time passes.
  • Reverse mortgage fees are often higher than fees for a traditional mortgage.
  • Your lender could still foreclose on your home in some instances if you fail to pay property tax and HOA fees.
  • The more home equity you use, the less you leave behind for your heirs.
  • Failure to meet the requirements of a reverse mortgage means that it will become immediately due. If you cannot pay the reverse mortgage back, you may have to sell your home to pay off what you owe. 
  • If the negative aspects of a reverse mortgage outweigh the positive ones, other financial alternatives might work better for your situation.

If the negative aspects of a reverse mortgage outweigh the positive ones, other financial alternatives might work better for your situation.

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FAQs about reverse mortgages

Are there conditions for a reverse mortgage? 

When you sign up for a reverse mortgage, you also agree to particular conditions:

  • Homeowners insurance is necessary 
  • You must stay current on their property taxes
  • You must live in the home as your primary residence
  • Keeping up with home repairs and maintenance is required

If you cannot meet any of those obligations — such as falling behind on your property taxes or failing to keep your home in good order — your reverse mortgage will immediately become due. It’ll also become due if you, as the borrower, pass away.

How much can you borrow with a reverse mortgage?

How much money is available through a reverse mortgage depends on several things, including:

  • Borrower's age or the youngest spouse's age when both are on the title
  • The appraised value of your home
  • The amount of equity you own 
  • Current interest rates
  • The FHA maximum loan amount if using the HECM program — which is currently $970,800

How do reverse mortgages pay out?

Common ways you can receive payments from your reverse mortgage include:

  • Line of Credit: Generally, accessing these funds requires you to submit a written request to the loan servicer.
  • Term Payments: Term payments permit a fixed monthly payout for a specific time, such as ten years. The amount of money you receive each month during this time will stay the same.
  • Payment Tenure: You'll receive these fixed monthly payments for as long as you live in your home and it remains your primary residence. The stipends will only end when you and your spouse, if applicable, pass away or leave your home.

Other reverse mortgage payout options include:

  • Modified term/line of credit: Allows borrowers a hybrid payout where they get a fixed monthly payment for a specified time and a line of credit.
  • Modified tenure/line of credit: This provides fixed monthly payments and a line of credit for however long you remain in your home and use it as your primary residence.
  • Single disbursement: You can also request a lump sum payment, meaning you will receive all the proceeds of your reverse mortgage at closing.

How do you pay back a reverse mortgage? 

One of the most enticing things about a reverse mortgage is that you'll never need to make monthly payments on it — ever. In fact, your reverse mortgage may outlive you, in which case your estate will settle the balance. 

Reverse mortgages are generally paid back in one lump sum, usually from the sale of the home. For many people, this happens when they move to a nursing home — or can't keep up with the required conditions — and have to sell their home. 

If leaving your home to your heirs is important, you'll want to think twice about taking out a reverse mortgage. In addition, if you have a spouse not listed on the reverse mortgage, you'll need to ask the lender how it could affect them. Unfortunately, most lenders require a sale and could remove your family from the property. 

What reverse mortgage alternatives are on the market?

  1. Home Equity Line of Credit: A Home Equity Line of Credit (HELOC) works like a reverse mortgage. You can use part of your home’s equity to get immediate access to a revolving line of credit — which you can use unrestrictedly. 

  1. Home Equity Loan: A home equity loan is another popular reverse mortgage alternative that allows you to access your equity for a lump sum of cash. Home Equity loans come with monthly payments but are less restrictive. 

  1. Home Equity Investment (HEI): HEIs are an innovative, more freeing reverse mortgage alternative. It has the advantage of giving you a lump sum — which you can alternatively use to get out of a reverse mortgage — and doesn’t require any payments until the 30-year term is up. In addition, it’s more flexible than a reverse mortgage. For example, your heirs can take over the HEI if they want to keep the house.

Is a reverse mortgage right for you?

Now that you can confidently answer, “how do reverse mortgages work,” it's critical to compare lenders and reverse mortgage alternatives to find your best solution. 

Though a reverse mortgage may sound like a good idea, it may only work for some. Some situations make a reverse mortgage impossible, even if you meet eligibility requirements. For example, a reverse mortgage wouldn't make sense if you are looking to move soon or you may need to transition into a nursing home. Reverse mortgages aren't assumable either, which means the loan can't be transferred along with the property. 

One alternative option is to leverage a Home Equity Investment from Point to unlock your equity without taking on monthly payments. You can use that money to fund home renovation projects, pay bills, or consolidate debt — without the restrictive conditions.

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