What Is a Reverse Mortgage and How Does It Work?

As a cash-strapped senior, a reverse mortgage may sound like a tempting way to stay in the home you love. But beware the high fees and other drawbacks associated with this type of loan. Photo: Chad Miller

Perhaps it took decades of mortgage payments, but you’ve achieved what’s still a dream for many: Homeownership (or, at least, substantial home equity). But like many seniors, you’re still on a very tight budget.

You see a commercial pitching a reverse mortgage, telling you that you can convert your home equity into cash as you live in your home. It seems like a no-brainer. After all, what good is all that equity if you don’t want to sell?

Reverse mortgages have undeniable appeal for cash-strapped seniors, but they also have enormous costs and many potential pitfalls. We’ll cover the basics of reverse mortgages below, including how they work, interest rates and fees, the pros and — perhaps most importantly — the cons, as well as some alternatives you’ll want to understand before signing on the dotted line.

What Is a Reverse Mortgage?

A reverse mortgage is a very specific kind of loan for homeowners 62 or older who either own their homes or can easily pay off their primary mortgage, either with savings or the help of the reverse mortgage.

A reverse mortgage taps (and slowly drains) the equity you’ve built up in your house. In most cases, you can use the money for anything. Payments are usually tax-free.

As long as you still live in your home, you won’t need to pay back the loan. However, if you sell the house, move out, or die, it must be repaid — whether that’s by you, your spouse, your heirs, or your estate.

What types of reverse mortgages are there?

There are three different kinds of reverse mortgages: home equity conversion mortgages, single-purpose reverse mortgages, and proprietary reverse mortgages.

• Home equity conversion mortgages, also known as HECMs, are the most popular reverse mortgages by far. HECMs are insured by the Federal Housing Administration, though the money still comes from private lenders. You will be required to receive borrower counseling before you can get an HECM.
• Single-purpose reverse mortgages are different from other reverse mortgages because the lender specifies what the money can be used for, such as home renovations. According to the Federal Trade Commission, these are available through some state or local government agencies and nonprofits.
• Proprietary reverse mortgages are the type you’re likely to receive if you go through a private lender. They aren’t subject to the same rules and regulations that govern federally backed reverse mortgages. They might be a better bet for owners of high-value homes who want to receive more of their equity than they could get through the federal HECM program.

How much can I receive with a reverse mortgage?

The amount you can get through a reverse mortgage will vary based on several factors: your age (or the age of your spouse, if he or she is younger), current interest rates, and your home’s value.

In the case of HECMs, reverse mortgages are capped at $625,500, but there’s no such limit for non-HECM reverse mortgages. You’ll generally be eligible for a bigger loan if you’re older and your house is worth more.

According to the National Reverse Mortgage Lenders Association (NRMLA), you’ll only be able to access up to 60% or your loan in the year after closing if you go with an HECM. After the first year, you can tap the remainder of the loan at your discretion.

How will I receive my reverse-mortgage payments?

You’ll have a variety of options for receiving the money. Typically, you can request either a lump-sum payment; fixed monthly payments for a certain time period; fixed monthly payments for as long as you’re in the home; or a line of credit that lets you choose how much you want to receive and when.

You may also opt to receive one portion of your reverse mortgage payments via a line of credit and another portion via fixed payments, whether that’s for a certain term or as long as you’re in your home.

What Costs are Associated with a Reverse Mortgage?

Reverse mortgages don’t come cheap. Unfortunately, most lenders don’t publicize rates for reverse mortgages, but interest rates are typically higher than what you’d pay with a conventional mortgage or home-equity loan. Fees can easily tack on thousands of dollars. In general, however, you will receive a lower rate with a federally backed HECM than a proprietary reverse mortgage.

How is my interest rate determined with a reverse mortgage?

Today, most reverse mortgages have variable interest rates. Your rate is typically tied to a certain rate index such as the one-month LIBOR that will go up and down with the market. The lender will add a margin of roughly two to three percentage points on top of that index to determine your rate.

Your lender doesn’t hold back a portion of your payments to cover interest. Instead, the interest compounds until repayment, when it must be paid along with the principal.

Fixed interest-rate reverse mortgages are out there, but you’ll probably be forced to take a lump-sum payout with this option, notes the FTC. You may also be limited to a lower amount than you could receive with a variable-rate reverse mortgage.

What kind of fees will I pay?

Fees can be quite steep on a reverse mortgage. Here’s what you can expect:

• Origination fee: This varies by lender, but with HECMs, it’s capped at 2% of the first $200,000 of your home’s value and 1% of the remaining value. The total is capped at $6,000.
• Home appraisal: Unfortunately, no one is going to take your word for what your home is worth. An official appraisal averages $450, according to the NRMLA.
• Closing costs: Remember all those fees you paid when you closed on your primary mortgage? They apply here, too, and may include fees for credit reports, title searches, document preparation, and much more. The total, which is highly dependent on your lender and location, could run anywhere from several hundred dollars to a couple thousand.
• Service fees: Your lender may charge a fixed monthly fee that is typically capped at $35, according to the NRMLA. This money is set aside during closing, and since the total is based on your age and life expectancy, it could be several thousand dollars. Other lenders may roll service fees into the loan’s interest rate.
• Mortgage insurance: If you decide on an HECM, you will be on the hook for an annual mortgage insurance premium, or MIP. MIP does two things: It makes sure you’ll still receive your money if your lender closes shop, and it ensures you won’t owe more than your home is worth once your HECM must be repaid. Initially, MIP is based on the amount of money you receive via your HECM during the first year: As long as you don’t take more than 60% of your funds, the MIP will be 0.5% of your home value. This number balloons to 2.5% if you take more than 60% of the funds, however. Then, in both cases, it adjusts to 1.25% annually. The MIP accrues over time and will be due once you repay your reverse mortgage.

