You may have heard the term “reverse mortgage,” but have you ever investigated how they work? Here’s a tutorial to help you understand if a reverse mortgage is right for you.
What is a reverse mortgage? A reverse mortgage, also known as a Home Equity Conversion Mortgage, is a tool typically used by an older adult to tap into the equity in the home to supplement retirement. In financial terms, a reverse mortgage converts the illiquid asset of equity in the home into the liquid asset of cash available for use. The money is not paid back until the home is sold or the last person named on the mortgage dies.
How does it work? First, you must meet certain qualifications: You must be 62 or older, own the home and live in it as your primary residence. The home must be no larger than a four-family residence, the home must be in good condition, and you must have substantial equity in it. Qualifying homeowners may apply for an amount up to the amount of equity in the home. For example: A homeowner with $300,000 in equity in a home valued at $350,000, could qualify for a reverse mortgage of up to $300,000. However, you must continue to live in the home. Expect several thousand dollars in lending fees to be subtracted from your equity. Homeowners may take the money in several ways: as a lump sum, as a monthly annuity for the time that you live in the house (called a tenure annuity), as an annuity for a set period of time (term annuity), or as a line of credit to be used at your discretion. Or you can chose a combination of these options. You do not make payments on the amount borrowed. The loan is paid back from the proceeds when the house is sold or when the last person on the mortgage dies and it is sold. If the house is worth more upon sale than the amount of the mortgage, then the heirs receive the additional amount. Reverse mortgages are guaranteed by the Federal Housing Administration or FHA. You are borrowing from a private lender, and FHA guarantees that the lender will make the payments owed to you. FHA also covers the difference if the amount owed to the lender exceeds the value of the home.
When does a reverse mortgage make sense? A reverse mortgage makes the most sense when you are well past the age threshold of 62 and have substantial equity or own your home outright and need to tap into that equity to supplement a fixed income. It doesn’t make as much sense if you don’t have a large amount of home equity, are in your early 60s, have enough retirement income, or if you desire to pass the home onto your heirs.
What are the downsides? The fees associated with a reverse mortgage can be high and the interest rate is higher than traditional mortgages. You must maintain the condition of the home and if you fall behind on your existing mortgage, homeowner’s association dues, homeowners insurance or taxes, you would be at risk of defaulting on the loan. For these reasons, alternatives, such as refinancing an existing mortgage, downsizing or borrowing privately, should be considered.
A reverse mortgage can be confusing, even to some financial experts. But for the right homeowner, in the right circumstances, it may be a good choice. Consult with your financial adviser and tax adviser before making a commitment.