How does a reverse mortgage work? Understanding how to tap into your hard-earned home equity can improve your retirement finances.
Imagine that you’re paying your mortgage loan every month, just as you’ve done for years. Then, on your 62nd birthday, someone tells you that you don’t have to make those monthly payments anymore.
In fact, you can start receiving monthly cash advances instead, so long as you pay your property taxes and homeowners insurance and keep up with the house’s maintenance and home repairs.
Sound a little bit like magic? Too good to be true? Pinch yourself, because you’re not dreaming.
Reverse mortgages allow homeowners 62 and older to borrow against the equity in their homes with no monthly payment requirement. You continue paying taxes, insurance, and upkeep expenses, but you don’t have to pay on the principal and interest until you pass away or leave the home.
That frees up money for day-to-day expenses, healthcare needs, retirement travel — or any other purpose. It can also help you extend your retirement savings.
OK, now that we’ve got your attention, it’s time to answer the question we know is on your mind: how does a reverse mortgage work?
What's in this Article?
You’ve been investing in a reverse mortgage as long as you’ve owned your home. You just didn’t know it at the time.
Reverse mortgages allow you to borrow against your home equity on a primary residence (meaning the home you live in most of the year). All of the payments you’ve made up to this point will now pay dividends, as you can take money out of the home — which has likely appreciated in value since you bought it.
There are three types of reverse mortgages: the home equity conversion mortgage (HECM), proprietary reverse mortgages, and single-purpose reverse mortgages.
The most common is the HECM, and that is what we will refer to throughout this article. To learn about the other types of reverse home loans, check out our complete guide to reverse mortgages here.
HECM loans are backed by the Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development (HUD).
To qualify for a HECM, you must be 62 or older and have equity in your home. Typically, reverse mortgage lenders require you to have 50% or more equity, though you may still qualify with less. You do not need to own your home outright to qualify for a reverse mortgage.
If you are 62 but your spouse is not, you can take out a reverse mortgage but they cannot be on the loan. You can refinance the reverse mortgage when they turn 62 to add them to the loan, or you can name them as a non-borrowing spouse. The latter can help them stay in the home without having to immediately repay the loan if you pass away (we’ll explain more later).
Reverse vs forward mortgage
A reverse mortgage is different from a traditional “forward” mortgage in three key ways:
- The loan balance does not come due until the last co-borrower leaves the home or dies
- The monthly mortgage payment is optional — you can make a payment but you’re not obligated to as long as you stay current with the property taxes, homeowners insurance, and property upkeep
- You can receive funds – the loan can pay you
A reverse mortgage does not mean the government owns your home. You retain full ownership of the property, and you can sell the home whenever you choose. Just think of a reverse mortgage as just another type of home loan.
What’s more, a reverse mortgage does not come due based on age. You can live in the home as long as you want, regardless of the loan balance or how much interest has accrued, as long as you stay current with your property taxes, insurance, and property upkeep.
HECM borrowers have several options for how they receive reverse mortgage proceeds:
- A lump sum payment
- A line of credit (LOC)
- Monthly cash advances for as long as you live in the house (known as “tenure” payments)
- Monthly cash advances for a set period of time (known as “term” payments)
- A combination of a line of credit and monthly cash advances
How you receive reverse mortgage funds is up to you, and you’ll want to work with your financial advisor to decide which is best for your circumstances. But taking a line of credit — whether as the sole means of receiving the funds or in combination with monthly cash advances — can help you maximize the financial benefits.
A reverse mortgage line of credit is guaranteed to grow (applies to unused funds), and interest only accrues on the amount you’ve used. So you can leave the line open and draw on it as needed, rather than seeing the interest owed increase right away. Additionally, you can pay down the line of credit if you want to and are able.
Reverse mortgage borrowers do not have to make monthly mortgage payments, though they must pay property taxes and homeowners insurance, as well as any maintenance and repair costs, for the life of the loan.
If a borrower fails to pay taxes and insurance or to maintain the property, the lender can foreclose on the home.
However, reverse mortgage lenders conduct financial assessments when a homeowner applies for a reverse mortgage to ensure that they have sufficient income to cover those expenses and reduce the risk of foreclosure.
Additionally, all HECM borrowers must complete counseling with a HUD-approved counselor to make sure they understand the terms and obligations of the reverse mortgage.
