What Is A Reverse Mortgage And How Does It Work?

If you’re worried about paying your bills in your retirement years, a reverse mortgage could be an option. However, this loan is a bit complex and can come with some drawbacks.

It’s important to know how this loan works, how it can help you and whether it’s the right option for your financial situation and retirement goals.

What Is A Reverse Mortgage Loan?

A reverse mortgage is a loan that allows homeowners – most often those 62 or older – to borrow against a portion of the equity in their home.

The loan first pays off your existing mortgage, if you have one, and then you can often use the remaining funds for anything you’d like. You must continue to pay property taxes and homeowners insurance, and you’re responsible for maintaining the home.

Reverse mortgage loans are designed for older homeowners who may have retired and want to eliminate their monthly mortgage payments or supplement their income. Rocket Mortgage^® doesn’t offer reverse mortgage loans at this time, but you may hear of one of these products when shopping for a lender and you should know what they are.

Who Qualifies for A Reverse Mortgage?

Not everyone can take out a reverse mortgage. Here are the typical requirements to qualify:

• You must be at least 62 years of age.
• You can only get a reverse mortgage on your primary residence, not a second residence or vacation home.
• To take out a home equity conversion mortgage (HECM), the U.S. Department of Housing and Urban Development (HUD) requires that you attend a reverse mortgage counseling session.
• You’ll be required to undergo a financial assessment to ensure you can meet the financial obligations of the loan.
• You can’t owe federal debt, such as student loans or income tax.
• The real estate property must meet required property standards.

Property Requirements

• Single-family, one-unit residences.
• Multi-unit residences (two to four units) that are owner-occupied.
• Select condominiums, planned unit developments (PUDs), or manufactured homes that meet eligibility requirements.

How Does A Reverse Mortgage Work?

A reverse mortgage works differently from a traditional mortgage loan. Instead of making payments to your lender, your lender will make a payment to you.

In exchange, the lender typically receives some or even all of the equity you’ve built in your home. The most common kind of reverse mortgage is aptly called a home equity conversion mortgage.

You borrow against your home’s equity with a reverse mortgage, meaning a lender financially gains the portion of your home that you own. Home equity is the difference between what you owe on your mortgage and what your home is currently worth.

Example of How A Reverse Mortgage Works

To determine how much money you can receive from a reverse mortgage, your lender will order an appraisal of your home. Suppose your home is worth $350,000 and you owe $100,000 on your mortgage.

In this scenario, you have $250,000 worth of equity. Most lenders wouldn’t allow you to borrow the full $250,000 with a reverse mortgage, but you could borrow a percentage of that amount. This leaves you with some equity still in the home.

What to Expect Once You Get A Reverse Mortgage

It’s important to understand what happens once you have a reverse mortgage. Let’s examine what to expect after you’re approved.

Your Existing Mortgage Is Paid Off First

The money from the reverse mortgage loan first pays off your existing mortgage, after which no monthly mortgage payments are required.

Depending on the option you choose, you may receive payment from your lender in a:

• lump sum
• monthly payments
• a line of credit
• any combination of the three

However, all options can impact certain need-based assistance programs through a reverse mortgage, meaning it’s best to speak with a financial advisor before taking out this type of loan.

While you’re receiving payments, your lender will add interest to your existing loan balance. This means the amount of money you’ll eventually owe will increase during the lifespan of your reverse mortgage.

You’ll Still Pay Certain Bills

A reverse mortgage doesn’t eliminate certain payments. Along with continuing to pay property taxes and homeowners insurance, you’ll be responsible for any origination fees and closing costs on your reverse mortgage. You must likewise continue to maintain the home and pay for any homeowners association dues.

You don’t have to pay the reverse loan back until you sell your home, move out or pass away. If you sell your home, you’ll have to pay back what you owe at that time, using the funds from the sale. You’ll get to keep any remaining proceeds.