If you’re considering a reverse mortgage, you probably don’t have thousands of extra dollars lying around to cover these fees. Most lenders will simply roll them into the loan so you don’t pay out of pocket.

Keep in mind, however, that this simply means you or your heirs will owe more — much more, because of interest — in the long run.

What are the Pros and Cons of a Reverse Mortgage?

As with any major financial decision, there are upsides and downsides to choosing a reverse mortgage. While the major upside — money in your pocket — is pretty clear, you may not have thought of some of the potential downsides.

Reverse mortgage pros

• Needed income: This is the most obvious benefit of a reverse mortgage. If you’re barely scraping by, a reverse mortgage can give you the additional funds you need to stay afloat, whether that’s for day-to-day expenses, medical bills, or other debt payments.
• Relaxed eligibility: Most conventional loans require a steady income and good credit. Perhaps you have neither. As long as you’re over 62 and own most or all of your home, you’ll probably still be eligible for a reverse mortgage.
• Flexibility: As we mentioned above, most reverse mortgages can be paid out as a lump sum, monthly payment, or line of credit. Most can also be used for any purpose — though, as we hope you’ll see below, a reverse mortgage is a very pricey, risky way to finance discretionary spending.
• Tax-free payments: Your reverse mortgage payments are not considered income; rather, they’re considered loan advances and aren’t taxable. However, note that interest is not tax-deductible until the loan is repaid.

Reverse mortgage cons

• High interest rates and fees: You’ll pay dearly for the convenience of a reverse mortgage, with rates and fees that are heftier than those of a conventional mortgage or home equity loan. Once you account for them, you may be surprised at how little you actually receive — and how much must be repaid. High fees make a reverse mortgage a particularly bad deal for anyone who thinks they may move in the near term.
• Loss of long-term freedom: Though you’ll gain short-term stability by receiving reverse mortgage payments, it could cost you your long-term financial freedom. For example, if your health suddenly nose dives and you must move in with an adult child or into an assisted living facility, you’ll suddenly have to repay your loan.
• Can affect benefit eligibility: Depending on how you receive your funds, a reverse mortgage may affect your eligibility for Medicaid or Supplemental Security Income (SSI) because you are limited to a certain amount of liquid assets to qualify. Regular Social Security and Medicare benefits should not be affected.
• You’re required to maintain your home: Living there is not enough — you must pay all homeowners insurance and property taxes on time and perform regular upkeep so that your home’s value does not tumble. If you fall behind in these areas, your lender could demand repayment.
• A burden for your heirs: After you die, your children or other heirs are responsible for paying off the reverse mortgage loan. Though the lender can’t try to seize your heirs’ assets for payment, they’ll still have the burden of deciding what to do with your home. Typically, they’ll pay back your loan by selling the property. They can also pay off the loan with other resources and keep the house, or if there’s no equity left, sign over the deed to the lender. This is all assuming lenders play by the rules — some unscrupulous ones do not.

Alternatives to a Reverse Mortgage

If money is tight, be sure to investigate all of your options before opting for a reverse mortgage. With the alternatives below, your house will still be your own asset (or if you die, that of your heirs).

While we won’t cover it below, be sure to weigh returning to the workforce (even part time) if you’re able, or if you haven’t left the workforce, delaying retirement. These alternatives also assume you’ve investigated tapping any other available assets and evaluated your eligibility for SSI or other benefit programs.

• Refinance your existing mortgage: If you’re still paying down your first mortgage and can wrangle a lower rate by refinancing, you can lessen your monthly payment and get a little more breathing room in your budget. You will pay closing costs, but if you are going to be in your home for several more years, it still makes sense.
• Traditional home equity loan or home equity line of credit: Home equity loans and lines of credit (HELOCs) are generally a better deal than reverse mortgages because of lower interest rates and fees, and the interest is usually tax-deductible. A fixed-rate home equity loan can be easy to budget for, and a HELOC can provide the convenience of cash on an as-needed basis. However, with either option, you must have a steady income to make payments. To learn more, check out our article What Is a Home Equity Line of Credit?
• Sell your house and downsize: This option will require some soul-searching — after all, part of the appeal of a reverse mortgage is staying in your home. However, if you’re struggling to keep up with upkeep or high property taxes, it makes more sense to access your equity through a sale and find a smaller, less expensive place to call home. A related alternative could be finding a roommate to help with the costs.
• Sell your house to a family member, then rent it from them: Though you’ll still need to carefully get everything in writing, this can be a win-win for everyone: Your family receives rental income, you get to stay in your house, and your house remains in the family when you die.

If You’re Considering a Reverse Mortgage, Proceed with Caution

Slick reverse-mortgage advertisements often do a good job of obscuring the truth, according to the Consumer Financial Protection Bureau. The truth is that a reverse mortgage is a loan with very high interest rates and fees. Moreover, it’s a loan that must be repaid — a simple point that some ads conveniently forget to mention.

Other ads imply that a reverse mortgage guarantees financial security. It does no such thing — you can get a reverse mortgage too soon and run out of equity, or you can fall behind on property taxes and upkeep and be forced out of your home. And even if a reverse mortgage keeps you afloat, it can mean you won’t have as much (if anything) to pass on to your heirs.

In short, there’s a reason most financial experts recommend reverse mortgages only as a last resort. Be sure to weigh all the pros, cons, and alternatives before you opt for a reverse mortgage.

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