You may have heard of reverse mortgages through Fred Thompson's ubiquitous daytime television ads, but you may not know much about them or how they work. So let us take over for Fred and explain them in detail.
In essence, the reverse mortgage is a variation of a home equity loan that is used to provide income during the retirement years. You are borrowing a certain amount of money using the equity in your house as collateral. The difference is that with a reverse mortgage, repayment is not required until the borrower passes away, chooses to sell the home, or permanently moves out of the home. At that time, the home is sold to repay the loan plus accrued interest and other charges. Any surplus from the sale beyond these costs is remitted to the borrower or his/her estate.
Fixed-rate reverse mortgages must be tapped as a lump sum, while variable-rate loans may be structured as regular payments or as an available line of credit.
To qualify, you must be at least 62 years old, own your home outright or have sufficient equity in the home (usually 50% or greater), and live in the home as your primary residence. Additionally, the loan requires that you pay all applicable property taxes and regularly maintain the home.
As a safeguard against borrowers overextending themselves, new rules as of April 27, 2015, require lenders to review the borrower's finances prior to approval to ensure that the borrower has enough stable income to pay those ongoing costs. Lenders must assess your "capacity to pay" via income, and your "willingness to pay" via your history of recent payments. Have this proof in hand when you apply.
If you fall short, you may be rejected or be required to "set aside" a portion of the loan amount. This set-aside is held in reserve explicitly to pay for the property taxes and other running expenses over the life of the loan.
Since this is a secured loan using your home as collateral, there are no credit score issues or restrictions on use of the money. The limit of the reverse mortgage amount depends on the anticipated value of the home over the expected term of the loan – thus there are assumptions involved in the loan term, based on your age and anticipated changes in the real estate market.
The vast majority of reverse mortgage are provided though HUD's FHA-insured program, known as Home Equity Conversion Mortgages (HECMs). There are two types, Standard and Saver loans. Saver loans have lower closing fees but provide lower loan limits and the ability to receive fixed-rate loans (Standard loans are only available as adjustable-rate as of 2013).
Some considerations of reverse mortgages, both favorable and unfavorable, are:
- Costs – Compared to most loans, reverse mortgages charge relatively high closing costs and origination fees, as well as monthly insurance premiums for FHA-insured loans. However, these costs may be folded into the mortgage, reducing out-of-pocket expenses.
Keep in mind that folding in all the costs, combined with the effect of compound interest, can burn through your home equity reasonably quickly. Therefore, it makes sense to consider a traditional HELOC (Home Equity Line of Credit) as a less costly way of tapping into your home equity.
- Residency – Some seniors have found themselves requiring nursing-home or long-term care, which can terminate the residency requirement and bring the loan due just when monetary concerns are the highest.
In the past, a widow or widower could potentially be forced to pay off the loan balance or vacate the home if the reverse mortgage was only in the deceased spouse's name. The residency requirement was not considered to apply to the spouse.
After the Federal Court ruling in Bennett et al. v. Donovan, HUD amended the program to establish eligibility requirements to allow spouses to stay in the home. For new reverse mortgages, non-borrowing spouses must be identified at the time of the application. Eligibility or non-eligibility is established upfront, and the rules for maintaining eligibility are outlined so there are no surprises. However, if it does not adversely affect your loan qualifications and eligible amount, the simplest path is still to name both spouses as co-borrowers
Generally, a reverse mortgage only makes sense if you intend to stay in the home for a relatively long time — five years plus is a good benchmark. If you are uncertain about the likelihood of staying in your home for several years, whether from health concerns or other reasons, you may want to consider other options.
- Taxes – As a loan, reverse mortgages are not considered taxable income. This is one of their primary appeals.
- Eligibility for Assistance Programs – Another benefit of a reverse mortgage is that it does not affect your Social Security or Medicare, but it may affect eligibility for Medicaid and other low-income assistance programs.
- Heirs – Heirs may have the option to pay off the mortgage, but no matter how a reverse mortgage is constructed, the result is less of an estate to pass along.
There are reverse mortgage calculators available online to help you run through multiple scenarios. This is a great way to crunch the numbers and be honest with yourself regarding affordability.
This type of finance is better done as part of a coordinated retirement plan than as the "loan of last resort"— however, if you are on a limited fixed income with significant home equity, it may be the best strategy for you. Just be sure to assess all of the potential risks of prematurely running out of home equity in your twilight years and being worse off than you were before you started. You may want to consider if conventional loans are a better fit for your needs.
If you are not sure, seek professional financial help – not from Fred Thompson or other equivalent pitchmen, but from independent financial advisers. There are plenty available at MoneyTips who can answer your questions about reverse mortgages.
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