Your Heirs Will Have Some Options

Your heirs will have some flexibility in how they repay your reverse mortgage loan. They may buy the home for what’s owed on the loan or for 95% of the appraised value – whichever is lower. They could sell the home and keep any remaining proceeds after paying the loan balance. Or they can simply turn the home over to the lender to satisfy the debt.

Reverse Mortgage Fees: Other Ongoing And Upfront Costs

A homeowner will need to pay a number of fees to a reverse mortgage lender, in addition to the fees mentioned earlier. You can pay them in cash or with money from your loan. Fees you can expect include:

• Housing counselor fees: As noted already, taking out a HECM loan requires meeting with an expert from a HUD-approved counseling agency. Costs vary.
• Mortgage insurance premium: This is in addition to your homeowners insurance, and it ensures you’ll receive the loan advances you expect.
• Servicing fees: These fees allow your lender to cover the costs of administering your account.

Types Of Reverse Mortgages

There are three main types of reverse mortgages, meaning each is unique in its own way.

Home Equity Conversion Mortgage (HECM)

The most common reverse mortgage is the home equity conversion mortgage – also called a HECM (pronounced “hekum”). This type of reverse mortgage is insured by the Federal Housing Administration (FHA). The most you can potentially borrow with one of these loans in 2024 is $1,149,825. If you must borrow more, you’ll need to apply for a jumbo reverse mortgage.

Eligible property types include single-family homes, HUD-approved condominiums, manufactured homes that meet FHA standards, and certain other homes.

Single-Purpose Reverse Mortgage

A single-purpose reverse mortgage is typically less expensive than a HECM, but it comes with limits. As the name suggests, you can only use the funds from this type of reverse mortgage for one purpose. Your lender might approve you for the loan but stipulate that you can only use the funds to cover home repairs, insurance premiums or your property tax bills.

Single-purpose reverse mortgages are offered by charities, nonprofits and local governments to homeowners who are struggling to pay their bills and have a lower-to-moderate income. These mortgages aren’t available everywhere.

Jumbo Reverse Mortgage

In 2024, you’ll need to take out a jumbo reverse mortgage – also known as a proprietary reverse mortgage – for any reverse loan amount of more than $1,149,825. Because a larger loan is considered riskier, your lender might charge you higher fees and a higher interest rate for a jumbo reverse mortgage.

Unlike a HECM, this type of reverse mortgage isn’t insured by the FHA. That means it doesn’t come with as many protections. It also doesn’t require a HUD-approved counseling session or financial assessment.

Pros And Cons Of A Mortgage Reversal: At A Glance

As with many financial products, reverse mortgages come with various benefits and drawbacks.

Advantages Of A Reverse Mortgage

While the pros of a reverse mortgage have already been listed in the table above, here’s a more detailed explanation of each:

• You’re able to stay in your home. Reverse mortgages will eliminate your monthly mortgage payment and provide you with an extra income stream. This might offer enough financial relief to make staying in your home more affordable.
• You won’t need to pay taxes on your funds. The IRS doesn’t treat any funds you receive from a reverse mortgage as income. As a result, this money isn’t taxable.
• Surviving family members have options with your estate. When the time comes for surviving family members to take over your financial responsibilities, they have plenty of options for dealing with loan repayment.
• You’ll be more financially secure in retirement. A reverse mortgage provides more money to use for other expenses since you’ll no longer have a monthly mortgage payment.
• You’re accessing existing equity, which can be a significant amount if you’ve been in the home for a long time.

