As pensions continue to be phased out in most industries, more and more retirees are relying on Social Security benefits that often do not cover all of their expenses. Unfortunately, there may be seniors who don’t realize that they have an additional asset at their disposal - their home.
Data from the 2020 US Census found that almost 80% of adults 65 or older own their own homes. Some of these adults don't know that they can use their homes to fund their retirement with a reverse mortgage, as long as they’re 62 or older. Read below to learn how a reverse mortgage works, when a reverse mortgage is a good idea and if a reverse mortgage is worth it for you.
What is a reverse mortgage?
If you own your own home or have a very low mortgage balance, you may qualify for a reverse mortgage. A reverse mortgage is a type of loan where the lender pays you a certain amount from the equity you’ve accrued. This can come in the form of a lump sum, a monthly payment or a line of credit, depending on the agreement.
Every month, you will accrue fees and interest that will not be due until you pass away or sell the house. After you no longer live in the home or pass away, the balance will be due. When that happens, the estate will be responsible for coming up with the funds to pay off the loan, usually by selling the home.
The home will always remain legally in your name while you have a reverse mortgage. You can only use a reverse mortgage on a primary residence. If you have a vacation home or rental property, you cannot take a reverse mortgage. If you change your mind about opening a reverse mortgage, you can cancel it within three days and receive your closing costs back from the lender.
Most seniors use reverse mortgages to cover the gap between their income and their expenses. They may also use the funds to pay for a child’s or grandchild’s college education, remodel their home to make it more senior-friendly, or to cover medical bills and other expenses.
Because you are allowed to stay in your home for as long as possible, your home’s value may drop below the amount of the reverse mortgage fees. This can also occur if your home’s value drops after taking out a reverse mortgage.
In most cases, there will be no penalty if the balance is larger than what your home sells for. In this instance, the mortgage insurance company will pay the difference between the home’s value and the reverse mortgage balance.
Unlike other types of loans, reverse mortgages do not have minimum credit score requirements. This is a huge perk for seniors with bad credit or no recent credit history.
Types of reverse mortgages
A Home Equity Conversion Mortgage (HECM) is the most common type of reverse mortgage. The HECM is insured by the Federal Housing Authority (FHA), the same federal organization that offers FHA mortgages.
A proprietary reverse mortgage is similar to an HECM, but is offered by a private lender and not the FHA. Proprietary reverse mortgages are often needed by homeowners with large home values. These reverse mortgages usually have higher interest rates than HECMs, but can offer more money to the homeowner than HECMs.
Single-purpose reverse mortgage
A single-purpose reverse mortgage is given by a state or local organization. Like it sounds, this type of reverse mortgage can only be used for a particular reason. This may include covering necessary home repairs or paying expensive property taxes.
This kind of reverse mortgage is usually less expensive, which can be a benefit for the homeowner who doesn’t need a large sum of money.
The benefits of a reverse mortgage
A home is the largest asset that most seniors possess. And while many are happy to sell their home and downsize, others want to grow old in the same residence they’ve had for decades.
That's the biggest benefit of a reverse mortgage - you can stay in your home while accessing the equity you’ve amassed over the years. This provides some comfort to seniors who aren’t ready for assisted living or nursing homes and want to stay independent.
For seniors who don't have a major nest egg, a reverse mortgage can help them pay for medical care, home repairs and other expenses without taking out a high-interest loan.
And unlike a home equity loan, payments for a reverse mortgage will not come due unless you pass away or move out of the home.
The drawbacks of a reverse mortgage
After you pass away, the reverse mortgage will be paid out of the estate. This often means that the home may have to be sold and the proceeds used to pay back the reverse mortgage. Because reverse mortgages have fees and interest charges, the amount remaining after the home sale may be less than you realize. This will affect how much your beneficiaries receive after your death.
A reverse mortgage also does not eliminate all of the expenses associated with having a home. When you have a reverse mortgage, you are still responsible for property taxes, homeowners insurance, and maintenance and upkeep.
While a reverse mortgage can sound like a perfect solution for a senior, there are significant costs. For instance, a reverse mortgage can come with origination fees, a one-time fee you pay to take out a loan. This can cost up to $6,000.
