How Do Reverse Mortgages Work?

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Most homeowners have heard of reverse mortgages, but there is still a lot of confusion surrounding them. They allow a homeowner to borrow based on his or her age and the amount of equity that has been built in his or her primary residence. Reverse mortgages are a financial tool appropriate for specific situations. They are not inherently bad, but they are best used when the homeowner does not have other ways to generate income. Reverse mortgages have advantages and disadvantages. Before jumping in head first with this type of loan product, you should have an understanding of how they work.

What Is a Reverse Mortgage?
In 1989, the FHA-insured reverse mortgage was first introduced. The loan was designed for older homeowners—those 62 or older—to access some of the equity they had built up in their primary residences. After paying off a mortgage, or paying down most of a mortgage, the homeowner could take out a loan that they would not have to pay back until they passed away, or until they sold the home.

There are some qualifications for getting a reverse mortgage that are important to understand. There are no monthly payments with a reverse mortgage; instead, the lender pays the homeowner a sum based on the age of the loan recipient and the amount of equity in the home. Generally, the older the homeowner is and the more equity he or she has in the home, the bigger the payment from the lender.

For owners with a fixed-rate mortgage, they receive one lump sum from the lender. For those with an adjustable-rate mortgage, it is possible to get a lump sum, a line of credit, a fixed monthly payment or a combination of these options.

When the borrower passes away, sells the home or moves out of the home, the lender expects to be paid back—typically through the sale of the home.

The most common type of reverse mortgage is known as the Home Equity Conversion Mortgage, or HECM for short. These mortgages are backed by the U.S. Department of Housing and Urban Development (HUD). They also tend to be the most widely available reverse mortgage option, with no income or medical requirements. They can be used for any purpose, but are also the most expensive.

Why Choose a Reverse Mortgage?
There are a number of reasons why a homeowner would choose a reverse mortgage. Sometimes the owner does not have enough money to live off of; other times a big expense surprises the owner, like a medical problem or a major home repair. When the owner is in need of income, it makes sense to consider tapping the equity built up in the home.

One of the great appeals of a reverse mortgage is the fact that you do not have to pay it back right away. You can get the money you need now and push off the repayment of the loan until you pass away or until you move out of your home.

Problems With a Reverse Mortgage
A reverse mortgage has its disadvantages. The fees and closing costs on a reverse mortgage are often high, which means you are losing part of your home’s equity in exchange for getting money now. The interest rates for reverse mortgages are also higher than traditional mortgages.

Borrowers are also expected to keep the home in good repair and to pay all their taxes and fees. Many people who find themselves in a position where they are considering a reverse mortgage are struggling financially, so much so that paying all the costs associated with homeownership may be too much to handle. If you fail to keep the house up or pay associated costs, the lender can demand the repayment of the loan.

Perhaps the biggest concern many homeowners face with reverse mortgages is that the loan complicates the process of leaving the home to heirs. If your heirs want to keep the family home, they will have to pay back the lender. The lender does not care where the payment comes from—either from the sale of the home, from the heirs, or a combination of the two. (Here is what you need to know about selling a home with a reverse mortgage. While it is not significantly different than a traditional sale, there are some nuances.)

Who Should Choose a Reverse Mortgage?
The ideal candidate for a reverse mortgage is a homeowner who has significant equity in the home, is older—so that the payments are substantial, and more than enough to meet the owner’s financial needs—and one who does not expect to pass the home on to his or her heirs. The ideal candidate should also be able to afford the upkeep of the home for the foreseeable future, including property taxes.

A Reverse Mortgage Should Be a Last Resort
Reverse mortgages are certainly one way to increase income for a homeowner, but they are often not the best way. Prudent financial advisers recommend selling off other investments first to generate income, liquidating portfolios and reducing living expenses first before choosing a reverse mortgage.

Once you have committed to a reverse mortgage, your options become much more limited concerning your home and your estate. You cannot move out of the home without needing to pay back the loan. You cannot pass on your home to your heirs without them needing to pay back the loan. You also need to pay for all the costs of homeownership consistently to avoid being forced to pay back the loan. (You should look over additional facts about reverse mortgages before choosing one.)

Mandatory Counseling for Reverse Mortgages
Reverse mortgages have a negative reputation for a reason. Many homeowners who were not aware of the disadvantages were encouraged to take out reverse mortgages, resulting in regulations requiring mandatory counseling. If you are planning on taking out a reverse mortgage, you will be required to go through mandatory counseling to ensure you understand what you are doing, and to help you consider other options first. The counseling is free, but the fact that it is mandatory is a good indication of how cautious you should be. Reverse mortgages definitely make sense for some homeowners—but not most. Make sure you do your research and explore all other financial options before committing to a reverse mortgage. Be sure to check out the helpful glossary of reverse mortgage terms you should know when considering this financial option.

This article is intended for informational purposes only and should not be construed as professional advice. The opinions expressed in this article are those of the author and do not necessarily reflect the position of RISMedia.

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