What is a Reverse Mortgage?

by Bob French, CFA

 

Reverse mortgages have gotten a bad rap. Admittedly, a lot of it was deserved. A bad rap doesn’t just happen without something to base it on.

But a lot has changed since Fred Thompson was selling them on daytime TV.

Now, reverse mortgages are tightly regulated at both the federal and state levels, not to mention they’re insured. Plus, rules are in place to deal with a lot of the abuses from the past.

A couple of different types of reverse mortgages exist out there, but today I want to focus on the Federal Housing Authority’s Home Equity Conversion Mortgage (HECM) program. When used appropriately, reverse mortgages can be great tools for managing retirement income.

But there’s still a lot of misinformation and misunderstanding out there on the subject.

What Is a Reverse Mortgage?

At its most basic, a reverse mortgage is pretty much what it sounds like – the opposite of a traditional mortgage. Instead of turning your money into home equity, you’re turning your home equity into money you can use.

The lender gives you money, and you promise to pay them back with the equity you have in your home (after you leave the home, of course). In other words, for as long as you are living in your home, you don’t have to pay anything back.

When the time comes to pay the loan back, you’re only on the hook for the value of your home. Even if the amount you owe on the loan is greater than the value of your home, the rest of your assets are protected (and if the amount you owe is less than the value of your home, you keep whatever is left over).

Am I Eligible for a Reverse Mortgage?

Reverse mortgages have a number of eligibility requirements, but they can generally be broken into two categories:

• Personal characteristics
• Use of the home

Not everyone is eligible for a reverse mortgage. The most prominent requirement is that you and anyone else on your home’s title must be 62 or older. If your spouse is younger than that, they can stay in the home even if you no longer live there provided they meet certain criteria.

You also must either own your home outright, or be able to pay off the remainder of your mortgage with the proceeds of the reverse mortgage – basically, your reverse mortgage can be the only lien on your home. Finally, you have to receive financial counseling to make sure you understand the risks and process of taking out a reverse mortgage.

On top of your personal characteristics, your home must also meet certain requirements for eligibility. The most important of these is that the home must be your full-time residence. If you’re not actively living in the home, you won’t be able to get a reverse mortgage, and if you leave the home – even for long-term care or work – you may be required to pay off the loan.

The home must also be a single family home, a two- to four-unit home (with you occupying one of the units), or a HUD-approved condominium or manufactured home (though these have specific FHA requirements).

You must also stay current on property taxes, insurance, and home maintenance. Remember, this is how the loan is being paid back, so the issuer needs this protection.

How Do You Pay Back a Reverse Mortgage?

Reverse mortgages are not free money. The loan will need to be paid back eventually – just not (hopefully) for a long time. When the house is no longer your full-time residence (or if you fail to meet the obligations of the loan), then you or your heirs have three options:

1. Write a check and pay off the loan
2. Sell the home and pay off the loan with the proceeds
3. Allow the lender to sell the home

With the latter two options, it’s important to recognize that your home is the only asset the lender can access. If you owe more than you can get for your home, the lender can’t come after your other assets. In such cases, the lender is made whole by the FHA mortgage insurance fund, which you pay into over the life of your loan.

If your home is sold for more than the amount you owe, you or your heirs get to keep the difference.

How Can You Get Your Money?

There are four different ways to collect the proceeds of a reverse mortgage:

1. Lump Sum Payment – You can take the proceeds all at once and then do with it as you would like.
2. Tenure – You can receive equal monthly payments for the life of the reverse mortgage. Think of this as essentially turning your home into a life (of the home) annuity.
3. Term – This is similar to a Tenure plan, except you will receive payments over a specified period of time rather than the life of the loan.
4. Line of Credit – This is like a Home Equity Line of Credit, in that you can take out what you need when you need it.

If you prefer, you can mix and match these approaches. (For instance, you could receive tenure payments, but also keep a line of credit in case you need it for emergencies.)

How Does This Fit Into Your Retirement Income Plan?

Reverse mortgages can be incredibly powerful tools to manage your retirement income. If you don’t have a strong desire to pass your home on (admittedly a pretty big “if” for some people), then it can make a whole bunch of sense. A reverse mortgage allows you to turn an illiquid asset (your home) into either a reliable income stream or line of credit.

Depending on your specific situation, adding a reliable income stream can mean the difference between a secure and insecure retirement. As with any financial product, there are always risks to consider.

But for many people, having an additional source of reliable income beyond Social Security can be a great comfort – especially if your Social Security benefits don’t cover your essential needs.

For more on reverse mortgages, take a look at our Reverse Mortgage 101 cheat sheet. If you really want to dive in, we’ve gone ahead and written the book on them.