How a Reverse Mortgage Works

Brian Roy

Reverse Mortgage Works

An Explanation of What a Reverse Mortgage Is

With tens of millions of baby boomers set to retire over the next two decades, many are wondering what a reverse mortgage is and how it figures into their retirement savings plan.  Some people approaching retirement age or already in their retirement years do not consider unlocking the equity in their home via a reverse mortgage, because they do not understand how a reverse mortgage works. 

Of course, a reverse mortgage is not right for every retiree or for every situation, but it is important to learn about reverse mortgages to understand the full range of income options during retirement.  Seniors that have a lot of equity in their home, but do not have a lot of monthly income, may want to consider a reverse mortgage to provide them needed monthly income, while being able to stay in the home that provides them shelter and comfort.

A reverse mortgage is essentially a loan by a financial services company to the owner of a home that is secured by the equity a homeowner has in their home.  A reverse mortgage can be received either as a lump sum or via set monthly payments.  The money paid is not subject to income taxes since it is a loan that is eventually paid back when the home is sold, and is not earned income. 

Receiving a lump sum or monthly reverse mortgage payment does not affect Social Security or Medicare benefits.  Depending upon the type of reverse mortgage, the money either has to be used for a specific purpose, such as paying property taxes, or can be used for just about anything, depending upon the type of reverse mortgage.

A reverse mortgage can provide a practical way to remain in one’s home during retirement, while generating needed retirement income.  A homeowner does not sign over the deed to their home to the financial services company that provides a reverse mortgage. 

The retiree retains ownership of their property.  The financial services company that provides a lump sum payment or monthly income via a reverse mortgage recoups their investment via fees and reimbursement for the loan’s principal amount at a later date, when the home is eventually sold.  The principal amount of a loan is the original amount that is lent.  If a retiree moves or passes away, they or their estate must repay the principal amount of the reverse mortgage to the financial services company to close the loan.

Qualifying For a Reverse Mortgage

To be able to take advantage of a reverse mortgage to provide extra income during your retirement years, you and your spouse (if applicable) must be 62 years old or older, and you must either own your home outright or have enough equity built up in your home to be able to repay the reverse mortgage principal to the lender, if it is necessary to do so. 

Additionally, you need to plan on living in your home as your primary residence during the time in which the reverse mortgage is in effect.

Since there are numerous up-front fees that must be paid to establish a reverse mortgage, you should plan on being in your home for a number of years to make the arrangement cost-effective. 

If you are planning on selling your home and moving elsewhere for retirement, then a reverse mortgage does not make sense for your current home.  However, a reverse mortgage may make sense for your new home, if it is going to be your primary residence during your retirement years.

The Different Types of Reverse Mortgages

Anyone considering purchasing a reverse mortgage and wants to know how a reverse mortgage works needs to understand the three types of reverse mortgages that are offered.

  • A Single-Purpose Reverse Mortgage is a reverse mortgage loan that is provided to cover a single expense, such as payment of property taxes or replacement of a heating, ventilation, and air conditioning (HVAC) system.  This type of reverse mortgage is set up to assist low-income homeowners in need of assistance and can be provided by either a private financial institution, a nonprofit group, or a government entity.  As the name implies, the funds are limited to a single purpose, such as home renovation or property taxes.  This type of reverse mortgage usually has lower upfront fees than other types of reverse mortgages.
  • A Proprietary Reverse Mortgage is a reverse mortgage loan that a private company arranges and owns.  Qualification for this type of mortgage is easier than other types of reverse mortgages.  However, the ease of qualification comes at a cost; including sizable upfront fees that are paid when the loan is made and a monthly service fee, if the money is received via a monthly payment.
  • A Home Equity Conversion Mortgage (HECM) is a reverse mortgage loan that is insured by the Federal Housing Administration (FHA).  While qualifications for this type of loan can be more complicated than other reverse mortgages, a HECM comes with a guarantee from the federal government to provide the payments associated with the loan. 

Risks Associated With a Reverse Mortgage

There are some considerations and risks that must be understood to fully understand how a reverse mortgage works.  Upfront reverse mortgage loan fees paid from a home’s equity reduces the amount of equity you have in your home and the amount of cash paid from the reverse mortgage loan.  If you do not maintain your home in good standing with local taxing authorities and in regards to upkeep, the lender who holds the reverse mortgage loan may have the right to take possession of your home to protect their investment.  Mortgage insurance is necessary to insure the lender against losses.  Lenders can require full repayment of a reverse mortgage loan, if you are not living in the home, even if it is due to a prolonged hospitalization or stay in a rehabilitation facility or nursing home.

If a reverse mortgage is not an appealing option, consider other ways to unlock the equity you have built up in your home over a lifetime of paying off a mortgage.  If you can sell your home for a decent amount of money, consider selling your home and either downsizing to a smaller less expensive home in your area, or move to an area that has cheaper home prices.  You can then invest the net money you receive from the sale of your home in a safe dividend paying security or an annuity to provide periodic income to supplement retirement income.

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