Although monthly payments are not required, many reverse mortgage borrowers make them anyway, especially those who are still working.
The interest due on a reverse mortgage gets added to the existing balance, so the loan amount increases each month if the homeowner chooses not to make payments.
There is no repayment requirement until the last co-borrower, or designated non-borrowing spouse, passes away or moves out of the home, as long as they maintain the taxes, insurance, and maintenance.
HECMs are non-recourse loans, which means the borrower (or their heirs) can never owe more than the home is worth. So if the loan balance is higher than the home’s value, due to the interest accrued or a drop in home prices, you will only owe 95% of the appraised value of the home or the remaining balance, whichever is less.
For instance, the home is worth $1 million at time of the last borrower’s death. The reverse mortgage balance has grown to $1.1 million. If the heirs want to keep the home, they could pay either the full loan balance or 95% of the current appraised value, whichever is less.
In this case, they would opt to pay $950,000 (95% of $1 million) if an only if they want to keep the home. The $150,000 balance would be paid by the FHA mortgage insurance that comes with every HECM loan. If your heirs do not want to keep the home, everyone can just walk away from the home and owe nothing.
However, your heirs would likely be better off selling the home in a short sale rather than signing the house over to the lender. Even if they don’t make money on the sale, they may qualify for a substantial tax deduction based on the interest that gets paid off in the short sale.*
The tax laws surrounding this are complex, and the benefits depend on other taxable income that gets inherited. But your heirs should consult with a financial advisor before making the decision to walk away from the home entirely.
Related reading: Why a Reverse Mortgage Should Be in Your Retirement Plan
All HECM borrowers pay upfront and annual mortgage insurance premiums (MIP). The upfront fee is 2% of the loan amount, and the annual fee is 0.5% of the remaining mortgage balance. Annual MIP is adjusted each year based on how much the borrower still owes.
As with a traditional mortgage, reverse loans come with closing costs, including appraisal and servicing fees, title search and title insurance expenses, recording fees, and other fees.
Your lender may also charge an origination fee, which can be $2,500 or 2% of the first $200,000 of the loan and 1% of the loan balance above $200,000 (whichever is greater). HUD caps origination fees at $6,000.
For instance, a $300,000 reverse mortgage could come with a $5,000 origination fee.
You may be able to finance your upfront MIP and closing costs as part of your reverse mortgage loan if you do not want to pay them as a lump sum upfront. However, adding them to your loan could reduce the amount of money you receive from the mortgage.
How do reverse mortgage interest rates work?
When you take out a reverse mortgage, interest accrues on the loan and your equity declines over time.
Interest rates may seem like less of a concern with a reverse mortgage than a forward one, since you aren’t obligated to make a monthly payment and therefore may be less concerned about affordability.
But the interest rate will substantially affect the loan balance when it comes due. If your children plan to pay off the loan to keep the house in the family, a high interest rate will mean they need more savings — or a larger forward mortgage — to do so.
Even if they plan to sell the house to pay off the loan, it’s worth considering that the larger the loan is, the less profit they might receive after the balance is paid off.
It’s important to get quotes from several reverse mortgage lenders to make sure you’re getting a competitive interest rate and not overpaying on fees in general.
There are no restrictions on how you use the money you borrow in a reverse mortgage. You can use the money on home improvements so you can age in place, to pay for long-term care, everyday living expenses, travel, help your grandkids pay for college — the choice is yours.
You can also use reverse mortgage funds to supplement other sources of income, such as Social Security, rather than withdrawing money from your investment accounts, particularly when the market is volatile. Your financial advisor can help you determine the best times to tap your retirement funds, and a reverse mortgage can help you cover periods when it seems preferable to leave money in the stock market.
Money received from a reverse mortgage is non-taxable income, so receiving a lump sum or cash advances will not put you in a higher tax bracket. Investment gains are taxable income, though — all the more reason to work with your financial advisor and see how reverse funds can enhance your retirement strategy.
If your spouse is younger than 62 and cannot be a co-borrower, you can name them as a non-borrowing spouse (NBS). Officially designating them as such may afford them protection if you pass away or need to move into a long-term care facility.
