By Jamie Johnson, WCI Contributor
If you’re looking for ways to leverage the equity in your home, you may have considered taking out a reverse mortgage. This loan is meant for homeowners who either own their home outright or have considerable equity in it. A reverse mortgage loan can help older homeowners cover their monthly expenses, and you don’t have to repay it until you move out of the home. However, you should consider the pros and cons of that decision before taking one out.
Here's what you need to know about a reverse mortgage and how it works.
What Is a Reverse Mortgage?
A reverse mortgage is a loan that lets homeowners borrow from the equity in their house. It’s pretty much the opposite of a traditional mortgage—instead of making monthly mortgage payments to your lender, your lender will pay you.
Some people choose to take out a reverse mortgage because they can take advantage of the equity in their home without selling it first. They eliminate the monthly payment but still have a place to live.
The proceeds of a reverse mortgage are typically tax-free, and there are no minimum income requirements or credit checks to apply. The loan doesn’t have to be repaid until the borrower dies or sells the home.
How Does a Reverse Mortgage Work?
With a reverse mortgage, you can take the equity in your home and convert it into monthly tax-free payments. You can continue living in the house and don’t have to repay the loan until you move out.
When you find a reverse mortgage program, you’ll start by applying for the loan. The lender will review your property, title, and appraised value. If you’re approved, your lender will fund the loan, and you’ll receive the money either as a lump sum or in monthly payments.
There aren’t usually any minimum income or credit requirements to take out a reverse mortgage. But there are certain eligibility requirements you’ll have to meet:
- You must be at least 62 years old to qualify for a government-sponsored reserve mortgage
- You need to either own the property outright or have at least 50% equity
- There can only be one primary lien on the property
- You must stay current on your property taxes and homeowners insurance and keep the home in good condition
Private lenders may have their own qualifications you need to meet. So, the exact eligibility requirements can vary depending on the lender you use.
The 3 Types of Reverse Mortgages
If you’re considering applying for a reverse mortgage, there are three options you can choose from.
Home Equity Conversion Mortgage (HECM)
A home equity conversion mortgage (HECM) is a popular type of reverse mortgage and the only one that the federal government backs. These loans can be used for any purpose, and the exact amount you borrow will depend on your age and the appraised value of your home.
Before you can apply for a HECM, you have to meet with a counselor who will explain the costs. The counselor is also required to inform you of alternatives to taking out a HECM.
HECMs are the most common type of reverse mortgages, but they’re also the most expensive. They typically come with high upfront costs and are usually more costly than a traditional mortgage.
Single-Purpose Reverse Mortgage
A single-purpose reverse mortgage is the least expensive type of reverse mortgage. This loan is offered by state and local government agencies and certain nonprofits.
Unlike HECMs, these loans can only be used for one purpose as outlined by your lender. For instance, your lender may specify that the funds can only be used for home repairs.
Proprietary Reverse Mortgage
A proprietary reverse mortgage isn’t backed by any government agencies. The lender you work with will set the eligibility requirements and terms for the loan. A proprietary reverse mortgage tends to be easier to qualify for, but you do have to be on the lookout for scams.
The Consumer Financial Protection Bureau (CFPB) warns of several reverse mortgage scams. For instance, contractors will occasionally approach homeowners about taking out a reverse mortgage to pay for home repairs. Meanwhile, some mortgage companies will advertise special deals for veterans, even though the VA doesn’t actually offer reverse mortgages. Both scenarios are likely just a way to scam seniors out of the equity in their homes. So, be extra careful if you're thinking about getting a reverse mortgage.
Reverse Mortgage Pros and Cons
Reverse mortgages are often sold as a helpful tool for seniors, but is that actually the case? Let’s look at some of the pros and cons of reverse mortgages.
Pros of a Reverse Mortgage
- Supplement your income: Most seniors experience a drop in their income after retirement, and a reverse mortgage could help supplement that loss of income. The income you receive is tax-free.
- Stay in your home: A reverse mortgage allows you to take advantage of the equity in your home without needing to move. You can remain in your current home instead of having to downsize to another location.
- Repay the loan when you move: A reverse mortgage doesn’t have to be repaid until after you move. And the debt you incur can never exceed the fair market value of the home.
Cons of a Reverse Mortgage
- Can be costly: Reverse mortgages can come with a number of fees, including origination fees, servicing fees, and closing costs. The amount you owe on your reverse mortgage will grow over time as the interest continues to accumulate.
- You could lose your home: Reverse mortgages may seem like a safe option for seniors, but this isn’t always the case. If you fall behind on your taxes, HOA dues, or home repairs, your home could be foreclosed on.
- Interest isn’t tax-deductible: When you take out a reverse mortgage, you can’t deduct the interest paid on your taxes until you sell the home.
Is a Reverse Mortgage the Right Choice for You?
Now that you understand how reverse mortgages work, are they a good option? The best answer to that question is maybe—for some people, a reverse mortgage could be a good way to utilize the equity in your home. However, you want to understand the upfront and ongoing costs of a reverse mortgage, and too often, reverse mortgages are used to scam seniors out of their home equity.
The historical reputation of reverse mortgages might be that they're used to take advantage of the elderly who are desperate to stay afloat, but in reality, they can provide better tax efficiency for your retirement income and they can prevent you from running out of money before you die.
Here are a few things you should do before taking out a reverse mortgage:
- Shop around: Before settling on a lender, you should shop around to see what your options are. Compare the terms and fees from various lenders, and see which is the best deal for you.
- Meet with a HUD-approved counselor: A salesperson will try to rush you through the process of taking out a reverse mortgage. Instead, you should meet with a HUD-approved counselor who will explain how the process works.
- Consider the alternatives: There may be better ways to meet your spending needs or even to access the equity in your home—you might look into refinancing, or even just simply selling the home.
- Know your rights: According to the Federal Trade Commission (FTC), you have the right to cancel a reverse mortgage for any reason within three business days of closing. If you change your mind, you can notify your lender in writing, and they have to return any expenses you’ve already paid.
Like whole life insurance and annuities, reverse mortgages and those who sell them have had a bad reputation among financially savvy folks and for good reason. But there are also plenty of ways to use a reverse mortgage to better your cash flow and decrease your taxable income. Hopefully, though, the typical white coat investor will already be financially independent by the time they're old enough to qualify for a reverse mortgage and, thus, they wouldn't need one anyway.
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