How Does a Reverse Mortgage Work?
TABLE OF CONTENTS
A reverse mortgage is a home equity loan for seniors age 62 or older. It makes a home’s built up equity available to the homeowner as cash. Borrowers continue to own the home, are able to continue living in it and are not required to make monthly mortgage payments.
This chapter will explain the “mechanics” of how reverse mortgages work and provide an overview of basic loan program elements. More detailed descriptions for FHA’s Home Equity Conversion Mortgage (HECM) program as well as property and borrower requirements are covered in subsequent chapters.
When a borrower takes out a standard mortgage — like the kind used to buy a home — a portion of the monthly mortgage payment is applied to the principal and another portion pays the interest on the loan. Over time, as one pays more and more of the principal, the equity in the home grows. For a standard mortgage, this scenario is called “falling debt, rising equity.”
The final outcome is that the loan is eventually paid off and the borrower owns the home free and clear.
With a reverse mortgage, equity in the home already exists and is either pulled out all at once (lump sum) or drawn down over time. Either way, the equity is paid to the borrower in cash. For a reverse mortgage, this scenario is called “rising debt, falling equity.”
As you know, one of the costs of taking out any loan — forward or reverse — is the interest that is charged. In the case of a reverse mortgage, the loan interest accrues over time and is added back into the loan balance.
The final outcome is that the total loan amount (principal plus accrued interest) is due when the borrower moves, sells the home or dies.
Key takeaway: In a forward mortgage the loan amount goes down over time. With a reverse mortgage, the loan amount grows over time.
Reverse Mortgage Borrower Protections
The U.S. Department of Housing and Urban Development (HUD) mandates that all reverse mortgage borrowers must first receive counseling from a HUD-approved counselor. Borrowers meet with a neutral advisor who will explain how reverse mortgages work, the costs and review other financial options. After the session, the borrower will be issued a certificate that verifies the completion of this HUD requirement.
Another layer of protection comes even after the loan is closed. Borrowers have three business days to cancel a reverse mortgage after closing, also known a three-day right of rescission.
There was a time when borrowers might pull out the full equity of their home in a lump sum and spend it all at once. That didn’t work out very well for folks who still needed cash for ongoing expenses like property taxes. Now there’s a protection called an Initial Disbursement Limit that caps the first year draw.
HECMs do not require repayment for as long as the borrower lives in his or her home.
HECMs are also non-recourse loans. FHA insurance guarantees that the borrower never owes more than the home’s value at the time the loan is repaid. Heirs to the property are also protected.
HUD rules stipulate limits on costs and fees. For example, fees are capped for origination and processing of an HECM loan. Lenders can charge the greater of $2,500 or 2% of the first $200,000 of the home’s value plus 1% of the amount over $200,000. All HECM origination fees are capped at $6,000.
Reverse Mortgage Payment Options
There are a few different ways to receive reverse mortgage payments. The most popular is all-at-once in a lump sum. Initial disbursement rules (a cap on how much and when loan proceeds can be disbursed) prevent borrowers from spending it all at once.
Term payments are another option which spreads out the disbursements in equal monthly payments for a specific (fixed) number of months.
Tenure payments provide equal monthly payments for as long as the borrower meets reverse mortgage eligibility requirements (e.g. still living in the home as a primary residence).
A line of credit gives borrowers flexibility to pull money out whenever they need it instead of on a fixed schedule.
It’s possible to combine the payout methods above. For example, a borrower could receive steady, equal monthly payments plus have access to a line of credit in case a little more cash is needed from time to time (this is known as modified tenure).
Reverse Mortgage Costs
Closing Costs (loan)
Closing costs may be rolled into the loan so that there is no out-of-pocket expense to the borrower. It’s important to note that those costs don’t disappear, they become part of the the total loan amount and will accrue interest over time. Here are few examples of fees that should look familiar:
- HUD Counseling fee
- Application fee
- Origination fee
- Recording and title fees
- Initial Mortgage Insurance Premium (IMIP)
Ongoing Costs (loan)
There are two kinds of ongoing costs. Costs that are directly related to the loan and others that deal with the property itself.
- Mortgage Insurance Premium (MIP)
- Monthly servicing fee
Ongoing Costs (property)
Both forward and reverse mortgages require that borrowers must pay property taxes, insurance, and for any repairs. These items are typically “outside” the loan. Failure to pay for them may compel the lender to make the payments (adding them the loan amount) or foreclose. However, lenders want to prevent that. So they may also require stowing away a portion of the loan proceeds as a “savings account” to pay for ongoing costs such as homeowner’s insurance and property taxes. These are known as set-asides.
The loan is due when the last living borrower (or non-borrowing spouse) dies, sells the home, or moves away.
- The estate, or heirs, can keep the house by paying 95% of the home’s appraised value or the loan balance, whichever is less.
- Or they can sell it and keep any remaining equity after paying off the loan.
- Heirs will never owe more than the house is worth. As mentioned above, HECMs are non-recourse loans.