A non-borrowing spouse can stay in the home under the same loan terms as the borrower — the balance will not come due until the NBS leaves the home or passes away. That means they can stay in the home as long as they choose, provided they continue paying their taxes, insurance, and upkeep costs.
If your children inherit your home with a reverse mortgage on it, they have a few options:
- Sell the house to pay off the loan
- Pay off the loan with cash
- Refinance to a forward mortgage
Remember that a reverse mortgage is a non-recourse loan: you will never owe more than the fair market value of the home, and neither will your heirs.
They can sell the home to pay off the loan and keep any profits made in the sale. If they’d like to keep the home in the family, they can pay off the reverse mortgage in cash or refinance to a forward mortgage in their names.
Many homeowners worry that taking out a reverse mortgage means leaving less for their children. If the home isn’t paid off in full when they inherit, the kids will have to sell the home or pay off the loan, and many parents fear burdening their children that way.
But here’s another way to think about it. Most children sell their parents’ homes when they inherit them, so you may not be doing them any favors by avoiding a reverse mortgage. If they will sell the home anyway, there’s no reason for you not to use the money to improve your retirement.
And using that money is also to their advantage. For one thing, if you are struggling to make ends meet in retirement, your children will likely step in and help you financially — which takes away from their own savings and, ultimately, their retirement.
Investing in your family now
You can also use reverse home loan proceeds however you choose. Maybe your child wants to pursue a graduate degree, or your grandchildren are about to start college, and you’d like to help pay their tuition. Perhaps your child just had their first child and you want to help them with their baby expenses. Or maybe you’d like to take a once-in-a-lifetime family trip to Europe.
Whatever your goals or priorities, a reverse mortgage empowers you to invest in your family here and now, rather than living on less than you really need so they can inherit your house free and clear.
If your kids do plan to keep the house after you die, that’s still not a deal-killer for a reverse mortgage. They’ll have the option to pay off the loan or refinance to a forward mortgage when the time comes. So if keeping the house is a priority, they can start planning now for how they’ll do that, but you can still take advantage of the reverse mortgage benefits.
Related reading: How does a reverse mortgage work when you die?
I have plenty of home equity. Why should I choose a reverse mortgage instead of a home equity loan or HELOC?
Plenty of homeowners use a home equity loan or home equity line of credit (HELOC) for the same expenses they’d use a reverse mortgage for — home renovations, education, travel, and other big ticket costs.
The difference between traditional home equity options and a reverse mortgage is in your payment options. When you take out a home equity loan, you receive the loan proceeds as a lump sum and you begin repaying the loan right away. With a HELOC, you’ll start making payments as soon as you draw on the line of credit.
There is no option to stop making payments on home equity loans and lines of credit. Payments that seem manageable initially can become burdensome later on in retirement, but not making them jeopardizes your home.
A reverse mortgage allows you to use your home equity for substantially less risk. As long as you uphold the terms of the loan — paying the property taxes, homeowners insurance, and maintaining the property — you can use the funds as you need without making monthly payments and without worrying about losing your home.
Reverse mortgages aren’t just for living more comfortably in your current home. You can also use a reverse mortgage to buy a house.
Perhaps you’d like to right-size into a new property now that your adult children are no longer in the house, or you want to move to a warmer climate. Or maybe you’re going through a divorce and are ready to start fresh in a new home.
If you’re 62 or older, a HECM for Purchase loan can help you in all of these scenarios.
The down payment requirement for a HECM for Purchase is higher than with forward mortgages — expect to put down 30-70%. That’s why this can be a good option if you’ve recently sold a home and can use the sale proceeds toward your new property.
Now, you could use the sale income to buy a home outright, especially if you’re buying a smaller home or moving to a less costly area. But a reverse mortgage allows you to keep more money available for day-to-day expenses, emergencies, or other retirement priorities.
Let’s say you recently sold your home in New York for $500,000, and you’re moving to the Georgia coast to fulfill your lifelong dream of retiring in Savannah. You find the perfect house for $300,000.
You could pay for the home outright and still have $200,000 left over. Or you could put down $150,000 on a reverse mortgage, have $350,000 left in your savings, and have an optional monthly payment — you’d only be responsible for the property taxes, insurance, and upkeep.
