What is a reverse mortgage?
Hardly a day passes without hearing an advertisement for a reverse mortgage, but while you may be familiar with the term, we doubt you’re familiar with what a reverse mortgage actually is.
Because we knew very little about reverse mortgages we decided to do a little research. This topic was especially important to us because it mostly affects senior citizens who may be confused about their options (heck, everyone is confused when it comes to mortgages!).
According to the U.S. Census Bureau there were 41.4 million people aged 65 or older in 2011, with that number projected to jump to 92 million by 2060.
With our older populations growing it will be more important than ever to make sure their golden years are actually golden.
So again, what is a reverse mortgage, and is it right for you or your loved one?
What Is a Reverse Mortgage?
A reverse mortgage is an option for those 62 and older who own their home outright or have a lower mortgage balance that can be paid off at closing with the proceeds.
To help explain, let’s start by talking about something most of you are more familiar with: a traditional mortgage.
With a traditional mortgage, what’s really happening is the lender buys the house FOR you and you make payments to them on the principal and interest until you fully buy it. Even though the lender technically owns the home until you pay it off, you move in right away and live there.
With a reverse mortgage, the lender is buying the house FROM you and they make a payment every month to you. Also like a traditional mortgage, the lender keeps track of the interest on the balance they’ve paid to you, although they don’t pay you monthly interest (we’ll discuss this more in a moment).
While there are some other options out there, most reverse mortgages are FHA insured through a program called HECM (Home Equity Conversion Mortgage), and this is the only program we recommend.
Once the loan and monthly payment amount are established, you will receive that payment and be free to stay in your home as long as you live, even if the loan paid to you exceeds the value of the house. After the owner passes away, the lender calculates the loan amount they paid plus interest, then sells the property. If the proceeds from the sale of the property exceed the balance of the loan (loan paid plus interest), then the heirs to the owner will receive that money.
Make sure you take an FHA approved HECM reverse mortgage because one of the biggest benefits of a this reverse mortgage program actually comes when the sale proceeds do not cover the money plus interest paid by the lender.
If the proceeds from the sale of the property do not cover the loan balance plus interest, the heirs are only obligated to pay the value of the home based on FHA guidelines, which is often 95% of the appraised value.
In other words, HECM borrowers who are underwater on their house can satisfy their loan by selling the house for 95% of its appraised value. Even though the sale may not cover the balance due on the loan, the FHA does not allow lenders to come after borrowers or their heirs for the difference.
Now, before we go any further let’s address the issue of interest.
Interest is calculated every month similar to a traditional mortgage. However, with a reverse mortgage the interest is charged to the funds that you receive from the loan. Interest is not paid up font or monthly. Instead, it is deferred to the end of the life of the loan. Please note that, as a result of this deferment, the loan balance grows over time.
Remember when we said that the lender buys the home for you and you move in right away with a traditional mortgage?
In this case you’re buying the home for the lender, but the lender doesn’t get to “move in” until you pass away. Because of this difference, they track interest and add it to the balance they paid you at the end as extra compensation for waiting x number of years to get the property.
Want to know something else?
The monthly amount they pay you isn’t even based on the full value of the house at the time of the loan origination.
The loan amount (and the monthly payment amount) is based on something called your Principal Limit Factor (PLF), which translates to a percentage of the homes equity you will get in a loan. You’re PLF, and the loan amount you’ll get, is less the younger you are. Essentially, the lender is assuming you’ll live longer (and they’ll be paying longer) if you’re younger, and vice versa for someone older.
For a 62 year old, the PLF is about 52.4% of your homes current equity. That means if you’re home value is $300,000 at the time of loan origination you’re maximum loan amount will be $157,000.
In other words, the maximum money you’ll get will be $157,000, even though your home is worth $300,000.
For someone aged 65 the percentage is 65.54%, and the older you are the higher the PLF percentage. The lender then uses that loan amount to determine the monthly payment they’ll make to you.
Basically, the longer they figure they’ll need to pay you, the less they are willing to give.
But wait, there’s more.
Not only do you not get the total value of your home with a reverse mortgage, but you’ll also pay some pretty hefty loan origination fees and other typical closing costs.
