Reverse mortgages are a type of mortgage in which a homeowner can borrow money against the value of his or her home, receiving funds in the form of a fixed monthly payment or a line of credit. No repayment of the mortgage (principal or interest), is required until the borrower dies, moves away permanently or sells the home. The transaction is structured so that the loan amount will not exceed the value of the home over the life of the loan.
Reverse mortgages have existed in one form or another since the 1960s, but the modern version has recently entered public awareness as a viable debt instrument for homeowners. Although this type of loan has been viewed with distrust by both the financial planning community and the media, demand has been increasing because it can provide a quick solution for people who are house rich and cash poor, especially senior citizens who need to supplement their retirement income or pay for long-term care. Before jumping in, however, it’s important to understand the basics, including how reverse mortgages work, how they are obtained and the costs involved.
How Does a Reverse Mortgage Work?
Most people purchase a home with a regular (or forward) mortgage: You borrow money from a lender, make monthly payments to pay down the balance, and steadily build equity in the home. Over time, your debt decreases and your home equity increases, and when the mortgage is paid in full, you own the home outright.
A reverse mortgage works differently – in fact, as the name implies, it works the opposite way. Instead of making monthly payments to a lender, a lender makes payments to you, based on a percentage of the value in your home. You choose whether the cash is paid as a single lump sum, a regular monthly cash advance (either for as long as you live in the home or for a certain number of years), a line of credit (where you decide when and how much to borrow), or a combination of these options.
Throughout the life of the reverse mortgage, you keep title to your home, which acts as collateral for the loan. You are charged interest only on the proceeds you receive, and both fixed and variable interest rates are available. Most reverse mortgages are variable interest rate loans tied to short-term indexes, such as the 1-year Treasury Bill or the London Interbank Offered Rate (LIBOR), plus a margin that can add an extra one to three percentage points. Any interest compounds over the life of the reverse mortgage until repayment occurs.
As the loan progresses, your debt increases while your home equity decreases. When you move, sell the home or pass away, the lender sells the home to recover the money that was paid out to you. After lender fees are paid, any equity left in the home goes to you or your heirs (in some cases, the heirs have the option of repaying the mortgage without selling the home). If you receive more payments than your home is worth (if you outlive the loan), you will never owe more than the value of the home, according to the Federal Trade Commission.
A reverse mortgage can become due if you fail to meet the obligations of the mortgage; for example, if you fail to pay your taxes and/or insurance, or if the property falls into disrepair. You remain responsible for paying property taxes, homeowners insurance and maintaining your home. But if its value drops below the amount you’ve borrowed for other reasons, like a decline in the housing market, you can’t be foreclosed upon.
Types of Reverse Mortgages
There are several different types of reverse mortgages. They include:
– Single-purpose reverse mortgages, which are offered by some state and municipal government agencies and non-profits
– Federally-insured reverse mortgages, known as HECMs (Home Equity Conversion Mortgages)
– Proprietary reverse mortgages, which are private loans backed by an issuing company
Single-purpose reverse mortgages are usually for low- and moderate-income homeowners. The lender determines how this type of reverse mortgage can be used (for example, to pay property taxes or for repairs to the house).
The Home Equity Conversion Mortgage (HECM) is the most common. HECM loans are issued by private banks and insured by the Federal Housing Administration (they are the only reverse mortgage products guaranteed by the U.S. government). These loans have no income limitations or medical requirements, and there are no restrictions on how the money can be spent. The primary drawback to this type of reverse mortgage is that the maximum loan amount is limited (currently, it’s the lesser of the residence’s appraised value or the HECM FHA mortgage limit of $625,500).
Proprietary reverse mortgages, also available from various lending institutions, offer amounts that are higher than HECM loans; however, that potential benefit comes at a cost. Non-HECM mortgages are not federally insured and can be considerably more expensive. Homeowners with higher-value homes (in the six figures, say) can benefit the most from this type.
How Much Can You Borrow?
Since you aren’t making payments on a reverse mortgage, but rather are receiving payments, you don’t necessarily need any earned income to qualify for one. However, lenders are now conducting financial assessments to ensure that borrowers are able to meet mandatory financial obligations, such as property taxes and insurance. Your income, assets, monthly living expenses, and credit history will be verified during the loan process (though your credit score isn’t a significant factor). If you don’t have enough income or liquid assets, the lender might set aside part of your reverse-mortgage proceeds to cover taxes and insurance.
The amount of money you receive depends on a number of factors, including the age of the youngest borrower (couples can borrow, not just individuals), the current interest rate, the value of the home and – in the case of a HECM loan – the lending limit. In general, the older you are, the more valuable your home and the more equity you have it, the more money you can get for a reverse mortgage.
Here’s an example of how it can work for two houses in the same area, both worth $300,000: John was born on January 1, 1942, and may be able to get a home equity loan of $174,900 (before fees, insurance and closing costs). John’s neighbor, Jim, born on January 1, 1952, will likely be able to borrow only $154,200 because of his younger age.
The Costs of Reverse Mortgages
Reverse mortgages involve a number of costs. The fees and charges include:
– Mortgage Insurance Premium (MIP)
Mortgage insurance guarantees that you will receive your loan advances if the company managing your account (the loan servicer) goes out of business. You will typically be charged an upfront MIP of 0.5% of the home’s appraised value (or 2.5% if you take more than 60% of available funds). You will also be charged MIP on an annual basis, equal to 1.25% of the outstanding loan balance. This amount accrues over time and is paid when the loan becomes payable.
– Third Party Charges
These include closing costs for items such as appraisals, title searches and insurance, inspections, credit checks, surveys, recording fees and mortgage taxes.
– Loan Origination Fee
If your home is valued at less than $125,000, your lender can change an origination fee up to $2,500. If you home is valued at more than that amount, the lender can charge up to 2% of the first $200,000 of your home’s value, plus up to 1% of any amount greater than $200,000. Origination fees for HECM loans are capped at $6,000.
– Servicing Fees
Lenders can charge you a monthly servicing fee if the loan has an annually adjusting interest rate, or $35 if the interest rate adjusts on a monthly basis. The fee covers things like sending your checks and account statements, plus any other customer service.
* Note *
You can roll these fees into the loan if you don’t want (or can’t afford) to pay for them up front and out-of-pocket. If you do, they will accrue interest as part of the overall balance.
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