How Does a Reverse Mortgage Work?

Homeowners with a lot of equity in their homes, senior homeowners, and others may require special loan instruments to pay for medical expenses, cover the cost of living, or for other reasons entirely. Reverse mortgages are unique loans that allow homeowners over the age of 62 to borrow against their houses without having to repay until they leave their homes.

However, reverse mortgages are not ideal for every financial situation. Furthermore, they are subject to scam risks. Today, let’s go over how a reverse mortgage works, who should consider a reverse mortgage, and how to distinguish legitimate mortgage loans from potential scams.

Reverse Mortgages Explained

Let’s begin by breaking down reverse mortgages in detail.

What Is a Reverse Mortgage?

Put simply: a reverse mortgage allows a homeowner over the age of 62 to borrow against the value of their home. They can then receive funds from that loan as cash in a lump sum, cash through a fixed monthly payment, or a line of credit.

They can be thought of as a type of second mortgage; regardless, they are useful personal finance solutions for seniors who need more cash for a period of time, a home remodel, retirement income, and medical expenses. 

Importantly, reverse mortgages do not require homeowners to make monthly payments toward the loan’s balance. Instead, the complete loan balance up to a preset limit is due and payable whenever the borrower/homeowner:

Sells their home

Moves out permanently

Passes away

Since reverse mortgages can be tricky and lead to financial issues, federal regulations require that all legitimate reverse mortgages be structured, so that loan amounts never exceed home values.

Even if this occurs, a borrower or borrower’s estate is not held responsible for paying the lender if there’s a difference in value/loan balance. Mortgage insurance covers this possibility and is part of what makes reverse mortgages potentially costly. It’s essential to consider the types of loans available to you, including their APRs/annual percentage rate and other factors.

What Are the Different Types of Reverse Mortgages?

There are three types of reverse mortgages overall:

• Home equity conversion mortgages or HECMs. These reverse mortgages make up the majority of these loans. They are federally insured and backed by the HUD. Note that these mortgages are more expensive compared to traditional home loans and have very high initial costs.

However, they don’t have any income limitations and can be taken out even if one doesn’t have medical requirements. Therefore, they can be used for any purpose.

• Single-purpose reverse mortgages. These are offered by state, local, and potentially nonprofit agencies. These are the least expensive types of reverse mortgage loans since they are backed by at least one institution.

Homeowners pay less interest and fewer fees. They’re the least common type of reverse mortgages since their funds are restricted to a lender-approved item, like home renovations, property taxes, or paying for medical bills.

• Proprietary reverse mortgages. These reverse mortgages are backed by private lenders only. They can be advantageous for homeowners who want more monthly income and who happen to have properties appraised at higher than average values. Notably, they don’t have any monthly mortgage insurance premiums since they are federally insured.

Who Is Eligible for a Reverse Mortgage?

Reverse mortgages are only available to homeowners over the age of 62. Additionally, homeowners must have a significant amount of equity in their homes to qualify. Equity, in a nutshell, is a home’s market value minus the amount for any outstanding home loans.

Since many homeowners over the age of 62 have mostly or completely paid off their houses, they can draw from a significant pool of equity and borrow against it.

How Do Reverse Mortgages Benefit Seniors?

Reverse mortgages can be very beneficial for seniors who:

• Are somewhat short on funds to pay for living expenses. For example, maybe they don’t receive as much from a pension as they expected, or maybe another source of income recently dried up.
• Have medical or credit card debt or other expenses that have depleted their other sources of income.
• Want to diversify retirement income sources and hedge their funds against risks, like market downturns or the possibility of outliving their savings.

Alternatively, a senior may wish for a credit line or sum from their home’s equity for home improvements, a down payment on a new home, or debt consolidation. It all depends on the person and their financial needs.

That said, reverse mortgages are not beneficial for all seniors. These special loan instruments are only appropriate in certain situations and, in some cases, can be financially devastating when leveraged improperly. It’s a good idea to get a loan with a low interest rate whenever possible and to keep the existing mortgage balance low.

In other words, this type of mortgage refinance must be used carefully.

How Do You Receive Payments from a Reverse Mortgage?

Those who take out reverse mortgages can receive their payments in one of several different ways:

Lump-Sum Reverse Mortgage Payments

Lump-sum reverse mortgage payments allow homeowners to get all of their proceeds when the loan closes. This payment type requires that the loan include a fixed interest rate — the other payment types have loans with adjustable interest rates.

This type of payment is advantageous for homeowners who want the lump sum or total loan amount delivered to a bank account quickly.

Reverse Mortgage Payments as Annuity

Alternatively, homeowners can receive equal monthly payments through an annuity. The lender makes state payments to the borrower, provided that the borrower lives in the home and the home is that borrower’s principal residence. In other words, the borrower can’t live in another property while receiving annuity reverse mortgage payments.

Reverse Mortgage Term Payments

Homeowners may instead choose to receive term payments for their reverse mortgages. With this system, the lender provides the borrower the full monthly payments during a set loan term, such as five years, ten years, or more. This can be good if a homeowner believes they will only need the regular monthly income for a certain period.

Reverse Mortgage Payments as a Line of Credit

Reverse mortgage payments may also be received as a line of credit. This makes the loan's amount available to the homeowner to borrow as necessary, like a typical credit card. Since this is still a reverse mortgage, the homeowner just has to pay interest on what they use, not pay back the total potential borrowed amount until the loan's balance is due.

