How Does A Reverse Mortgage Work?

Actor Tom Selleck (Magnum, P.I.) is the latest celebrity shilling for them on television.

Maybe you have an older family member or neighbor who has gotten a phone call from a financial institution offering them.

But what are reverse mortgages and how do they work?

If you are a senior homeowner with most of your net worth tied up in your home, these loans can sound pretty appealing. If you’re a real estate investor, you may be wondering if you can use a reverse mortgage to your advantage.

In this article, we’ll explain what a reverse mortgage is, the pros and cons this cashflow option can offer to some older Americans, and how you can decide if it’s right for your financial strategy now or in the future.

what is a reverse mortgage hand holding coffee WHAT IS A REVERSE MORTGAGE?

 A reverse mortgage is a type of federally insured loan available to Americans age 62 and over. It gets its name because it works in the opposite way as a standard home loan.

With a regular mortgage, the bank gives you a lump sum that you pay back with interest over a set period of time.

With a reverse mortgage, the lender makes payments to YOU based on the equity you have built in your home. You have the option of receiving monthly payments, a lump sum, a line of credit, or a combination of the different options.

 Over time, the amount you owe in interest and fees on the loan grows while your home equity declines. You retain the title to your home, and the balance isn’t due until you or your heirs sell your home. 

WHO QUALIFIES FOR A REVERSE MORTGAGE?

Reverse mortgages are only available to a specific set of homeowners. In order to qualify for a reverse mortgage, you must: 

  • be at least 62 years old
  • own the home outright or have built up a considerable amount of equity in the home
  • live in the home as your principal residence
  • not be delinquent on any federal debt
  • be current on property taxes, insurance, and any homeowners’ association fees
  • pass a credit check
  • complete counseling session about reverse mortgages from an approved counselor

Reverse mortgage loan values may be influenced by the home’s value, how much equity is in the house, and other factors. And older borrowers are eligible for greater total loan amounts because age directly correlates with limits. 

what is a reverse mortgage dog wearing glasses WHAT ARE THE ADVANTAGES OF A REVERSE MORTGAGE?

With life expectancy in the U.S. growing closer to 80 years, many Americans are outliving their personal retirement savings. As a result, they may be unprepared for the rising cost of living and the mounting medical expenses that often accompany aging.

Reverse mortgages are ideal for older homeowners who may not have much in the way of savings or investments but who have built up wealth in their homes. In other words, this type of loan allows you to turn an otherwise illiquid asset into a liquid asset without having to move out of your home.

Whether they’re living with the results of an investment gone awry or the difficulties of a fixed income, any senior with cash flow issues may want to consider a reverse mortgage.

Here are some of the other attractive features of these home loans.

 FLEXIBLE LENDING OPTIONS

 This type of loan offers flexible disbursement options, meaning you can borrow only the amount you need. Investors may choose to accept the loan as a single lump sum, in monthly installments, or even as a line of credit. This amount of control the borrower has in this regard is greater than most loans.

 If your need is more about your long-term budget, try to put a number on what you need for, say, one year. This amount will help you and anyone helping with your financial planning determine what a conservative loan amount for you might be.

 MORE CASH ON HAND

 For some cash-strapped retirees, a reverse mortgage allows them to remain in their long-time homes without having to downsize. Some borrowers even use the proceeds of a reverse mortgage to pay off their existing home loan.

You can use the money from your reverse mortgage for any purpose, including:

  • Paying off other debts
  • Investing in mortgage notes
  • Taking a bucket list trip
  • Investing in assisted living facilities
  • Acquiring investment property
  • Starting a charitable trust

 We’ll discuss below why you’ll need to account for reverse mortgages in your estate plan. However, if you just want to live out your golden years comfortably, you can do so and even plan to pay off your mortgage at the same time.

Lock In the Value Of Your Home

If we’ve learned anything about the economy in recent years, it’s that anything can happen. If for whatever reason, the value of your home ends up being less than the amount owed on the reverse mortgage, you are protected. In practical terms, that means, if home prices fall in your area, you or your heirs won’t have to worry about paying the balance. 

INTEREST LIMITS

 The reverse mortgage has an interesting set of rules regarding interest. On the plus side, you’re not charged interest while you continue to live in the reverse-mortgaged home as your primary residence. Interest is also capped on the first $100,000 worth of debt.

NO TAX LIABILITY

 The IRS considers the funds you receive from a reverse mortgage as a loan advance rather than income. That distinction means the money is not taxed, unlike other retirement income from distributions from a 401(k) or an IRA.

what is a reverse mortgage chess set WHAT ARE THE DISADVANTAGES OF REVERSE MORTGAGES?

A reverse mortgage isn’t for everyone. There are some risks to this type of loan that you should carefully consider.

Here are some of the potential downsides of taking out a reverse mortgage.

DECEPTIVE OR INFLEXIBLE TERMS

 Although we have come a long way since the unscrupulous practices by some lenders in the 1990s and early 2000s, not all reverse mortgage providers are ethical. Some will assume you won’t do your due diligence and will take advantage of you.

