Reverse Mortgage: Overview, Pros and Cons, Avoiding Scams
You’ve probably seen commercials from celebrities boasting the appeal of reverse mortgages. A reverse mortgage may seem like a retirement dream come true for seniors who need extra money to live on. Can it really be that simple? Here are a few things to consider…
Reverse Mortgage: An Overview
A reverse mortgage is a type of loan available to homeowners aged 62 and older. It allows a homeowner to receive payments in exchange for part of their home equity. An extra income source can be a good reason for getting a reverse mortgage if you find yourself struggling to make ends meet.
These mortgages can be categorized into three main types that I’ll break down below, along with answers to some important questions. At the end, you’ll find a list of reverse mortgage pros and cons. In this industry, it’s important to be aware of scams.
Types of Reverse Mortgages
Home Equity Conversion Mortgage (HECM)
This is the most common type of reverse mortgage. Lenders can only offer it if they are approved by the Federal Housing Administration (FHA). All borrowers must receive HUD-approved counseling before closing. Once you receive the loan, you can use it however you like.
Proprietary Reverse Mortgage
This is a private loan. It’s not federally insured by the government. A borrower will typically receive a larger loan with this type of reverse mortgage, but at a much higher interest rate than with an HECM.
Single Purpose Reverse Mortgage
The least common of all, this kind of reverse mortgage is usually offered by state and local governments, or nonprofit organizations. This loan can only be used for a specific purpose, like property tax payments or home repairs.
How Does a Reverse Mortgage Work?
A traditional mortgage allows you to borrow money to buy a house. You make monthly payments to the lender to reduce the balance of your loan. You build equity in your home over time. Once your mortgage is paid off in full, you own your home outright.
In a reverse mortgage, you borrow money against the value of your home. Reverse mortgages are typically eligible for borrowers who are…
- 62 years old or older
- Owning your property outright or having paid down most of your debt on it
- Living in the home as main residence
- Paying off an existing mortgage with money from the reverse mortgage
- To determine eligibility, meet with a housing counselor approved by the government
You will receive money in exchange for equity in your home. Generally, the loan can be paid in monthly installments, as a lump sum or as a credit line.
You qualify for a certain amount of money depending on the value of your home. But your age and other factors can also come into play.
As for repaying the loan, you don’t have to do that as long as you live in the house. The loan doesn’t mature until the borrower passes away, moves out or sells the home. For many borrowers, the loan must be repaid by selling the house. Any leftover funds often go to the borrower’s heirs.
How Much Does a Reverse Mortgage Cost?
Reverse mortgages are generally more expensive than other types of loans. Their fees can cost you thousands of dollars. Here are some of the fees you might see…
- Mortgage Insurance Premium (MIP)
In an HECM reverse mortgage, this fee guarantees a non-recourse loan. The MIP is a fee that borrowers pay to the FHA. The insurance covers any losses arising from the loan. This protects both the lender and the borrower if the balance of the loan exceeds the value of the home at maturity. Initial premiums are 2% of the property value or maximum claim (whichever is less). The current max claim is $822,375. There is an annual renewal on 0.5% of the outstanding balance of the loan.
- Origination Fee
Origination fees are charged upfront by your lender to cover loan origination and processing costs. Costs are typically based on the value of the home. Your lender may charge 2% of the first $200,000 of your home’s value plus 1% on value above that. If your house is worth $200,000, it can cost you as much as $4,000!
- Servicing Fee
A servicing fee is a monthly expense charged by your lender to service and administer the loan. It’s usually 0.25% to 0.5% of the mortgage balance.
- Interest Rates
Interest varies based on the lender, the type of loan, and whether you get a fixed or adjustable-rate mortgage.
- Closing Costs
- Credit Report Fee
- Flood Certification Fee
- Appraisal Fee
- Title Insurance
- Recording Fee
- Document Preparation Fee
Fees add up quickly, and they’re easy to overlook. Borrowers often pay the fees with the money they receive from the loan, which reduces their available funds.
Pros and Cons
- Provide income to cover bills and living expenses
- Can be used to pay off an existing mortgage
- Provide tax benefits
- Balance continues to increase with accumulating interest and fees
- Often requires the sale of the home to repay loan
- Failure to meet ongoing requirements can result in the loss of the home
- Requires borrower to continue paying property taxes, homeowners insurance and HOA fees
- Borrows against the equity of your home, a key source of retirement funds
Avoiding Reverse Mortgage Scams
It’s important for homeowners to be cautious when choosing a mortgage product. The risks associated with reverse mortgages can be high. And you should be especially wary of scammers in the industry.
Many of these people target older Americans through local churches, investment seminars, and media advertising. The following scams should be avoided if you are considering a reverse mortgage.
- Taking advantage of an elderly homeowner by forcing them to apply for a reverse mortgage
- Using a senior homeowner’s identity, Social Security number, or other information to obtain a loan
- Foreclosure scams that target senior homeowners at risk for foreclosure
Perpetrators can use a dishonest appraiser to inflate the value of the home and get a reverse mortgage on it. The perpetrator has the homeowner transfer the title of the home over to them. The victim is left without a home or reverse mortgage income.
- Free home scams
These scams present seniors with the opportunity to live in a home for free while the perpetrator takes out a reverse mortgage on it. The scammer keeps all the funds and leaves the person living in the home burdened with debt.
When Compounding Interest Works Against You
At Investment U, we value the power of compounding dividends and total returns over time to increase wealth. To see how this works, consider trying out our free Investment Calculator.
Reverse mortgage loans compound every year, just like a regular mortgage. But with a reverse mortgage, your balance only increases, because you’re never making payments on the loan.
The balance of your loan compounds with interest and fees. Your equity in the home decreases as the reverse mortgage continues. At the end of your loan, you may have little to no equity left in your home.
Home equity is often a homeowner’s most valuable asset. It can be a precious source of retirement security. Reverse mortgages can be useful for extra income, but homeowners should consider the high risks.
To learn more about personal finance and investing, sign up for Wealthy Retirement. It’s a free e-letter that’s packed with tips and tricks from experts.
About Aimee Bohn
Aimee Bohn graduated from the College of Business and Economics at Towson University. Her background in marketing research helps her uncover valuable trends. Researching IPOs and other trends has been her primary focus over the past year. When Aimee isn’t writing for Investment U, you can usually find her doing graphic design or traveling with friends.