Reverse Mortgage Definition: How Does It Work?

What Is a Reverse Mortgage?

In a word, a reverse mortgage is a loan. A homeowner who is 62 or older and has considerable home equity can borrow against the value of their home and receive funds as a lump sum, fixed monthly payment, or line of credit. Unlike a forward mortgage—the type used to buy a home—a reverse mortgage doesn’t require the homeowner to make any loan payments.

Instead, the entire loan balance becomes due and payable when the borrower dies, moves away permanently, or sells the home. Federal regulations require lenders to structure the transaction so that the loan amount doesn’t exceed the home’s value and that the borrower or borrower’s estate won’t be held responsible for paying the difference if the loan balance does become larger than the home’s value. One way that this could happen is through a drop in the home’s market value; another is if the borrower lives for a long time.

Cash in Equity

Reverse mortgages can provide much-needed cash for seniors whose net worth is mostly tied up in the value of their home. On the other hand, these loans can be costly and complex, as well as subject to scams. This article will teach you how reverse mortgages work and how to protect yourself from the pitfalls, so you can make an informed decision about whether such a loan might be right for you or your parents.

According to the National Reverse Mortgage Lenders Association, homeowners ages 62 and older held $7.14 trillion in home equity in the first quarter (Q1) of 2019. The number marks an all-time high since measurement began in 2000, underscoring how large a source of wealth home equity is for retirement-age adults. Home equity is only usable wealth if you sell and downsize or borrow against that equity. That’s where reverse mortgages come into play, especially for retirees with limited incomes and few other assets.

How a Reverse Mortgage Works

With a reverse mortgage, instead of the homeowner making payments to the lender, the lender makes payments to the homeowner. The homeowner gets to choose how to receive these payments (we’ll explain the choices in the next section) and only pays interest on the proceeds received. The interest is rolled into the loan balance so that the homeowner doesn’t pay anything up front. The homeowner also keeps the title to the home. Over the loan’s life, the homeowner’s debt increases and home equity decreases.

As with a forward mortgage, the home is the collateral for a reverse mortgage. When the homeowner moves or dies, the proceeds from the home’s sale go to the lender to repay the reverse mortgage’s principal, interest, mortgage insurance, and fees. Any sale proceeds beyond what was borrowed go to the homeowner (if still living) or the homeowner’s estate (if the homeowner has died). In some cases, the heirs may choose to pay off the mortgage so that they can keep the home.

Reverse mortgage proceeds are not taxable. While they might feel like income to the homeowner, the Internal Revenue Service (IRS) considers the money to be a loan advance.

Types of Reverse Mortgages

There are three types of reverse mortgages. The most common is the home equity conversion mortgage (HECM). The HECM represents almost all of the reverse mortgages that lenders offer on home values below $765,600 and is the type that you’re most likely to get, so that’s the type that this article will discuss. If your home is worth more, however, you can look into a jumbo reverse mortgage, also called a proprietary reverse mortgage. 

When you take out a reverse mortgage, you can choose to receive the proceeds in one of six ways:

1. Lump sum: Get all the proceeds at once when your loan closes. This is the only option that comes with a fixed interest rate. The other five have adjustable interest rates.
2. Equal monthly payments (annuity): For as long as at least one borrower lives in the home as a principal residence, the lender will make steady payments to the borrower. This is also known as a tenure plan.
3. Term payments: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years.
4. Line of credit: Money is available for the homeowner to borrow as needed. The homeowner only pays interest on the amounts actually borrowed from the credit line.
5. Equal monthly payments plus a line of credit: The lender provides steady monthly payments for as long as at least one borrower occupies the home as a principal residence. If the borrower needs more money at any point, they can access the line of credit.
6. Term payments plus a line of credit: The lender gives the borrower equal monthly payments for a set period of the borrower’s choosing, such as 10 years. If the borrower needs more money during or after that term, they can access the line of credit.

It’s also possible to use a reverse mortgage called a “HECM for purchase” to buy a different home than the one in which you currently live. Also called a Federal Housing Administration (FHA) reverse mortgage, this type of mortgage is only available through an FHA-approved lender.

In any case, you will typically need at least 50% equity—based on your home’s current value, not what you paid for it—to qualify for a reverse mortgage. Standards vary by lender.

Would You Benefit from a Reverse Mortgage?

A reverse mortgage might sound a lot like a home equity loan or a home equity line of credit (HELOC). Indeed, similar to one of these loans, a reverse mortgage can provide a lump sum or a line of credit that you can access as needed, based on how much of your home you’ve paid off and your home’s market value. But unlike a home equity loan or a HELOC, you don’t need to have an income or good credit to qualify, and you won’t make any loan payments while you occupy the home as your primary residence.