What Are Combination Reverse Mortgage Payments?

The final ways to receive reverse mortgage payments are:

• Combined line of credit plus equal monthly payments. With this setup, the lender gives the homeowner/borrower regular monthly payments but also allows the borrower to access the line of credit if they need more money than the monthly amount of money.
• Combined line of credit plus term payments. With this setup, the lender gives the borrower equal monthly payments for a set timeframe as described above. The borrower also has access to a line of credit when needed.

5 Steps To Determine if a Reverse Mortgage Is for You

As you can see, reverse mortgages can be very useful in certain circumstances. Consider whether a reverse mortgage is truly right for you before signing on the dotted line.

To determine this, follow these five steps and answer the questions yourself or with a loan officer’s advice.

1. Are You 62 or Older?

Generally, you can’t take out a reverse mortgage unless you are 62 or older. If you’re 61, you’ll likely have to pursue a different means of financial stability.

2. Do You Want To Avoid Monthly Payments?

One of the most significant advantages to reverse mortgages is that you don't have to pay regular monthly installments against the loan's balance. Reverse mortgages can be advantageous if you want to add to your regular income without deducting a loan payment from the sum each month. This stands in contrast to other loans you can take out, including those that revolve around your home and its equity.

3. How Is Your Cash Flow?

Before taking out a reverse mortgage, you should consider your current cash flow situation. For example, if you only need a little bit of cash, a reverse mortgage might be helpful since you don’t have to make any monthly payments. The balance for the loan will be due after the homeowner leaves the property or after their passing.

Indeed, many senior citizens take out reverse mortgages specifically because of cash flow needs. The bit of extra income provided by your home might help you avoid taking out costlier loans or sinking into medical debt.

4. Is the Loan’s Interest Rate Good?

Naturally, it’s still a good idea to compare different reverse mortgage loans before signing up for any of them. Check that the interest rate for the loan you are considering is good before accepting it.

The interest rate immediately affects reverse mortgages in which you receive your loan total as a line of credit. But it will still affect the total amount due for the loan no matter how you receive the money. A lower interest rate is always good. Remember that a variable interest rate can seem like a lower rate at first but change later.

5. Would a Home Equity Loan Be Better?

Additionally, it’s a good idea to consider whether a home equity loan might be better for your financial needs. Home equity loans or home equity lines of credit (HELOC) are closer to traditional loan instruments, but the advantage is that you can pay off the loan more regularly without having the entire balance due upon loan close.

You have to have good credit and other factors to qualify for most home equity loans. Refinancing your loan or taking out a second mortgage comes with its own problems for credit score, interest rates, and so on. For instance, second mortgages will likely have higher interest rates.

Bottom line: consider all your options before reversing your first mortgage.

Reverse Mortgage Scams: How To Be Prepared

Unfortunately, the complexity of reverse mortgage loans means that there are lots of scams to watch out for.

Here’s how you can be prepared for reverse mortgage scams and avoid signing for a loan that isn’t in your best interest:

How Common Are Reverse Mortgage Scams?

Reverse mortgage scams can tend to be quite common. In fact, they are sometimes advertised on television because many senior citizens own their homes but have cash flow troubles.

How Scammers Can Benefit From Reverse Mortgages

Scammers typically benefit from reverse mortgages by saddling extra fees or interest rates that write otherwise acceptable contracts.

Hypothetically, with a foreclosure scam, the loan provider promises the homeowner financial relief through a reverse mortgage. However, the loan they offer comes with very high closing costs and extra fees. They require the homeowner to pay property taxes, home maintenance costs, and more.

Then, if the homeowner doesn’t stay current with those expenses, they may lose their home. In other words, scammers typically benefit from reverse mortgages by adding new costs to homeowners, not relieving their financial burdens.

How To Know if a Lender Is Trustworthy

Homebuyers can tell that a lender is trustworthy by looking for positive signs, including:

• Check if the lender is properly licensed. A lender’s NMLS number should be easily attainable and can be searched on the NMLS® Consumer AccessSM. 
• The mortgage lender is a reputable company with a good reputation and a good standing with the Better Business Bureau.
• The lender is referred to you by your financial advisor, real estate attorney, or someone you trust.
• The mortgage lender has good reviews from previous clients.
• The mortgage lender is upfront about any costs or fees and does not seem cagey or avoidant when you ask about what you’ll have to pay each month if anything.
• The mortgage lender does not try to rush you through a deal.

Generally, reverse mortgages from trustworthy institutions like the USDA, VA, FHA, or proven lending companies are best to pursue. Alternatively, consider whether you’d take out a personal loan from a lender. If the answer is no, look for another provider when considering loans and mortgage rates.

Professional Assistance

Ultimately, reverse mortgages can be very useful financial instruments when leveraged properly. You should consider your options carefully before taking one out. A reverse mortgage can be helpful, but it can also lead to unexpected expenses by accident.

While Vaster doesn’t offer reverse mortgages, we do offer a wide variety of high-quality private loans for residential or commercial real estate or for land purchasing opportunities. Contact us today for a meeting with a loan officer and more information.

Sources:

What is a reverse mortgage? | Consumer Financial Protection Bureau

What Are the Different Types of Reverse Mortgages? | Investopedia

Variable Interest Rate Definition | Investopedia

Reverse mortgage loans | Consumer Financial Protection Bureau

Consumer Access | NMLS® Consumer AccessSM