That $350,000 can be used any way you choose, and it will give you the flexibility to decide if and when to draw on your retirement funds. Your mortgage loan would not come due until you move out of the house or pass away, at which point you or your heirs could sell the house to pay off the balance.
Learn more: How to Use a Reverse Mortgage to Purchase a Home
The unfortunate truth is that scammers exist and they often target senior homeowners. But just because there are some bad actors doesn’t mean reverse mortgages are predatory.
Quite the opposite — a reverse mortgage from a reputable, trusted lender can provide substantial benefit to older homeowners.
Here’s how to take advantage of the reverse mortgage opportunity while protecting yourself from scams:
- Choose an FHA-approved lender with reverse mortgage knowledge. Ask your lender how many reverse home loans they do each year and how often they work with retirement-age borrowers
- Don’t sign a contract if you’re not 100% clear on the terms
- Never sign a contract or send or accept money until you’ve reviewed it with your financial advisor
- Never respond to unsolicited reverse mortgage offers; only pursue a loan you applied for with a lender you chose
Related reading: Reverse Mortgage Fact vs. Fiction: Common Myths Debunked
How does a reverse mortgage loan work FAQs
If you don’t have a lot of equity in your home or you’re planning to sell your home soon, a reverse mortgage isn’t going to be a good bet. Also, if you are planning to leave your home to your heirs (and they’re counting on the full value of that inheritance), a reverse mortgage probably isn’t right for you.
Because of the protections offered by FHA insurance on a traditional reverse mortgage, you will not be required to pay more than the value of your home, so it really doesn’t offer a significant downside, even if your loan value outpaces your property value.
The balance of a reverse mortgage comes due when the last co-borrower dies or leaves the home. Borrowers, or their heirs, can sell the home to pay off the loan. They can also pay it off in cash or refinance to a traditional forward mortgage.
No — reverse mortgages can be life-changing tools to enhance your retirement and later years. However, there are scammers who target senior homeowners with illegitimate reverse mortgage offers.
To avoid being ripped off, it’s important to work with a reputable, licensed mortgage company and review any contracts with a trusted financial advisor before you sign.
You can use a reverse mortgage to pay off your existing mortgage, assuming you have enough home equity to qualify for the new loan. Lenders typically look for at least 50% home equity, though you may qualify with less.
The prospect of having a mortgage that doesn’t require monthly payments — and actually pays you — may sound too good to be true.
But reverse mortgages are very real options for millions of homeowners to tap their home equity and improve their retirement finances.
And doesn’t that seem only right? After decades of working hard and putting money into your home, your Golden Years should provide you peace of mind and a good quality of life.
*This article does not constitute tax advice. Please consult a tax advisor regarding your specific situation.
Copyright©2021 Fairway Independent Mortgage Corporation (“Fairway”) NMLS#2289. 4750 S. Biltmore Lane, Madison, WI 53718, 1-866-912-4800. All rights reserved. Fairway is not affiliated with any government agencies. These materials are not from HUD or FHA and were not approved by HUD or a government agency. Reverse mortgage borrowers are required to obtain an eligibility certificate by receiving counseling sessions with a HUD-approved agency. Youngest borrower must be at least 62 years old. Your monthly reverse mortgage advances may affect your eligibility for some other programs. At the conclusion of the term of the reverse mortgage loan contract, some or all of the equity in the property that is the subject of the reverse mortgage no longer belongs to you, and you may need to sell or transfer the property to repay the proceeds of the reverse mortgage with interest from your assets. We will charge an origination fee, a mortgage insurance premium, closing costs or servicing fees for the reverse mortgage, all or any of which we will add to the balance of the reverse mortgage loan. The balance of the reverse mortgage loan grows over time, and interest will be charged on the outstanding loan balance. You retain title to the property that is the subject of the reverse mortgage until you sell or transfer the property, and you are therefore responsible for paying property taxes, insurance, maintenance and related taxes. Failing to pay these amounts may cause the reverse mortgage loan to become due immediately and may subject the property to a tax lien or other encumbrance or to possible foreclosure. Interest on reverse mortgage is not deductible to your income tax return until you repay all or part of the reverse mortgage loan. This is not an offer to enter into an agreement. Not all customers will qualify. Information, rates and programs are subject to change without notice. All products are subject to credit and property approval. Other restrictions and limitations may apply. Equal Housing Opportunity.