With a regular mortgage, a homebuyer borrows the money to buy a house, making regular monthly payments to build up equity in the house, eventually owning the home outright if it is not sold before then. A reverse mortgage reverses this process: a homeowner with substantial equity receives a lump sum, periodic payments, or a line of credit from a lender, who will ultimately be reimbursed by the sale of the home. Thus, reverse mortgages allow senior citizens to convert the equity of their home into cash for their retirement.
The U.S. Department of Housing and Urban Development (HUD) created one of the first reverse mortgages. HUD's Reverse Mortgage is an FHA-insured private mortgage loan, and it's a safe plan that can give older Americans greater financial security. A reverse mortgage is a nonrecourse loan made to a homeowner, where the lender pays the homeowner either a lump-sum payment or periodic payments, usually monthly (which is why it is often called a reverse annuity mortgage, or RAM), based on the equity in the house, or approves a line of credit that the homeowner can draw on at any time. The loan is repaid when the homeowner dies, or when the home is sold. If the lender fails to receive the full amount of the loan with interest, then the lender must accept the loss. Any remaining equity is returned to the borrower, his estate, or to his heirs.
The reverse mortgage differs from a traditional 2nd mortgage, or a home equity line of credit, in that the homeowner's income and debt ratio is not considered in the qualification for the loan, nor are monthly mortgage payments required. The reverse mortgage pays the homeowner, and is available regardless of the homeowner's current income. However, HUD requires that income, assets, monthly living expenses, credit history, and the timely payment of ongoing homeownership costs, including real estate taxes and homeowners insurance, be verified. This verification is designed to ensure that the borrower can continue to pay monthly living expenses.
Generally, the amount that can be borrowed is proportional to the value of the home, the age of the homeowner, and inversely proportional to the prevailing interest rate. There are no monthly payments, because the loan is not due as long as the house is the borrower's principal residence. However, the homeowner is still required to pay real estate taxes and other conventional payments like utilities, but with an FHA-insured HUD reverse mortgage, the home cannot be foreclosed nor can the homeowner be forced to vacate the house.
Home Equity Conversion Mortgages (HECMs)
HUD calls its reverse mortgage the home equity conversion mortgage (HECM), so-called because the equity of the home is being converted into a monthly payment paid to the borrower. The HUD reverse mortgage has both borrower and property requirements. To satisfy borrower requirements, the Federal Housing Administration (FHA) requires that you must:
- be a homeowner;
- be at least 62 years of age;
- own the home outright, or have a low mortgage balance that can be paid off at the closing with proceeds from the reverse loan;
- live in the home as the primary residence;
- have enough money or a source of income to continue paying the ongoing costs of home ownership, including homeowners insurance, real estate taxes, and, if applicable, homeowner association fees; and
- not be delinquent on any federal debt.
The borrower is also required to receive consumer information from HUD-approved counseling sources prior to obtaining the loan. Contact the Housing Counseling Clearinghouse at 1-800-569-4287 to obtain the name and telephone number of a HUD-approved counseling agency and a list of FHA approved lenders within your area, or use this search engine provided by HUD: HECM Counseling Agencies. The counselor must explain the loan's costs, financial implications, and alternatives. For example, counselors should tell you about government or nonprofit programs for which you may qualify, and any single-purpose or proprietary reverse mortgages available in your area.
The property requirements are that the home be a single family dwelling or a 2-to-4 unit property that the borrower owns and occupies. Townhouses, detached homes, units in FHA-approved condominiums and FHA-approved manufactured homes are also eligible.
There are 5 options for receiving payments from a reverse mortgage:
- Tenure - equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence.
- Term - equal monthly payments for a fixed period of months selected.
- Line of Credit - unscheduled payments or in installments, at times and in amounts of borrower's choosing until the line of credit is exhausted.
- Modified Tenure - combination of line of credit with monthly payments for as long as the borrower remains in the home.
- Modified Term - combination of line of credit with monthly payments for a fixed period of months selected by the borrower.
The amount of money you can borrow with a HECM or proprietary reverse mortgage depends on several factors, including your age, the type of reverse mortgage you select, the appraised value of your home, current interest rates, and where you live. In general, the older you are, the more valuable your home, and the less you owe on it, the more money you can get. If there is a non-borrowing spouse, or if there are multiple borrowers, then the youngest age of those people will be the determinative age factor, since it is more likely that they will remain in the house longer.
HECMs generally provide larger loan advances at a lower total cost compared with proprietary loans. But owners of higher-valued homes may get bigger loan advances from a proprietary reverse mortgage. That is, if you have a higher appraised value without a large mortgage, then you may likely qualify for greater funds. Location (for example, your neighborhood) is only one part of the determination of appraised value.
Other Types of Reverse Mortgages: Single-Purpose Reverse Mortgages and Proprietary Reverse Mortgages
Besides the HECM loans, other basic types of reverse mortgages are the single-purpose reverse mortgage, which are offered by some state and local government agencies and nonprofit organizations; and proprietary reverse mortgages, which are private loans that are backed by the companies that develop them.
