If you’re not sure what a reverse mortgage is and what it does, you’re not alone. Put simply, instead of making a monthly mortgage payment to a lender, with a reverse mortgage the lender makes payments to you. When you sell your home, you repay the loan. Reverse mortgages allow older homeowners to tap the equity in their homes while they are still alive. This sounds like a great deal, but there are still risks involved.
While homeowners will appreciate the extra cash a reverse mortgage can bring in retirement, those withdrawals, plus compound interest, will draw down hard-earned home equity. Also, consumers need to be aware of sales pitches around reverse mortgages to make sure the financial arrangement is in their long-term interests.
The Federal Housing Administration backs one type of reverse mortgage, called a home equity conversion mortgage. FHA backing guarantees that you or your family won’t be stuck with a huge bill if your loan debt is higher than your home value when you move out. This makes an HECM the most popular type of reverse mortgage.
Learn more about HECMs, how they compare with other reverse mortgages, how to qualify for one, and when or if they might be right for you.
[Read: Best Mortgage Lenders.]
What Is a Reverse Mortgage?
Reverse mortgages allow older homeowners with home equity to turn the equity they’ve earned into cash. Unlike a conventional mortgage, where you are paying off the debt each month to build equity, a reverse mortgage allows you to draw on the equity while you own the home, without giving up the title.
Once you secure a reverse mortgage, you can use it to pay off what’s left on your traditional mortgage — if you have one — and can then draw a lump sum or monthly payments from your equity to cover expenses. The loan is repaid when the last surviving homeowner sells the home, dies or has a different principal residence.
“If you remove that big expense out of your budget, you can really improve your cash flow situation and don’t have to take as much from your investments,” says Wade D. Pfau, co-director of the American College Center for Retirement Income.
What Types of Reverse Mortgages Are There?
There are three types of reverse mortgages:
HECM. The vast majority of reverse mortgages are HECMs. Only homeowners 62 and older can get a HECM, and there are substantial fees and insurance costs at closing and during the life of the loan. The benefit is that HECM loans are nonrecourse, which means the homeowner or the estate (if the homeowner dies) won’t have to pay more at the end of the loan than what the home is worth — no matter whether the home value at the time of sale is less than the loan amount.
For example, if your reverse mortgage loan reaches $325,000 but the appraised value of the home is only $300,000, “that gap is covered by the FHA insurance,” says Shelley Giordano, founder of the Academy for Home Equity and Financial Planning at the University of Illinois. “No one ever has to make a payment on a reverse mortgage other than what the house provides.”
Also, if you default on an HECM, such as by failing to pay property taxes, your home is the only collateral the lender can go after, and the FHA helps cover the lender’s costs.
There are several payment options to choose from with an HECM loan, including a lump-sum withdrawal, monthly cash advances and a line of credit.
HECM loans also have a cap on how large they can be — for 2022, the maximum FHA claim amount is $970,800. For homeowners who want to take out a larger reverse mortgage, another option is available.
Proprietary. This type of reverse mortgage has fewer restrictions, but as a result it isn’t backed by the FHA. The maximum loan amount is much higher, and the minimum age is lower — typically starting at 55.
Payment options include lump sum, term payments and a line of credit.
Single purpose. Some local and state governments and nonprofit organizations offer these loans, which are geared toward low- to moderate-income homeowners and limited to expenses such as home repairs, improvements or property taxes.
How Do You Qualify for an HECM?
You can take out an HECM for just about any reason, as long as you are at least 62 years old and can meet the federal government and lender requirements, which include a financial assessment.
As an HECM applicant, you will need to:
— Have a large amount of equity in your home or own it outright. At least 50% equity would be ideal, Giordano says.
— Attend financial counseling sessions with an FHA-approved HECM counselor.
— Designate the property your principal residence.
— Owe no debt to the federal government.
Lenders will review your credit history, assets and expenses as part of a comprehensive financial examination developed by the FHA. Factors include the value of the home, whether you are able to pay for property taxes and homeowners insurance, the current interest rate and longevity projections based on the ages of the borrowers, Giordano says.
The financial analysis tells the lender how much you’re eligible to take out in the loan, Giordano says. If you want to have the payments or credit line stretched over a period of years, lenders will use formulas that are based on longevity tables and interest rates.
“The FHA really wants to make sure people are not in a reverse mortgage unless it’s a sustainable solution for them,” she adds.
Another key part of having an HECM loan is maintaining your home to preserve its fair-market value. Your lender wants you to be able to sell your home for a good price, so it can recoup its loan.
What Are the Best HECM Options?
The ideal HECM option depends on your financial situation and retirement plan.