 Carefully vet a financial company before considering a loan, and have someone you trust to read the fine print. This person could be a CPA, financial planner, family member working in the industry, or even another investor you know who’s successfully used a reverse mortgage and knows what to look for in a loan agreement.

 You’re examining the documents for any terms that the sales reps haven’t disclosed. Any added terms should serve as red flags that you need to shop around with other lenders.

 Also, be on the lookout for inflexibilities. For instance, reverse mortgages are often challenging to refinance. Ask your salesperson about your refinancing options, and then be sure to see how these claims compare with the written agreement. Any time a salesperson’s word vastly differs from a written offer, it may be time to walk away.

Here are some tips for avoiding reverse mortgage scams from the FBI and the U.S. Department of Housing and Urban Development (HUD):

  • Do not respond to unsolicited ads for reverse mortgages.
  • Be wary of anyone claiming that you can own a home with no down payment.
  • Do not sign any agreement that includes terms that you do not understand.
  • Do not accept any payment for a house you do not own.
  • Get advice from a reverse mortgage counselor of your own choosing.

 REVERSE MORTGAGES ARE NOT FREE

 Some of the unscrupulous ads of the past have promoted reverse mortgages as a means to get free access to your own money. These loans do have the following costs associated with them: 

  • Counseling fee. Before getting the loan, you must participate in a counseling session with a nonprofit housing counseling agency. The typical counseling fee is around $125.
  • Lender fee. You’ll pay an origination fee of either 2% of the first $200,000 of your home’s value or $2,500 or (whichever amount is higher) plus 1% of your home’s value above $200,000. (There’s a cap of $6,000).
  • Closing costs. You’ll need to pay for a home appraisal, home inspection, and title search. In some cases, you may also have charges for a credit check, escrow services, land survey, flood certification, and pest inspection.
  • Insurance premiums. The Federal Housing Administration (FHA) charges an upfront mortgage insurance premium equal to 2% of your home’s value. These loans also have annual mortgage insurance premiums equal to 0.5% of the outstanding loan amount.

You may have the option of rolling some or all of these fees into your loan balance, but, of course, if you choose to do that, you’ll receive less money.

YOUR LOAN MAY BECOME YOUR FAMILY’S DEBT

If you fail to make an estate plan or somehow account for a way to pay your debt after your death, your reverse mortgage may be subject to probate. Probate can take time and cost money, and in the meantime, your heirs do not have access to your estate.

If you die with debt, the debt gets passed on, just like your assets and earnings do. You can offset this downside of a reverse mortgage in two ways:

  • By minimizing your loan to what you’re confident you can pay directly from your estate
  • By updating your estate plan to account for the reverse mortgage

Our suggestion is to take care of this critical detail immediately after seeking the loan. You may pay it off during your lifetime or pre-arrange for your estate to make payments. However, interest is likely to increase if you delay, and your beneficiaries must pay off the debt.

ASSETS ENCUMBERED BY DEBT CAN’T PASS TO HEIRS

Let’s say you take out a substantial loan against your home’s equity. If you pass away before making payment or fail to update your estate plan, your heirs may be unable to inherit the home until the loan is paid off in full. If you lack the funds in your estate, that could mean one less asset for your heirs. 

Also, it’s important to remember that a reverse mortgage diminishes the equity you have in your home. By the time the loan needs to be paid off, there may much equity left for your heirs to inherit. 

Difficulty SECURING OTHER LOANS

A reverse mortgage is relatively easy to obtain if you meet the qualifications, but it doesn’t necessarily “look good” to traditional hard lenders. Some seniors who take out reverse mortgages may find it difficult to secure additional lending elsewhere. This factor can be problematic for investors who rely on good terms to make their deals profitable. 

This type of loan also could limit your ability to qualify for other need-based government programs such as Medicaid or Supplemental Security Income (SSI).  

SHOULD YOU GET A REVERSE MORTGAGE?

If, after weighing the pros and cons of a reverse mortgage, you’re still unsure if it is right for you, here are some factors to consider. A reverse mortgage could be a good option for you if:

  • Your home is increasing in value. In this case, you may be able to take out a reverse mortgage and still have money left over for your estate.
  • You plan to live in your home for a long time. The longer you live there, the more the upfront costs associated with the loan are worth it.
  • You can cover the current cash expenses – including property tax, insurance, and maintenance — of living in your home.

As with taking on any form of debt, you should take your time deciding on a reverse mortgage. Although it is a relatively easy way to boost your cash flow in the short term, it could put your finances at risk down the road.

Make sure you fully understand the pros and cons of reverse mortgages and enlist the help of professionals to help you make the judgment call. Even a close network of fellow homeowners and savvy borrowers with experience in reverse mortgages can be a valuable source of information.

Learn everything you can about these financial tools, shop smart for a lender, read the written loan terms carefully, and be sure to ask plenty of questions. If a reverse mortgage doesn’t feel like it’s for you, you can always explore other financial options.

 

 

Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.

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