How a Reverse Mortgage Works
- Reverse Mortgage Overview
- Review Our Mortgage Expert Insights on Top Reasons to Get a Reverse Mortgage
- Example: How a Reverse Mortgage Works
The official term for a reverse mortgage is Home Equity Conversion Mortgage (HECM) but most lenders and borrowers use the term reverse mortgage. Similar to a regular, forward mortgage, a reverse mortgage allows you to borrow money using the equity in your home. The equity in your property is the value of your property minus the amount of any mortgages you have on the property. For example, if you own a property that is valued at $300,000 and you have a mortgage against the property with a $50,000 principal balance, you have $250,000 in equity in your property ($300,000 (property value) - $50,000 (mortgage balance) = $250,000 in property equity.
Like a regular mortgage, when you take out a reverse mortgage you get a sum of money from the bank. With some types of reverse mortgages you can take equal monthly disbursements or draw down a line of credit. The disbursements you receive from a reverse mortgage are tax-free.
The biggest difference between a regular mortgage and a reverse mortgage is that the borrower does not make monthly payments with a reverse mortgage so the mortgage balance increases over time. This compares to a regular mortgage where the mortgage balance typically decreases over time as the borrower makes his or her monthly mortgage payments. Instead of making monthly payments comprised of both principal and interest, the interest expense with a reverse mortgage is added to the mortgage balance. By adding interest expense to the mortgage balance every month instead of paying it, you increase the principal mortgage balance, so you pay interest on interest which is one of the biggest drawbacks of a reverse mortgage.
Unlike a regular mortgage, with a reverse mortgage you do not pay down the loan over time (because you do not make any monthly mortgage payments). Instead, the loan balance is paid off when you sell the property, refinance the reverse mortgage or pay-off the loan balance with other funds. In short, a reverse mortgage is due in full when you vacate the property by: 1) selling it; 2) when you move into an assisted living facility for longer than a year; or, 3) when you pass away.
According to government regulations, the borrower or the borrower's heirs can never owe more on a reverse mortgage than the value of the property, even if the reverse mortgage balance exceeds the value of the property when the mortgage is due. If the mortgage balance is greater than the value of the property the lender is protected against any loss by insurance paid for by the borrower over the course of the reverse mortgage.
The example below demonstrates how the mortgage balance for a reverse mortgage increases over time while the mortgage balance for a regular mortgage decreases over time. The chart compares a reverse mortgage with an initial balance of $100,000 and an interest rate of 5.1% to a regular mortgage with an initial balance of $100,000 and an interest rate of 4.0%. The interest rate on a reverse mortgage is typically higher than the interest rate on a regular mortgage. After 30 years, the regular mortgage has been paid off and the principal balance of the reverse mortgage is approximately $660,000.
This example shows a reverse mortgage after 30 years, which is longer than usual, but there is no set term for a reverse mortgage. A reverse mortgage lasts as long as the owner lives in the property or until the mortgage is paid off.
- Forward Mortgage Balance
- Reverse Mortgage Balance
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- How Much Money Can I Get from a Reverse Mortgage?
- Your Age: the older you are, the larger the reverse mortgage you qualify for. If there are two people on a property title, lenders use the age of the youngest person to determine what size reverse mortgage you can obtain
- Interest rate: the lower the interest rate the larger the reverse mortgage you qualify for
- Property value: the higher the value of the property you are getting a reverse mortgage on, the larger the reverse mortgage you qualify for
- Program type: there are two types of reverse mortgage programs - fixed rate and adjustable rate. The amount of proceeds you receive varies depending on what program you select. Depending on their age, borrowers receive approximatley the same amount of proceeds up-front with both types of programs but can receive significantly more proceeds over the life of the loan with an adjustable rate reverse mortgage
- Example: Reverse Mortgage Proceeds
Assumptions Transaction Type Refinance Property Value $300,000 Age 62 Age 70 Reverse Mortgage Program Fixed Rate Adjustable Rate Fixed Rate Adjustable Rate Proceeds Available at Closing $94,000 $94,000 $95,000 $100,000 Additional Proceeds Available After One Year 0 68,000 0 69,000 Total Proceeds Available Within One Year $94,000 $162,000 $95,000 $169,000 Assumptions Transaction Type Purchase Property Value $300,000 Age 62 Age 70 Reverse Mortgage Program Fixed Rate or Adjustable Rate Fixed Rate or Adjustable Rate Proceeds Available at Closing $141,525 $157,125 Additional Proceeds Available After One Year 0 0 Total Proceeds Available Within One Year $141,525 $157,125 Down Payment Required to Purchase Home $158,475 $142,875
- What Can I Spend My Reverse Mortgage Proceeds On?
