Reverse Mortgage

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A reverse mortgage is a popular way for older homeowners to tap into their home equity to create an income stream, or to take care of large expenses. However, reverse mortgages aren't well understood by many people, so here's what you need to know about these loans, as well as their benefits and drawbacks.

What is a reverse mortgage?
A reverse mortgage is a type of loan where a lender makes payments to you in exchange for equity in your house -- the exact opposite of how a traditional mortgage loan works.

Proceeds from a reverse mortgage can be received in several different forms:

  • A lump sum of cash
  • Monthly payments, for either a set time period or for as long as you own the home
  • A line of credit
  • Some combination of these three options

As the lender makes payments to the borrower, interest begins to accrue, as well as mortgage insurance that you're responsible for. If you choose to take a lump sum, you'll get a fixed interest rate -- otherwise, your loan will be originated with a variable rate. Instead of making payments, as with other types of loans, a reverse mortgage is paid back when you sell your home, die, or vacate the property for more than 12 months.

The amount you can receive through a reverse mortgage depends on several factors, including your and your spouse's age, current interest rates, and the value of your home (or your equity).

Finally, most reverse mortgages are "nonrecourse" loans, meaning that there is no other way for the lender to recoup the balance other than through the sale of the home. This means that the lender is not allowed to collect more than the sale price of the home to satisfy the debt -- for example, if a borrower has an outstanding reverse mortgage balance of $400,000 upon their death and their home sells for $300,000, the lender cannot try to collect the additional $100,000 from the borrower's estate.

Are you eligible?
In order to be eligible to receive a reverse mortgage, the following conditions must be met:

  • You are over 62 years old
  • Your home conforms to HUD standards -- It must be a single-family home, two-to-four unit property, condo, townhouse, or a manufactured home built after June 1976. Co-ops and buildings with more than four housing units are not eligible.
  • You must have enough equity in your home to justify the reverse mortgage
  • The reverse mortgage lender must be the first lienholder on the property. In other words, if there is an existing mortgage on the home, it must be paid off with the proceeds from the reverse mortgage.

It's also worth noting that under current law, lenders must conduct financial assessments of prospective reverse mortgage borrowers. Unlike with traditional mortgages, borrowers are still responsible for paying their own taxes and insurance, so the lenders need to make sure this won't be an issue. If it appears the borrower may have trouble keeping up with these costs, it won't prevent them from getting a reverse mortgage, but a portion of the proceeds will be set aside to ensure the property's taxes and insurance will continue to get paid.

An example
To illustrate how a reverse mortgage works, let's say that you own your home free and clear, and its current appraised value is $250,000. After considering your age and the loan's anticipated interest rate, HUD approves you for a $100,000 reverse mortgage, which you choose to receive as a lump sum with a 5% fixed interest rate (including mortgage insurance).

After you get the $100,000, the interest will start to accumulate. In this scenario, here's how your loan balance could increase over time.

Years since loan origination

Approximate loan balance

1

$105,116

2

$110,494

5

$128,336

10

$164,701

15

$211,370

20

$271,264

30

$446,774

The important takeaway from this chart is how quickly a reverse mortgage can eat away at your home equity -- especially as the loan ages. Since the loan won't be repaid until the home is sold, the balance continues to climb rapidly.

A reverse mortgage could give you some much-needed cash
It's easy to see why people might want to get a reverse mortgage. It can be a good way to get some extra money to cover expenses, or could provide an income stream to compliment Social Security and any other sources of retirement income you may have.

In addition, under the terms of a reverse mortgage, the borrower retains the title to their home. Any income received from a reverse mortgage will have no effect on Social Security or Medicare eligibility.

...but there are some drawbacks
Before you apply for a reverse mortgage, you need to be aware of the cost. According to a calculator provided by the National Reverse Mortgage Lenders Association, the average reverse mortgage borrower can expect to pay $8,908 in fees and other closing costs on a $100,000 reverse mortgage.

In other words, a reverse mortgage is a rather expensive form of borrowing, and there might be cheaper alternatives. For example, a home equity line of credit can generally be obtained without any closing costs and just a small annual fee. According to the HELOC calculator on one lender's website, a $100,000 HELOC on a $250,000 home can be obtained with a variable interest rate as low as 3.875%, with a low $75 annual fee and no closing costs. Plus, with a HELOC, you have the ability to borrow only the money you need. Keep in mind however, that unlike with a reverse mortgage, you'd be responsible for making loan payments.

Another drawback is that you'll own less of your house. If you plan on leaving your home to your loved ones, a reverse mortgage is probably not the best idea.

A reverse mortgage can get you some much needed cash to help with expenses or increase your cash flow in retirement, but make sure you know what you're getting into before applying. If you can live with the expenses and aren't worried about leaving your home to your heirs, getting a reverse mortgage in 2016 may be the right move for you. And, if you decide to proceed with a reverse mortgage, interest rates and fees can vary considerably, so be sure to get quotes from several lenders in order to get the best deal.

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