“You want to position your assets for the best retirement outcome,” Pfau says. “Your home is a big asset, but it’s not the only one. Do not get a reverse mortgage without thinking of the big picture of building your retirement strategy.”
At closing, the lender will establish the initial principal limit, which is the total amount you can get from the HECM.
An HECM, which can have a fixed or variable rate, can be used for:
— Traditional use. If you’re obtaining an HECM for your principal residence.
— Refinancing. If you’re refinancing from another HECM loan.
— Home purchase. If you use the HECM loan to buy a new primary residence.
[Read: Best Mortgage Refinance Lenders.]
The home purchase option, which began in 2009, and the refinance option are both popular ways to use an HECM. Refinances have been attractive in recent years because of rising home values and low interest rates.
A home purchase HECM gives homeowners a chance to buy a new primary residence without taking out a traditional mortgage. For example, if you own a home outright, you could apply your sale proceeds as a down payment on a more expensive house and cover the remaining amount with a reverse mortgage.
If you opt for a fixed-rate HECM, you only have one payout option. Adjustable-rate HECMs offer a variety of options:
— Single disbursement. If you get a fixed-rate HECM, this lump-sum distribution is your only option. It might provide you with less money than other types of HECM loans.
— Tenure. You can receive equal monthly cash advances as long as one of the borrowers lives in the home as a primary residence.
— Term. This provides for equal monthly cash advances for a fixed amount of time.
— Line of credit. You can have cash available at a time of need, at any amount you choose, until the line is used up. You would only pay interest on the credit you use.
— Combinations. You can also combine the term or tenure options with a line of credit.
What Does an HECM Cost?
If you take out an HECM, you’ll likely pay thousands — or tens of thousands — in fees and insurance costs at closing and during the life of the loan. Here’s how the costs break down:
— Mortgage insurance premium. At closing, you will pay a mortgage insurance premium of 2% on the maximum claim amount. You’ll also be charged an annual premium that equals 0.5% of the remaining balance of the mortgage. These charges help cover the federal government’s commitment to insure the loans. The initial premium can be financed within the loan, although that will limit the amount of equity that gets paid to you.
— Closing costs. You’re also likely to pay all or most of the typical processing and closing fees, such as for the appraisal, title search and recording fees.
— Origination fee. The minimum origination fee is $2,500. A lender can charge 2% of the first $200,000 of your home’s value plus 1% of the amount over $200,000. HECM origination fees are capped at $6,000.
— Servicing fee. Lenders can charge an ongoing servicing fee capped at $30 or $35, depending on how often the interest rate adjusts.
If you pursue HECM offers from multiple lenders, you can look for an interest rate and fee package that’s best for you.
“Just like with a regular mortgage, you can decide whether or not you want to have a higher interest rate in return for less in closing costs,” Giordano says.
[Read: Best Home Equity Loans.]
When Is an HECM a Good Idea?
— You’re staying in your home. You can spread the closing fees over a longer period of time and also rely on the payments from the HECM to pay for ongoing and/or emergency expenses. An HECM could also help you pay for renovations to retrofit your home for aging in place.
— You want to preserve your estate. If you have other nonhome assets — such as an investment portfolio — funds from an HECM can cover everyday costs while the investments remain untouched and can grow. “If they’re using it responsibly, a reverse mortgage can serve to extend the longevity of their assets,” Pfau says.
— You’re planning for the future. Don’t look at the HECM as a last resort — it can be a ready source of credit that you take out at 62 and don’t use until you really need it years later. Unlike some other funding sources, such as a home equity line of credit, an HECM will always be there. “If housing values drop, you still have access to that line of credit, which makes it completely different than a HELOC,” Giordano says.
When Is an HECM Not a Good Idea?
— You’re moving soon. The upfront costs of an HECM are considerable, and dropping the loan after a year or two isn’t a wise financial move.
— You can’t manage money. “People who struggle controlling their spending might be better off not tapping into their home equity,” Pfau says. Interest on the HECM will compound over time, which can cut into your equity and limit your ability to use those funds for expenses in years to come.
— You haven’t planned effectively. Speak with your family — your spouse, children and others — to consider whether your short-term and long-term plans are sound. For example, if you take out an HECM, it will decrease the amount of available equity in your home, which could make it more difficult to afford costs at an assisted living facility in years to come, since financing such a move often depends on the value of your assets and income.
Taking out an HECM is a life-changing decision that will affect your retirement as well as the value of your estate, and can be a good way to help you address long-term expenses — both anticipated and unanticipated.
“Anybody who recognizes that they don’t know what the future holds and would like to be in a position to protect their nest egg, that’s what a reverse mortgage is perfect for,” Giordano says.
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