Once the lender calculates the loan amount based on the PLF percentage, they subtract the closing cost fees. Depending on the loan amount, these fees could take extra thousands out of the loan amount you get. Furthermore, the loan process can take anywhere from 30 to 60 days, just like with a traditional mortgage.
Hold on, there’s still more!
Last but not least, the lender will perform a rigid evaluation of the property and homeowner to ensure that they are fiscally sound enough to maintain the property, as well as to pay property taxes, HOA fees, and insurance. They also require the homeowner to do any necessary repairs before they’ll approve the loan. If the homeowner cannot afford repairs, the lender will generously use the funds from YOUR reverse mortgage proceeds.
The table below provides an example of what a reverse mortgage loan calculation might look like.
|Your Home Value:||$350,000|
|Loan Amount Available (for a 62 year old): 52.4%||$183,400|
|Settlement Cost (average 9%)||($ 16,506)|
|Mortgage Balance Owed||($ 20,000)|
|Bathroom Repair||($ 9,000)|
|Actual Reverse Mortgage loan payout available to you||$137,897|
We’re telling you, lenders are not your friends. They ALWAYS make the deal advantageous for them.
Is a Reverse Mortgage Right for You?
So, is a reverse mortgage right for you or your loved one?
If you’re struggling to survive every month with your retirement/social security/disability, can no longer work, and have no other options for income, a reverse mortgage will allow you to receive a monthly income and may be right for you.
However, if you have an adequate monthly income and only need money for a one-time major expense, there may be a better option.
Home Equity Line of Credit – Another Option
If you have a short-term need but can otherwise manage your monthly expenses, a Home Equity Line of Credit (HELOC) might be a better option for you. Both a HELOC and reverse mortgage use your home’s equity to decide the loan amount, and thus the interest rates for both are very similar.
The difference is in the closing costs, interest, and terms. With a HELOC you’ll pay less in closing costs, and you can get approved within a couple of weeks. Often all it takes is an appraisal cost, which is typically less than $600.
If you have a substantial amount of equity in the home or it’s fully paid off, some financial institutions (like credit unions) may do away with the appraisal depending on the amount you’re borrowing.
With a HELOC, you’re approved for a certain line of credit but you’ll only be charged interest if you use funds from the approved loan, similar to a credit card. You can take as little or as much as you need, but know that interest will start accumulating from the time you take some of the funds.
Finally, with a HELOC you are only required to pay when you take money from the loan, and you must only pay back what you take plus interest.
Note: Do not treat your HELOC as an ATM. Use it only when you need to.
Moral of the Story
Remember, lenders are not your friends!
A reverse mortgage is one of the options out there for older people who need a source of monthly income.
However, a reverse mortgage may not be for everyone, and there are a lot of pros and cons to weigh when considering one.
The pros are that you will receive a monthly payment for the remainder of your life, no matter how long you live. With a reverse mortgage established by the FHA you will never be asked to leave your home, and your heirs will not owe a dime out of pocket to the lender even if the payment balance plus interest ends up being greater than the value of the home. To satisfy the loan, they’ll simple need to sell the house for 95% of the appraised value and use the proceeds to make up the difference.
The cons are that you will pay higher closing costs, must make a long-term commitment, go through a vetting process, and your monthly payment is based on only a portion of the value of your home.
If you do decide to take a reverse mortgage, we only recommend HECM, which is a federally insured (FHA) program. While there are some other options out there, with an FHA reverse mortgage you are guaranteed to be able to stay in the home as long as you live, and your heirs can satisfy the loan by selling the house for 95% of its appraised value.
Overall, we would only recommend a reverse mortgage for someone who has no other way of obtaining the monthly income they need to remain comfortable. In order to ensure you are making the right decision, make sure you review the critical points we mentioned, especially the costs associated with it.
It is always a good idea to consult with someone you trust who understands the nuts and bolts of a reverse mortgage. You can also visit HUD’s counselor search page or call their housing counselor referral line (1-800-569-4287) to find a HUD-approved housing counselor.
Whatever you decide, remember you are committing a long-term loan to the biggest investment of your life.
Take it seriously, ask questions, and understand fully.