- Review Our Mortgage Expert Insights on How to Buy a Home With a Reverse Mortgage
- Reverse Mortgage Qualification Requirements
- Borrower Credit History Review: Unlike for a regular mortgage, for a reverse mortgage your credit score is not a significant factor in determining your interest rate or what size mortgage you qualify but lenders do review your credit history. All borrowers that meet the minimum credit score requirement typically receive the same interest rate from a lender so reverse mortgage borrowers are not rewarded for having higher credit scores. Lenders typically require borrowers to have a minimum credit score of 620 to qualify for a reverse mortgage although borrowers with extenuating circumstances may be able to qualify with lower scores. Lenders do review your credit report to verify that you have no late payments or derogatory credit events within the past year. Additionally, borrowers cannot have defaulted on government debt such as a student loan. Late payments or other derogatory credit events may make it challenging for you to qualify for a reverse mortgage or require the lender to set aside a portion of your reverse mortgage proceeds to pay for property tax and insurance.
- Residual Income Analysis: You must demonstrate that you have sufficient income or assets to afford non-mortgage housing expenses such as property taxes, homeowners insurance, homeowners association (HOA) fees (if applicable) and property maintenance. Failure to pay these ongoing housing expenses can result in default or foreclosure and you losing the property. To ensure that borrowers can afford the home after the reverse mortgage closes, the lender performs a residual income analysis that measures a borrower's income against ongoing housing expenses. A borrower's income can come from a multitude of sources including a job, military or private pension, retirement account income, social security, alimony and child support. When you apply for a reverse mortgage, the lender requests financial documents such as your tax returns and banks statements to verify that your income and assets. If a borrowers fails to pass the residual income test, the lender must set aside a portion of the proceeds to pay for ongoing housing expenses.
- Extenuating Circumstances: Lenders will review extenuating circumstances such as a job loss, reduced working hours or a medical hardship that may have impacted a borrower's financial profile or credit history. Borrowers with poor credit histories that may not otherwise be approved for a reverse mortgage may be able to qualify if they can prove that a derogatory credit event resulted from an extenuating circumstance. Additionally, in some cases, borrowers with extenuating circumstances may not be required to set aside a portion of their reverse mortgage proceeds for ongoing housing expenses even if they have poor credit profiles. Borrowers with extenuating circumstance must provide the lender with documentation that verifies and explains the event.
- What Lenders Offer Reverse Mortgages?
- Use the FREEANDCLEAR LENDER DIRECTORY to find lenders in your state that offer reverse mortgages
- Shopping your reverse mortgage business and comparing lenders can save you thousands of dollars on your loan
- Questions Borrowers Should Ask Before Getting a Reverse Mortgage
- Review our Jumbo Reverse Mortgage Overview
- Review our Mortgage Expert Insights on Reverse Mortgage Misconceptions
- Review our Mortgage Expert Insights on Tips for Saving Money on Your Reverse Mortgage
- Related FREEandCLEAR Resources
What size reverse mortgage you qualify for depends on several factors
The example below illustrates the amount of proceeds a borrower can receive from a reverse mortgage for a refinance transaction, when the borrower refinances the existing mortgage on the property they currently own and live in and continues to reside in the property after the transaction. For this example, we assume the borrower's home is valued at $300,000 and compare the difference in proceeds between a fixed rate reverse mortgage and an adjustable rate reverse mortgage for borrowers aged 62 and 70.
The example demonstrates how a fixed rate reverse mortgage provides borrowers with a single lump sum disbursement at closing and no additional proceeds while an adjustable rate reverse mortgage provides a lump sum disbursement at closing and also enables borrowers to take additional disbursements one year after closing, either with another large disbursement, monthly disbursements or through a line of credit. The example also illustrates how the amount of proceeds the borrower receives at closing with an adjustable rate reverse mortgage is equal to or greater than a fixed rate reverse mortgage, plus the borrower is able to access more total proceeds over the life of the mortgage as compared to a fixed rate reverse mortgage.
Finally, the example illustrates how age impacts the amount of proceeds you receive from a reverse mortgage with the older borrower receiving more proceeds. Please note that the chart below represents one example and the actual amount of proceeds you receive from a reverse mortgage depends on many additional factors including interest rate and property value.
The example below illustrates the amount of proceeds a borrower can receive from a reverse mortgage used to buy a home, which is very different than the amount of proceeds from a reverse mortgage used for a refinance. This example assumes the borrower purchases a home valued at $300,000 and compares a 62 year old borrower to a 70 year old borrower.
With a purchase reverse mortgage, the amount of proceeds the borrower receives is the same for both a fixed rate reverse mortgage and an adjustable rate reverse mortgage. Additionally, the borrower receives the proceeds as a single lump-sum disbursement at mortgage closing and is not able to access additional proceeds over the life of the loan. Because the amount of proceeds is the same for both a fixed rate and adjustable rate reverse mortgage used to buy a home, most borrowers select the fixed rate option which eliminates the risk that their interest rate can increase over the course of the mortgage. The example also demonstrates that the older borrower receives more proceeds from the reverse mortgage.