A reverse mortgage is the only way to access home equity without selling the home for seniors who either don’t want the responsibility of making a monthly loan payment or can’t qualify for a home equity loan or refinance because of limited cash flow or poor credit.

What If You Don’t Qualify?

If you don’t qualify for any of these loans, what options remain for using home equity to fund your retirement? You could sell and downsize, or you could sell your home to your children or grandchildren to keep it in the family, perhaps even becoming their renter if you want to continue living in the home.

Pros and Cons of a Reverse Mortgage

Once you’re 62 or older, a reverse mortgage can be a good way to get cash when your home equity is your biggest asset and you don’t have another way to get enough money to meet your basic living expenses. A reverse mortgage allows you to keep living in your home as long as you keep up with property taxes, maintenance, and insurance and don’t need to move into a nursing home or assisted living facility for more than a year.

However, taking out a reverse mortgage means spending a significant amount of the equity that you’ve accumulated on interest and loan fees, which we will discuss below. It also means that you likely won’t be able to pass down your home to your heirs. If a reverse mortgage provides a short-term solution to your financial problems rather than a long-term one, then it may not be worth the sacrifice. 

What if someone else, such as a friend, relative or roommate, lives with you? If you get a reverse mortgage, that person won’t have any right to keep living in the home after you pass away.

Another problem that some borrowers run into with reverse mortgages is outliving the mortgage proceeds. If you pick a payment plan that doesn’t provide a lifetime income, such as a lump sum or a term plan, or if you take out a line of credit and use it all up, you might not have any money left when you need it.

What Are the Requirements for a Reverse Mortgage?

If you own a house, condominium, or townhouse, or a manufactured home built on or after June 15, 1976, then you may be eligible for a reverse mortgage. Under FHA rules, cooperative housing owners cannot obtain reverse mortgages since they do not technically own the real estate in which they live but rather own shares of a corporation. In New York, where co-ops are common, state law further prohibits reverse mortgages in co-ops, allowing them only in one- to four-family residences and condos.

While reverse mortgages don’t have income or credit score requirements, they still have rules about who qualifies. You must be at least 62 years old, and you must either own your home free and clear or have a substantial amount of equity (at least 50%). Borrowers must pay an origination fee, an up-front mortgage insurance premium, ongoing mortgage insurance premiums (MIPs), loan servicing fees, and interest. The federal government limits how much lenders can charge for these items.

Lenders can’t go after borrowers or their heirs if the home turns out to be underwater when it’s time to sell. They also must either allow any heirs several months to decide whether they want to repay the reverse mortgage or allow the lender to sell the home to pay off the loan.

The U.S. Department of Housing and Urban Development (HUD) requires all prospective reverse mortgage borrowers to complete a HUD-approved counseling session. This counseling session, which usually costs around $125, should take at least 90 minutes and cover the pros and cons of taking out a reverse mortgage given your unique financial and personal circumstances. It should explain how a reverse mortgage could affect your eligibility for Medicaid and Supplemental Security Income (SSI). The counselor should also go over the different ways that you can receive the proceeds.

Your responsibilities under the reverse mortgage rules are to stay current on property taxes and homeowners insurance and keep the home in good repair. And if you stop living in the house for longer than one year—even if it’s because you’re living in a long-term care facility for medical reasons—then you’ll have to repay the loan, which is usually accomplished by selling the house.

What Are the Costs of a Reverse Mortgage?

HUD adjusted insurance premiums for reverse mortgages in October 2017. Since lenders can’t ask homeowners or their heirs to pay up if the loan balance grows larger than the home’s value, the insurance premiums provide a pool of funds that lenders can draw on so that they don’t lose money when this happens.

One change was an increase in the up-front premium, from 0.5% to 2.0%, for three out of four borrowers and a decrease in the up-front premium, from 2.5% to 2.0%, for the other one out of four borrowers. The up-front premium used to be tied to how much borrowers took out in the first year, with homeowners who took out the most—because they needed to pay off an existing mortgage—paying the higher rate. Now, all borrowers pay the same 2.0% rate. The up-front premium is calculated based on the home’s value, so for every $100,000 in appraised value, you pay $2,000. That’s $6,000 on a $300,000 house, for example.

All borrowers must also pay annual MIPs of 0.5% (formerly 1.25%) of the amount borrowed. This change saves borrowers $750 a year for every $100,000 borrowed and helps offset the higher up-front premium. It also means that the borrower’s debt grows more slowly, preserving more of the homeowner’s equity over time, providing a source of funds later in life, and increasing the possibility of being able to pass down the home to heirs.