You will also have to pay closing costs, just like if you were selling or refinancing your home. These can include appraisal fees, title searches, formal inspections, surveys and more. It’s very similar to the process of buying a home, because the lender is ensuring that their investment will pay off.
There are also several fees that accrue each month. The first is interest charged by the lender. You also have to pay the mortgage insurance premium, which is similar to what you pay when you have less than 20% equity on a home.
When is a reverse mortgage a good idea?
A reverse mortgage can be appropriate if you’ve looked into any other way to increase your income or decrease your living expenses. It also allows seniors to improve their quality of life without having to sell their beloved home.
Before taking out a reverse mortgage, you should meet with a reverse mortgage counselor to determine how much it will cost. Knowing what your heirs will be left with can be helpful in making the right decision.
When is a reverse mortgage a bad idea?
Fees for a reverse mortgage can vary and are often higher than homeowners realize. If you are hoping to leave your home behind as a legacy and wealth-building tool for your children, then a reverse mortgage could destroy the asset’s value.
Because the home may be used to pay off the reverse mortgage, the homeowner is required to maintain a certain condition. If the home falls into disrepair, you may lose access to the reverse mortgage funds until repairs are completed.
Also, if someone lives in the home with you who is not a co-borrower or an eligible spouse, then they may have to pay off the balance to stay in the house if you pass away or move out.
Alternatives to a reverse mortgage
Home equity loan
Just like it sounds, a home equity loan uses the built-up equity in your home as collateral. You usually need to have at least 15% equity in the home to qualify for a home equity loan.
Terms for home equity loans can range from five to 20 years, but you can also find 30-year repayment terms. Like a reverse mortgage, you can use home equity loans to pay for home repairs, remodeling projects, living expenses, other debts and more.
Home Equity Line of Credit
A home equity line of credit (HELOC) is similar to a home equity loan in that it relies on your home’s equity as collateral. However, instead of receiving a lump sum amount, you have a line of credit you can borrow against.
A HELOC has a draw period, during which time you can use the funds. The draw period can range between five and 10 years. After the draw period is over, you can no longer borrow from the HELOC and you will have to start paying back the money you borrowed. The repayment period generally lasts between 10 and 20 years.
A HELOC is often more flexible than a home equity loan, because you’re not required to borrow the full amount you qualify for. This can make it easier for homeowners who don’t know exactly how much they need to borrow. For example, if you're doing a home improvement project, you won't know the full cost until it's over. By using a HELOC, you may be able to save on interest fees if you don't need the full loan amount.
A cash-out refinance is when you take out extra equity in your home and replace your existing mortgage with a higher mortgage. A cash-out refinance lets you borrow up to 80% of your home’s value.
For example, let's say you have a $150,000 mortgage on a home worth $400,000. This means you have $250,000 in equity. In this case, the maximum amount you can cash out would be $170,000.
If you decide to go through with a cash-out refinance, you will replace your $150,000 mortgage with a $320,000 mortgage. This means that your total monthly mortgage payment will be higher. Many consumers do not realize they will also end up paying more in total interest with a cash-out refinance, especially if overall rates are significantly higher than when they first took out a loan.
Home Equity Investment
A Home Equity Investment (HEI) is when you receive an up-front payment in exchange for a share of your home's future appreciation. The percentage will be agreed upon at the beginning. There are no monthly payments, and homeowners can buy back their equity anytime within a 30-year term — without prepayment penalties.
HEIs are a flexible solution, as there are no income requirements or need for perfect credit to qualify. If you're not interested in having an extra monthly payment by taking out a home equity loan or a HELOC or want to avoid the balance of a reverse mortgage, an HEI may be one of your best options.
Taking out a reverse mortgage is a major decision and should not be done lightly. Speaking with a financial planner or other qualified source can help you decide if there are any other alternatives that will be less costly and more in line with your goals.
They may also be able to help you determine the best way to access your home equity, as well as how much you actually need to live on each month. All in all, treating your home as a financial asset can help you reap the rewards of decades of growth and help you achieve your financial goals faster than you imagined.