The example also highlights that a reverse mortgage used to buy a home requires the borrower to make a significant down payment of approximately 50%, which is a major difference as compared to a regular mortgage. After closing costs of approximately $15,500, the 62 year old borrower receives $141,525 in proceeds from the reverse mortgage and the 72 year old borrower receives $157,125 in proceeds. This means that the 62 year old borrower makes a down payment of $158,475 to buy a home (53% of the purchase price) and the 70 year old borrower makes a down payment of $142,875 (48% of the purchase price). The example demonstrates that borrowers who use a reverse mortgage to buy a home must be prepared to make a significant personal financial contribution to complete the purchase.
Both examples assume a 5.060% interest rate for the fixed rate reverse mortgage and a 3.774% initial interest rate for the adjustable rate reverse mortgage. Interest rates are subject to change depending on market conditions and the interest rate for the adjustable rate reverse mortgage is subject to change and increase over the life of the loan.
Other than paying off your existing mortgage, there are no restrictions on how borrowers can spend the proceeds from a reverse mortgage. For example, if you have $50,000 mortgage balance on your home and obtain a $150,000 reverse mortgage with $5,000 in closing costs then your proceeds are $95,000 ($150,000 reverse mortgage - $50,000 existing mortgage - $5,000 closing costs = $95,000 in money to you). Borrowers can use the proceeds from a reverse mortgage for a variety of purposes including to pay off debt and improve their monthly cash flow; to pay for college tuition for a child, grandchild or themselves; to travel the world; to make investments; to remodel their home; or, to buy a home. For example, borrowers who currently own a home could sell their existing property and combine the proceeds with a reverse mortgage to buy a new home while also eliminating their monthly mortgage payment.
In short, you can spend the proceeds from a reverse mortgage on just about anything but keep in mind that borrowers remain responsible for ongoing monthly housing expenses such as property taxes, homeowners insurance, homeowners association (HOA) dues and property upkeep.
One borrower must be at least 62 years old. If two people own a property jointly then the age of the youngest individual on the property title is used to determine the loan amount for the reverse mortgage. The younger the borrower the lower the loan amount. You should have a low mortgage balance or own your home free and clear. You are required to pay off any existing mortgage balance you have on the property with the proceeds of the reverse mortgage so the lower your existing mortgage balance, the more money you receive from the reverse mortgage.
Borrower Financial Assessment
Lenders are required to perform a three part borrower financial assessment to determine your ability to qualify for a reverse mortgage. The financial assessment is designed to reduce reverse mortgage defaults and to make sure that borrowers can afford to live in their homes after the reverse mortgage closes. The reverse mortgage financial assessment focuses on a borrower's credit history, income and any extenuating circumstances the borrower has experienced that impact their financial or credit profile.
Life Expectancy Set Aside
If the borrower does not demonstrates sufficient income to pay for property tax and homeowners insurance or has poor credit, the lender sets aside a certain portion of the reverse mortgage proceeds to pay for these expenses. The amount of the Life Expectancy Set Aside is based on the borrower's age and expected property tax and insurance costs. The younger the borrower and higher the costs, the higher the set aside. Similar to an impound account for a regular mortgage, the Life Expectancy Set Aside is placed in a separate bank account from which property tax and insurance costs are paid when due.
A Life Expectancy Set Aside can be tens of thousands of dollars and take up a significant portion of a borrower's reverse mortgage proceeds. For example, for a 65 year old borrower with $3,000 in annual property tax and insurance expenses, the Life Expectancy Set Aside is approximately $40,000 which means the borrower receives $40,000 less in proceeds from the reverse mortgage. Borrowers should determine if the Life Expectancy Set Aside applies to them before deciding if a reverse mortgage makes financial sense.
You must live in the property for which you are getting a reverse mortgage so investment properties and vacation homes are not eligible. The property can be one-to-four units as long as the borrower occupies one of the units. The property can be a home or condominium although the condominium project must be HUD-approved. Borrowers who are seeking a reverse mortgage on a condominium should check with the condominium project's homeowners association (HOA) to determine if the project is approved by HUD.
HUD-Approved Reverse Mortgage Counseling Class
Borrowers must also complete a reverse mortgage class offered by a government-approved counselor. The class typically costs $100 - $175. Certain HUD-approved reverse mortgage counselors use HUD grants to offer counseling classes for free. Free reverse mortgage counseling classes save the borrower money but may take more time to find and complete due to greater borrower demand. Please note that lenders must wait seven days after receiving a signed certification that indicates the borrower completed a HUD-approved reverse mortgage counseling class before creating an FHA case number for the borrower. Creating the FHA case number enables the lender to order a property appraisal which is a key step in moving the reverse mortgage process forward.