Reverse Mortgage Lenders

To obtain a reverse mortgage, you can’t just go to any lender. Reverse mortgages are a specialty product, and only certain lenders offer them. Some of the biggest names in reverse mortgage lending include American Advisors Group, One Reverse Mortgage, and Liberty Home Equity Solutions.

It’s a good idea to apply for a reverse mortgage with several companies to see which has the lowest rates and fees. Even though reverse mortgages are federally regulated, there is still leeway in what each lender can charge.

Reverse Mortgage Interest Rates

Only the lump sum reverse mortgage, which gives you all of the proceeds at once when your loan closes, has a fixed interest rate. The other five options have adjustable interest rates, which makes sense since you’re borrowing money over many years, not all at once, and interest rates are always changing. Variable-rate reverse mortgages are tied to the London Interbank Offered Rate (LIBOR).

In addition to one of the base rates, the lender adds a margin of one to three percentage points. So if the LIBOR is 2.5% and the lender’s margin is 2%, then your reverse mortgage interest rate will be 4.5%. As of January 2020, lenders’ margins ranged from 1.5% to 2.5%. Interest compounds over the life of the reverse mortgage, and your credit score does not affect your reverse mortgage rate or your ability to qualify.

How Much Can You Borrow with a Reverse Mortgage?

The proceeds that you’ll receive from a reverse mortgage will depend on the lender and your payment plan. For an HECM, the amount that you can borrow will be based on the youngest borrower’s age, the loan’s interest rate, and the lesser of your home’s appraised value or the FHA’s maximum claim amount, which is $822,375 as of Jan. 1, 2021.

However, you can’t borrow 100% of what your home is worth, or anywhere close to it. Part of your home equity must be used to pay the loan’s expenses, including mortgage premiums and interest. Here are a few other things that you need to know about how much you can borrow:

• The loan proceeds are based on the age of the youngest borrower or, if the borrower is married, the younger spouse, even if the younger spouse is not a borrower. The older the youngest borrower is, the higher the loan proceeds.
• The lower the mortgage rate, the more you can borrow.
• The higher your property’s appraised value, the more you can borrow.
• A strong reverse mortgage financial assessment increases the proceeds that you’ll receive because the lender won’t withhold part of them to pay property taxes and homeowners insurance on your behalf.

How much you can actually borrow is based on what’s called the initial principal limit. In January 2021, the maximum initial principal limit was $822,375. The average borrower’s initial principal limit is about 58% of the maximum claim amount.

The federal government lowered the initial principal limit in October 2017, making it harder for homeowners, especially younger ones, to qualify for a reverse mortgage. On the upside, the change helps borrowers preserve more of their equity. The government lowered the limit for the same reason that it changed insurance premiums: because the mortgage insurance fund’s deficit had nearly doubled over the past fiscal year. This is the fund that pays lenders and protects taxpayers from reverse mortgage losses.

To further complicate things, you can’t borrow all of your initial principal limits in the first year when you choose a lump sum or a line of credit. Instead, you can borrow up to 60%, or more if you’re using the money to pay off your forward mortgage. If you choose a lump sum, the amount that you get up front is all you will ever get. If you choose the line of credit, then your credit line will grow over time, but only if you have unused funds in your line.

Reverse Mortgages, Your Spouse, and Your Heirs

Both spouses have to consent to the loan, but both don’t have to be borrowers, and this arrangement can create problems. If two spouses live together in a home but only one spouse is named as the borrower on the reverse mortgage, then the other spouse is at risk of losing the home if the borrowing spouse dies first. A reverse mortgage must be repaid when the borrower dies, and it’s usually repaid by selling the house. If the surviving spouse wants to keep the home, then the mortgage loan will have to be repaid through other means, possibly through an expensive refinance.

Only one spouse might be a borrower if only one spouse holds title to the house, perhaps because it was inherited or because its ownership predates the marriage. Ideally, both spouses will hold title and both will be borrowers on the reverse mortgage so that when the first spouse dies, the other spouse continues to have access to the reverse mortgage proceeds and can continue living in the house until death. The non-borrowing spouse could even lose the home if the borrowing spouse had to move into an assisted living facility or nursing home for a year or longer.

Avoiding Reverse Mortgage Scams

With a product as potentially lucrative as a reverse mortgage and a vulnerable population of borrowers who may either have cognitive impairments or be desperately seeking financial salvation, scams abound. Unscrupulous vendors and home improvement contractors have targeted seniors to help them secure reverse mortgages to pay for home improvements—in other words, so they can get paid. The vendor or contractor may or may not actually deliver on promised, quality work; they might just steal the homeowner’s money.

