A reverse mortgage can help senior citizens use the equity in their home to help cover living expenses, but how does a reverse mortgage work?
Jun 9, 2015 at 12:40PM
A reverse mortgage is a special type of mortgage loan based on the equity in your home. Unlike a traditional mortgage, you don't make payments on a reverse mortgage -- in fact, the payments are made to you. This may sound a little strange, so let's take a look at how a reverse mortgage works, who can get one, and whether or not it might be a good idea for you.
How it works and who can get one
A reverse mortgage gives homeowners four ways to extract equity from their homes: via a lump sum payout, monthly payments, an open line of credit, or a combination of the three. When it comes to monthly payments, moreover, there are two ways they can be structured: "term", or payments for a set number of years, and "tenure," which means you'll continue to receive payments for as long as you own the home.
The money you receive begins to accrue interest at either a fixed or variable interest rate, depending on your loan terms, and you'll also have to pay mortgage insurance, calculated as a percentage of the loan balance. Once you die, sell the home, or vacate the home for 12 months or more, the loan becomes due and the lender recoups the outstanding loan balance from the sale of your home.
A reverse mortgage loan is a nonrecourse loan, meaning that the lender can only recoup their money upon the sale of the property, and the amount the lender collects cannot exceed the sale price of the home. Borrowers aren't responsible for any loan balance that builds up above the value of the home, and heirs cannot
be held responsible for any part of the balance.
In order to be eligible to receive a reverse mortgage, you must own a home conforming to HUD standards -- a single family home, two-to-four unit property, condo, townhouse, or manufactured home built after June 1976. Co-ops or apartment buildings with more than four units are not eligible. You also must be at least 62 years of age and have enough equity in your home to justify the reverse mortgage. If there is an existing mortgage on the property, it must be paid with the reverse mortgage proceeds: the reverse mortgage lender must be in a first lien position.
As of April 27, 2015, all lenders are required to conduct financial assessments of prospective borrowers in order to determine their financial condition, since unlike a standard mortgage where an escrow account is established, borrowers are responsible for paying their own property taxes and homeowner's insurance. If it is determined that they might have trouble with these expenses, a portion of the reverse mortgage proceeds may be set aside in order to make sure they get paid.
Let's say that you own a home worth $300,000 free and clear, and decide to take out a reverse mortgage on the property. And, after considering your age and expected interest rate (we'll say a 5% total fixed interest rate, for the sake of simplicity, although monthly reverse mortgage payments tend to come with a variable rate), HUD determines you are eligible for a $140,000 reverse mortgage. You choose to receive this as equal monthly payments over a 10-year period, so $1,167 per month.
Every time you receive a check, your outstanding loan balance increases. Then, interest begins to accumulate on the money you've received, and the balance begins to rise. Here's an example of how the loan balance could increase over time.