You can apply for a reverse mortgage with any HUD-approved reverse mortgage lender. Most types of lenders offer reverse mortgages including banks, mortgage bankers and mortgage brokers. Many larger, national banks, however, do not offer reverse mortgages. Mortgage bankers are the most common type of reverse mortgage lender and there are several mortgage banks that specialize in reverse mortgages. Many mortgage brokers work with a network of reverse mortgage lenders and are able to compare rates and fees from multiple competing lenders to find the reverse mortgage that is right for you.
You should treat the reverse mortgage process like you would any other major purchase, such as buying a car -- shop around, compare proposals from multiple lenders and negotiate the best terms for your reverse mortgage. Remember that the interest rate and closing costs, especially the lender origination fee, are subject to negotiation between you and the lender. We highly recommend that you speak to at least four lenders when shopping for your reverse mortgage including one mortgage broker and one mortgage banker.
Gathering and comparing reverse mortgage proposals from several lenders will help ensure that you receive the lowest interest rate and fees for your mortgage. Compare the interest rate and fees outlined in the lender proposals and negotiate the best terms for your mortgage. For example, if lender A offers a lower interest rate but higher fees than lender B, see if lender A will reduce their fees to match lender B.
Is There a Size Limit for a Reverse Mortgage?
Yes. For almost all reverse mortgages, the mortgage amount cannot exceed the FHA reverse mortgage limit of $679,650. This is also known as the FHA HECM limit (Home Equity Conversion Mortgage). Some lenders offer jumbo reverse mortgages which permit higher loan amounts although lenders charge a higher interest rate and fees on jumbo mortgages and they represent a small portion (10%) of the reverse mortgage market.
Do I Lose Ownership of My Home?
No. With a reverse mortgage you keep ownership of your property as long as you continue to pay property tax and homeowners insurance. You maintain title of the property until you sell it or pass away.
What is the Length of a Reverse Mortgage?
Unlike a traditional mortgage, there is no pre-determined length for a reverse mortgage. With a reverse mortgage, the loan lasts as long as you live in the property or until you decide to pay back the loan (which you are not required to do as long as you live in the property). A reverse mortgage could last five years or it could last 32 years -- there is no set term. It is important to highlight that the the longer a reverse mortgage is outstanding, the higher the principal balance.
When Do I Have to Pay Back the Reverse Mortgage?
If the borrower moves out of the property or passes away, the mortgage ends and the principal balance is due in full. Additionally, if a borrower is required to live in an assisted living facility for one year or longer then the borrower is no longer considered to live in the property and loan balance is due in full. A reverse mortgage is typically paid off by selling the property that is mortgaged and using the proceeds from the sale to pay off the loan but in some cases the borrower or the borrower’s heirs may decide to pay off the loan with other funds.
A Reverse Mortgage Eliminates My Mortgage Payment. Does It Also Eliminate My Other Monthly Housing Expenses?
No. We want to emphasize this point. Although reverse mortgage borrowers do not make a mortgage payment they are responsible for ongoing housing expenses including property taxes, homeowners insurance, homeowners association (HOA) fees (if applicable) as well as property repairs and upkeep. Failure to pay these expenses could result in default or foreclosure which could require the borrower to pay off the mortgage balance in full or the borrower could potentially lose the home.
What are the Costs for a Reverse Mortgage?
Closing costs for a reverse mortgage are the same as for a normal mortgage including lender origination, appraisal report, settlement agent (escrow) and title fees. Lenders also charge a monthly servicing fee which is included in the mortgage interest rate and added to the mortgage balance over the life of the loan. Most closing costs for a reverse mortgage are regulated and there are limits on the total fees that can be charged. The lender origination fee for a reverse mortgage is capped at 2% of the value of the property up to the first $200,000 and 1% of the property value greater than $200,000. There is an overall cap on reverse mortgage lender origination fees of $6,000 but their is no minimum fee. The lender, escrow and title costs are typically financed which means they are included in the loan amount and paid for with the initial proceeds from the reverse mortgage. You are typically required to pay for the cost of the appraisal report and the FHA-required reverse mortgage counseling class up-front. Borrowers may also be required to pay for property repairs identified in the appraisal report prior to the mortgage closing.
Reverse mortgage borrowers are also required to pay an up-front and ongoing annual FHA Mortgage Insurance Premium (MIP). The up-front FHA MIP for a reverse mortgage equals 2.0% of the maximum claim amount (the maximum claim amount is the value of the property you are mortgaging up to the FHA mortgage limit in your county). The ongoing annual MIP for a reverse mortgage is 0.5% of the outstanding mortgage balance, calculated on a monthly basis. The borrower does not pay for either of these fees out of pocket as the up-front MIP is included in the closing costs which are financed as part of the reverse mortgage and the ongoing annual fee is added to the mortgage balance.