Relatives, caregivers, and financial advisors have also taken advantage of seniors either by using a power of attorney to reverse mortgage the home, then stealing the proceeds, or by convincing them to buy a financial product, such as an annuity or whole life insurance, that the senior can only afford by obtaining a reverse mortgage. This transaction is likely to be only in the so-called best interest of the financial advisor, relative, or caregiver. These are just a few of the reverse mortgage scams that can trip up unwitting homeowners.

Do This to Avoid Foreclosure from a Reverse Mortgage

Another danger associated with a reverse mortgage is the possibility of foreclosure. Even though the borrower isn’t responsible for making any mortgage payments—and therefore can’t become delinquent on them—a reverse mortgage requires the borrower to meet certain conditions. Failing to meet these conditions allows the lender to foreclose.

As a reverse mortgage borrower, you are required to live in the home and maintain it. If the home falls into disrepair, it won’t be worth fair market value when it’s time to sell, and the lender won’t be able to recoup the full amount that it has extended to the borrower. Reverse mortgage borrowers are also required to stay current on property taxes and homeowners insurance. Again, the lender imposes these requirements to protect its interest in the home. If you don’t pay your property taxes, then your local tax authority can seize the house. If you don’t have homeowners insurance and there’s a house fire, the lender’s collateral is damaged.

Reverse Mortgage Interest Rates
Month	Adjustable Rate	Fixed Rate
August 2021	2.33%	3.38%
July 2021	2.30%	3.36%
June 2021	2.37%	3.35%
May 2021	2.47%	3.35%
April 2021	2.55%	3.32%
March 2021	2.64%	3.31%
February 2021	2.77%	3.24%
January 2021	2.84%	3.21%
December 2020	2.91%	3.26%
November 2020	2.99%	3.30%
October 2020	3.02%	3.35%
September 2020	3.08%	3.44%

Is a Reverse Mortgage Expensive?

Home equity conversion mortgages (HECMs), the most common type of reverse mortgage, bring a number of fees and costs. Some are one-time fees, and some are ongoing costs.

Before even taking on the reverse mortgage, all borrowers taking out a HECM reverse mortgage loan must undergo counseling from a U.S. Department of Housing and Urban Development (HUD)-approved reverse mortgage counselor. Counseling costs will vary, depending on the agency and the borrower’s specific circumstances. Other fees include origination fees, closing costs, and mortgage insurance premiums. You’ll also have to pay servicing fees to the lender for costs such as sending account statements, distributing loan proceeds, and making certain that you keep up with the loan requirements.

How Does a Reverse Mortgage Work When You Die?

It’s important to have a plan to deal with your reverse mortgage loan after you die. Family members also need to understand their options for keeping the house, as well as their payment responsibilities. Repaying the loan can get complicated, depending on how much equity you have in your house and whether you want the house to stay in your family after your death.

How Do You Repay a Reverse Mortgage?

You do not have to repay a reverse mortgage unless you are selling the home, are residing outside the home for more than a year, or pass away. If selling, you can use the proceeds from the sale to pay off the reverse mortgage. If the reverse mortgage comes due as a result of residing outside of the home, even involuntarily because of medical needs, you may not have the funds to pay off the reverse mortgage and may lose your home. This is one of the biggest risks in a reverse mortgage. In the event of your passing, your heirs will be responsible for paying off the reverse mortgage with other funds from your estate, their own funds, or proceeds from the sale of the home.

Can You Refinance a Reverse Mortgage?

Yes. You can refinance a reverse mortgage as long as it has been at least 18 months since you closed on the original reverse mortgage. Due to the exceptionally high origination fee and other fees, refinancing a reverse mortgage should be reserved for situations where a spouse needs to be added to the loan, more equity is needed, or the interest rate can be lowered substantially.

The Bottom Line

A reverse mortgage can be a helpful financial tool for senior homeowners who understand how the loans work and what tradeoffs are involved. Ideally, anyone interested in taking out a reverse mortgage will take the time to thoroughly learn about how these loans work. That way, no unscrupulous lender or predatory scammer can prey on them, they’ll be able to make a sound decision even if they get a poor-quality reverse mortgage counselor, and the loan won’t come with any unpleasant surprises.

Even when a reverse mortgage is issued by the most reputable of lenders, it’s still a complicated product. Borrowers must take the time to educate themselves about it to be sure that they’re making the best choice about how to use their home equity.