Disadvantages Of A Reverse Mortgage

While the cons of a reverse mortgage have, like the pros, already been listed in the table further up, here’s a more detailed explanation of each:

• You’ll see a decrease in equity. Remember, you’re borrowing from the equity in your home. This means your heirs will inherit less or you’ll reap a smaller profit if you decide to sell.
• It could impact how you qualify for other retirement benefits. Since a reverse mortgage can affect certain need-based assistance programs, be aware of how it could impact your eligibility for Medicaid and other retirement benefits.
• Your heirs could encounter complications. As with any financial responsibilities after losing a family member, your heirs could face a larger repayment amount than you anticipated.
• You’ll have to pay various fees. Borrowers will still need to pay some fees with their reverse mortgage. These typically include origination fees, closing costs and servicing fees.
• Reverse mortgage scams are common. Older homeowners are a frequent target of reverse mortgage scammers. Insist that reverse mortgage lenders explain the loan conditions plainly. Also, ensure these conditions aren’t too good to be true.

If You Have A HECM And Sell Your Home

If owners decide to sell their home after taking out a reverse mortgage, they must use the proceeds from this sale to pay off their loan. If the home sells for less than what the owners owe on the loan, they won’t be responsible for making up the difference as long as they have a HECM.

If You Have A HECM And Pass Away

Your reverse mortgage must be paid off if you pass away. In this case, your heirs can sell your home and use the proceeds to pay off the reverse mortgage. They can also give the home to your lender. If they want to keep your home, they’d have to purchase it.

If You Move Out Of The Home

You must live in the home as your primary residence for more than half the year. If you move out, the reverse mortgage balance will come due. You’ll need to pay back the loan even if you wish to keep the home. You could do this with your personal funds or by refinancing the loan.

Reverse Mortgage Vs. Refinance: Which Is Better?

While a reverse mortgage can supplement your income as you age, this financial tool might not be your ideal choice. It might be better to explore alternatives to a reverse mortgage, especially if you want to leave your home to your children after you die or you’re planning on selling the property.

Perhaps you’ll consider refinancing options for seniors. You might find a type of mortgage refinancing more suitable for you than a reverse mortgage.

Cash-Out Refinances

A cash-out refinance is one option. Most people refinance to lower their interest rate and/or shorten or lengthen the repayment term of their existing mortgage loan. A cash-out refinance, though, can also provide you with a lump sum of cash you can spend on anything.

Remember: If you pass away before repaying your new mortgage, your heirs would have to pay off that loan before taking possession of your home.

Can You Cancel A Reverse Mortgage?

There can be any of a number of reasons you might at some point want to cancel your reverse mortgage. Perhaps your financial situation has improved and you no longer need the extra income the loan provides. Or you might want to sell the house and move into an assisted living community. 

Thankfully there are several ways you can cancel a reverse mortgage:

• Use your Right of Recission: This provision protects consumers in a wide variety of contracts if they experience “buyer’s remorse.” It only covers the first 72 hours after you close on the contract, however, and you must notify your lender in writing.
• Sell the house: You can use the proceeds from the sale to pay off the reverse mortgage loan. Anything extra is yours to keep. And thanks to the FHA Insurance you have on your home, you do not have to cover the difference if your home sells for less than what you owe on your reverse mortgage loan.
• Refinance your reverse mortgage loan: Just as with a standard mortgage, reverse mortgages can be closed and redrawn if better terms or a lower interest rate becomes available. Consider that you will have to pay closing costs and other fees when you refinance.
• Return to a conventional loan: If you have a change of heart or your circumstances have changed since you took out the reverse mortgage, you can also simply refinance to a conventional loan like the one you had before. You’ll once again make monthly mortgage payments that should build equity in your home for your use down the road, or for your heirs when you pass on.
• Pay back the reverse mortgage loan with your own funds: If you want to cancel the loan and stay in your home, you can pay it back as a lump sum or in agreed-upon installments. Of course, this could require a significant amount of cash you’ll have to pull from savings or a retirement account.

The Bottom Line: Know What’s Risky About Reverse Mortgages

A reverse mortgage can provide extra money for older homeowners, but this somewhat complicated financial tool isn’t right for everyone. Luckily, homeowners may have other options – one being a cash-out refinance.

Start your mortgage application with Rocket Mortgage to see if you qualify for a cash-out refinance. This type of loan could be a better way to reach your financial goals in retirement.