Single-purpose reverse mortgages have low costs. But they are not available everywhere, and they only can be used for a single purpose specified by the government or nonprofit lender, for example, to pay for home repairs, improvements, or property taxes. You can qualify for these loans only if your income is low or moderate.
Proprietary reverse mortgages tend to be more costly than other home loans. The up-front costs can be high, so they are generally most expensive if you stay in your home for just a short time. They are widely available, have no income or medical requirements, and can be used for any purpose.
One company, Circle Lending, has a program that allows family or friends to lend money for a reverse mortgage instead of using a bank. For about $2,500, Circle Lending prepares the documents, services the account, and counsels those involved about the loan process.
Reverse mortgage loan advances are not taxable, and generally do not affect Social Security or Medicare benefits. You retain the title to your home and do not have to make monthly repayments. The loan must be repaid when the last surviving borrower dies, sells the home, or no longer lives in the home as a principal residence. In the HECM program, a borrower can live in a nursing home or other medical facility for up to 12 months before the loan becomes due and payable.
As you consider a reverse mortgage, be aware that:
- Lenders generally charge origination fees and other closing costs for a reverse mortgage. Lenders also may charge servicing fees during the term of the mortgage. The lender generally sets these fees and costs.
- The amount you owe on a reverse mortgage generally grows over time. Interest is charged on the outstanding balance and added to the amount you owe each month. That means your total debt increases over time as loan funds are advanced to you and interest accrues on the loan.
- Reverse mortgages may have fixed or variable rates. Most have variable rates that are tied to a financial index and will likely change according to market conditions.
- Reverse mortgages can use up all or some of the equity in your home, leaving fewer assets for you and your heirs. A nonrecourse clause, found in most reverse mortgages, prevents either you or your estate from owing more than the value of your home when the loan is repaid.
- Because you retain title to your home, you remain responsible for property taxes, insurance, utilities, fuel, maintenance, and other expenses. So, for example, if you don't pay property taxes or maintain homeowner's insurance, you risk the loan becoming due and payable.
- Interest on reverse mortgages is not deductible on income tax returns until the loan is paid off in part or whole.
Disadvantages of Reverse Mortgages
The disadvantage of reverse mortgages is the substantial fees, which can include an origination fee for up to 2% of the home's equity, not the lower loan amount; and 0.5% to 1.25% of the loan amount for the mortgage insurance premium. Also, there will probably be an additional $900 to $1,200 to pay for closing costs.
Because most reverse mortgages, about 90%, are insured by the Department of Housing and Urban Development with a Home Equity Conversion Mortgage, borrowers must follow federal requirements. One major requirement — but a prudent one — is that borrowers for all federally insured mortgages, and most privately insured mortgages, must take counseling about reverse mortgages to ensure that they understand the risks.
HECM loans insured by the FHA cannot exceed the lesser of appraised value, sales price, or the HECM FHA mortgage limit of $625,500 (2016). Jumbo reverse mortgages exist for more expensive homes, but these are privately insured, and have higher fees, including an interest rate up to 2% higher than for a federally insured loan.
There are several costs associated with reverse mortgages, but most of these costs can be paid with the loan proceeds. A mortgage insurance premium (MIP) is charged to cover the risks of the loan. There is an initial MIP of 0.5% or 2.5% of the mortgage amount, depending on how the money is dispersed, and an annual MIP, equal to 1.25% of the remaining mortgage balance.
There is also an origination fee equal to the greater of $2500 or 2% of the 1st $200,000 of the home's value + 1% of any amount over $200,000. However, the total origination fee cannot exceed $6000.
There will also be 3rd party charges, that may include an appraisal, surveys and inspections, recording fees, credit checks, title search and insurance, and other possible fees.
Lenders may also charge a servicing fee that covers the cost of sending account statements, sending disbursements to the borrower, and updating credit checks on the borrower. For fixed interest rate loans or for variable-rate loans that are adjusted annually or less frequently, the maximum service fee that can be charged is $30 monthly; for a variable-rate loan that adjusts monthly, the maximum fee is $35 monthly.
Getting a Good Deal
Reverse mortgages have been surging. With baby boomers retiring, this number is expected to increase rapidly, which will increase competition in the marketing of reverse mortgages, thereby lowering fees and costs.
HUD is also trying to lower origination fees and mortgage insurance premiums. Ginnie Mae announced in October, 2006 that it will package reverse mortgages as securities, which will help to lower interest rates on the loans by reducing the risk for lenders.
HUD does NOT recommend using an estate planning service, or any service that charges a fee just for referring a borrower to a lender! HUD provides this information without cost, and HUD-approved housing counseling agencies are available for free, or at minimal cost, to provide information, counseling, and free referral to a list of HUD-approved lenders. Call 1-800-569-4287, toll-free, for the name and location of a HUD-approved housing counseling agency near you.
