So how do reverse mortgages work? Whether you want to take your family on vacation or need to make repairs to your home, a reverse mortgage could be a great option for senior homeowners to supplement their income. But a reverse mortgage is still a loan, and at some point, someone has to pay it back.
How Do Reverse Mortgages Work?
A reverse mortgage lets homeowners over the age of 62 borrow money against the equity of their home without required monthly payments. The term reverse mortgage sounds like homeowners receive back the money they spent buying their homes.
Home Equity Conversion Mortgage, however, describes the process a bit better: Homeowners exchange the fair market value of their homes for cash.
A HECM is the most common option of reverse mortgage because the U.S. Federal Government insures it, and only lenders approved by the Federal Housing Administration may offer them.
But that is just the definition of what a reverse mortgage is. What you really want to know is: How do reverse mortgages work?
How do I qualify for a reverse mortgage?
First, in order to qualify for a HECM, the U.S. Department of Housing and Urban Development (HUD) outlines the following requirements for borrowers:
In addition to the borrower qualifications, the property must meet all FHA property standards and must be one of the following types of property:
Once the HUD-approved HECM counselor verifies your eligibility, you may contact an FHA-approved lender to complete your application for a reverse mortgage.
What are my options to receive the loan?
There are a variety of ways you can access your newly available funds based on your interest rates. If you choose a fixed interest rate for your reverse mortgage, you will receive your loan as a single disbursement lump sum.
If you choose a monthly or annually adjustable interest rate, you cannot receive the money as a lump sum, but you have five alternate options:
The amount you can borrow depends on the age of the youngest borrower (or eligible non-borrowing spouse), the current interest rate, and the appraised value or the HECM mortgage limit (whichever is lower.)
So, how do reverse mortgages work regarding upfront costs?
What are the upfront costs for a reverse mortgage?
You can either pay the costs for a reverse mortgage out of pocket, or you can finance the costs through the mortgage. If you choose to finance them, you will receive less money from the loan than if you pay the costs out of pocket.
First, there is the Mortgage Insurance Premium, which is not unique to reverse mortgages. The initial MIP is 2 percent of the loan. Additionally, there will be an annual MIP of 0.5 percent of the outstanding balance of the loan.
Then there is the origination fee, which the lender charges to process the loan.
The lending institution can charge $2,500 or 2 percent of the first $200,000 of your home’s value, plus 1 percent of the amount over $200,000. But the maximum amount origination fees can reach is $6,000.
After that, there may be third-party charges. These are not fixed amounts, but they are fees to keep in mind. Third-party charges can include appraisals, inspections, mortgage taxes, credit checks, title search, and recording fees.
And finally, there are servicing fees, which may be monthly costs. Lenders may charge a maximum monthly servicing fee of $30 for loans with annually adjusting or fixed interest rates.
The maximum monthly servicing fee for a monthly adjusted interest rate is $35. The lender may add the monthly service fee to your loan balance, which means it is not an out-of-pocket expense; however, the lender may include the servicing fee in the interest rate.
If you decide to cancel your reverse mortgage, you must notify the lender within three business days after the closing date to cancel without penalty.
Are There Other Types of Reverse Mortgages?
Because the U.S. federal government backs HECMs, there's a cap on the loan amount. Plus, the interest rates and fees can add up quickly. But there are two other options for reverse mortgages: a proprietary reverse mortgage and a single-purpose reverse mortgage.
If you take a proprietary reverse mortgage from a private company that is not FHA-approved, you may not need to pay as much in upfront costs. There also may not be as many restrictions on how you can access the loan.
But because a proprietary reverse mortgage is not subject to the same regulations as a HECM, it may not have the same protections.
A proprietary reverse mortgage may be more suitable for people with high-value homes that exceed the HECM FHA mortgage limit.
If you choose a single-purpose reverse mortgage, the loan can only be used for a specific purpose; however, the loan will often have lower interest rates and fees. And like an HECM, these also don't require monthly payments.
A single-purpose reverse mortgage, however, is only available to households with a low or moderate-income. They are usually available only through government agencies.
Pros and Cons of Taking out a Reverse Mortgage
After answering the question "How do reverse mortgages work?" you should consider how a reverse mortgage will positively or negatively impact your current situation.
Pros of how reverse mortgages work
One of the most attractive features of a reverse mortgage is that you don’t have to make monthly payments.
As long as you maintain your property and keep up with regular costs (i.e., taxes, insurance, HOA membership), you do not have to make any payments if at least one borrower is alive.
Plus, the money you receive is usually tax-free, and will not affect the benefits you receive from the federal government.
Furthermore, the loan balance cannot exceed the value of your home. So when either you or your family needs to sell the house or pay back the reverse mortgage, you won't pay more than the house is worth.
If, however, there's a drop in the property’s market value, you or your estate will only have to pay 95 percent of the property’s have to move.
Cons of how reverse mortgages work
While the loan balance cannot exceed the value of your home, it can grow very quickly because of the interest. With a standard mortgage, the borrower gradually pays off the balance, which means the amount of the interest added also decreases.
But the interest compounds with a reverse mortgage because borrowers don't make regular payments. As a result, the balance will be significantly higher when payment is finally due.
There are three occasions when the lender may require payment for the loan: when you sell the property, when the home fails to meet FHA property standards, or after the last borrower passes away.
If you are unable to maintain the property or fall behind on insurance and tax payments, the lender may consider you as defaulted on your reverse mortgage. And for anyone living on a fixed or limited income, this may require you to sell your home.
If you don't pay back the loan before the last borrower passes away, the debt passes on to the surviving heirs. Or, if your spouse is not a co-borrower, your spouse has to pay back the loan.
Any residents of the property will most likely have to move if the loan cannot be repaid. And in the event your heirs cannot repay the loan, they cannot reside in the home.
How Do Reverse Mortgages Work? Is It for Me?
Now that we've answered the question "How do reverse mortgages work?" and evaluated the pros and cons, you need to determine whether a reverse mortgage is the best choice for you.
With the rising cost of living, supplementing your fixed income with a reverse mortgage seems like an easy and attractive option. But if you or your family already struggle to make ends meet, a reverse mortgage may add to your burdens rather than relieve them.
If you have more questions about how reverse mortgages work, be sure to contact an HECM counselor in your area. While there may be a fee, they can clarify any questions you may have about the process.
And be sure to talk to your family about it. They may also be asking "How do reverse mortgages work?" and if they will be paying back your loan, they need to be aware of the process. By staying informed, you and your family will rest easier!
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