What is a reverse mortgage, and how does it work?

What is a reverse mortgage?

A reverse mortgage is a type of loan for homeowners aged 62 or older that lets them borrow against the equity in their homes. A reverse mortgage is almost the opposite of a traditional mortgage — instead of making loan payments to buy a house, homeowners can use reverse mortgages to get paid for their equity. These homeowners can receive money in the form of a lump sum, fixed monthly payments or a line of credit, depending on their preferences and the lenders they work with.

How does a reverse mortgage work?

When you take out a reverse mortgage, you first have to use the funds to pay off any outstanding balance on your existing mortgage. Once that's paid off, you get access to whatever amount is left over. Your home is collateral for this loan, and the IRS considers your money to be a loan advance rather than income.

Your home is considered collateral for a reverse mortgage.

You can use the funds from a home equity loan in a variety of ways and for a variety of reasons, including:

• Lowering your monthly mortgage payment
• Consolidating debts
• Covering medical care
• Investing in home improvements
• Living more comfortably in retirement

Reverse mortgages do not have to be paid back until the final borrower on the loan moves out, dies or fails to meet certain requirements. This can include not taking care of the home or failing to pay taxes or insurance. Once the loan is due, you or your heirs must pay it back with interest.

Types of reverse mortgages

There are three types of reverse mortgage loans: single-purpose reverse mortgages, federally insured reverse mortgages and proprietary reverse mortgages. The right one for you usually depends on your financial situation and the cost of your home.

Single-purpose reverse mortgages

This type of reverse mortgage is often the most affordable option for a reverse mortgage because it’s more limited in scope. You can only use the funds from a single-purpose reverse mortgage to pay for a lender-approved expense, like property taxes or home repairs. Interest rates and fees are lower with this option than with other reverse mortgages.

Home equity conversion mortgages

These are reverse mortgages backed by the Federal Housing Administration (FHA), which is why the government requires you to undergo counseling before getting one. HECMs are also the most widely used reverse mortgage option because they theoretically pose less risk to lenders, and borrowers can use the funds for any reason. You can also get a federally backed reverse mortgage specifically to help buy another home — this is called a HECM for Purchase.

Proprietary reverse mortgages

These reverse mortgages, also known as jumbo reverse mortgages, are mostly used by homeowners with homes valued over the HECM limit ($822,375 in 2021). Like HECMs, the funds are available for a variety of purposes, but the amounts dispersed can be much higher.

Reverse mortgage pros and cons

Reverse mortgages are pretty complicated, and that complexity means they’re not right for everyone. Even if you qualify for a reverse mortgage, it’s still smart to know the potential downsides so you can make an educated decision.

Here are some benefits of a reverse mortgage:

• You can age in place. Many people find it hard to maintain their standards of living as they age. With a reverse mortgage, you can essentially take out money you’ve already paid toward your home in order to live more comfortably and stay in your home.
• There are no income taxes. Although it may seem like you’re being paid, that’s not actually the case with a reverse mortgage (at least in the eyes of the IRS) since the money you receive is not taxed as income.
• They’re nonrecourse loans. As a nonrecourse loan, reverse mortgages won’t charge you more than the current value of the property. That means if your home loses value, you won’t be stuck with a huge bill (as long as it sells for 95% of the appraised value).

Here are some drawbacks to a reverse mortgage:

• There are risks involved. Because your home is collateral on your reverse mortgage, the risks of accidentally triggering repayment are severe. Reverse mortgage counseling helps you understand these risks and how to avoid them.
• Regulations can be confusing. In some cases, taking out a reverse mortgage might complicate other factors of your financial situation, including your “income” for Social Security. This is another area where reverse mortgage counseling may come in handy.
• They’re hard to qualify for. While a homeowner of any age could have equity built up, most reverse mortgage lenders require that borrowers are at least in their 60s. Depending on your loan, there are also limitations on your property, your residency and your ownership status.

Should I get a reverse mortgage?

It’s difficult to make a blanket generalization. While reverse mortgages might be a good option for some people, they can be a poor choice for others. The safest way to make sure a reverse mortgage is right for you is to talk with a counselor before borrowing. Take a step back and evaluate your options with a thoughtful eye, especially given the popularity of reverse mortgage scams.