If you are considering a reverse mortgage, shop around to compare your options and the offered terms. Learn as much as you can about reverse mortgages before you talk to a counselor or lender. It will help you ask more informed questions, which could lead to a better deal.
- If you want to make a home repair or improvement or need help paying your property taxes, you may want to find out if you qualify for any low-cost single-purpose loans that may be available in your area. Area Agencies on Aging (AAA) generally know about these programs. To find the nearest agency, visit www.eldercare.ad.gov or call toll-free, 1-800-677-1116. Ask the AAA for information about available loan programs for home repairs or improvements, property tax deferral, or property tax postponement.
- If you are interested in a federally-insured HECM, know that all HECM lenders must follow HUD rules, and that many of the loan costs including the interest rate will be the same no matter which lender you select. Still, some costs including the origination fee, other closing costs, and servicing fees may vary among lenders.
- If you live in a higher-valued home, you may be able to borrow more from a proprietary reverse mortgage. But it generally will cost more. The best way to see key differences between a HECM and a proprietary loan is with a detailed side-by-side comparison of future costs and benefits. Many HECM counselors and lenders can provide you with this important information.
- No matter which type of reverse mortgage you are considering, be certain you understand all the conditions that could make the loan due and payable. Ask a counselor or lender to explain the Total Annual Loan Cost (TALC) rates, which show the projected annual average cost of a reverse mortgage, including all itemized costs.
- A federal insurance fund, which reverse mortgagors pay into every month, covers the lenders for any deficiency between the debt and sales proceeds of the home, when it is finally sold. Surviving family members have the option of buying the home by paying 95% of the home's current fair market value (FMV) instead of the full amount of the reverse mortgage debt, but this must be done before the lender forecloses on the property. The lenders must give the heirs at least 30 days to decide what to do with the property and 6 months to arrange financing. Note, however, that the FMV is determined by a real estate appraisal done by an appraiser hired by the lender.
No matter why you decide to take a reverse mortgage, you have at least 3 business days after signing the loan documents to cancel it for any reason without penalty, but you must cancel in writing. The lender must return any money you have paid so far for the financing.
New HUD Rules for Reverse Mortgages
A major cause of defaults in reverse mortgages occurs when the borrowing spouse dies or moves to a nursing home, making it harder for the remaining spouse to maintain the residence. In this case, the non-borrowing spouse must repay the loan immediately to prevent foreclosure. So unless both spouses qualified for the reverse mortgage, the home may be sold after the death of the qualifying spouse, leaving the surviving spouse without a home.
Since June 2015, the HUD has issued new rules that will allow a non-borrowing spouse to remain in the house as long as taxes and insurance are paid and it is the primary residence.
To prevent abuses with reverse mortgages, which often arose because of misleading advertising by lenders, HUD enacted additional rules from 2013 to 2015 to ensure that the loans were not sold to borrowers who were unsuitable for reverse mortgages and also to reduce their own risk of insuring these loans. Beginning in 2014, borrowers cannot take out more than 60% of the home's value in the 1st year unless they are willing to pay higher upfront costs. Starting in April 2015, lenders must assess the borrower's income, credit history, and cash flow to better ensure successful repayment of the loan. If homeowners failed to qualify, they may qualify later by saving additional money for future insurance costs, maintenance, and taxes.
How to Avoid Problems with Reverse Mortgages
Many of the problems with reverse mortgages arises because the borrowers do not understand the loan provisions. Hence, an effective way to avoid problems is to ensure that the borrowers understand how reverse mortgages work and what the likely outcome of different scenarios would be, such as the death or disability of either spouse.
Another way to avoid problems is to make better use of the loan proceeds. Although the loan proceeds are tax-free, it often makes better sense to use the reverse mortgage as a line of credit rather than as income. Or it could be used to delay taking Social Security until age 70, when payments would be maximized, or to avoid selling losing investments, until the market turns around. Because the market does eventually improve, a well diversified portfolio should also improve, if it is not sold before then.
Borrowers must also pay closing fees, such as for a real estate appraisal and other charges, and a loan origination fee of up to 2%, or more, of the loan value, and an initial MIP, in addition to the annual MIP charge. Therefore, reverse mortgages don't make sense for homeowners who do not plan to stay in the house for more than a few years.
To determine whether staying in the house is a viable option, consider whether you can continue living in the house if you are physically disabled or if family members are close by to provide help.
Advantages of Reverse Mortgages over Annuities
If you are considering buying an immediate annuity, compare it to a reverse mortgage. The money that would otherwise be invested in the annuity can remain invested in stocks, bonds, or other investments. If the homeowners die before using up the equity in their home, then any remaining value can be distributed to their heirs instead of being lost to the insurance company. Interest rates and closing costs are higher than for conventional mortgages but if the homeowners are willing to accept less than 60% of available funds within the 1st year, then the FHA will eliminate most of the upfront mortgage insurance, significantly reducing closing costs.