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How does a reverse mortgage work?

Reverse mortgages provide a way to access funds without having to sell a home or take out a traditional loan, but they come with some risks.

Reviewed by
Kate Grayson

For many Americans, Social Security income is not enough to fund retirement. Without sufficient additional assets, many families look to reverse mortgages to supplement retirement income.

Reverse mortgages allow individuals to convert some of their home’s equity into cash, without having to sell their house. However, they come with some substantial risks and are not the right fit for everybody. Keep reading to find out how reverse mortgages work, who can benefit from them, and what the risks are.

How does a reverse mortgage work?

Reverse mortgages allow homeowners to leverage their home’s equity to supplement retirement income. It’s a way of accessing extra funds without having to sell your home or take out a traditional loan with monthly payments.

Only homeowners who are above 62 years of age and have substantial equity in their home are eligible for reverse mortgages. 

The homeowner pays interest on the proceeds received, but doesn’t owe any cash upfront since the home itself serves as collateral for the loan. The homeowner retains the title to and ownership of the home.

Unlike a traditional home equity loan, people who take out a reverse mortgage receive monthly income payments, instead of a single lump sum payment. This income is tax free, since it’s technically classified as a loan advance instead of as income. 

How is the loan paid back?

The entire loan balance is due when the borrower dies, sells the home, or moves away permanently (including into a care facility or with family). Unless the borrower has sufficient cash available to pay back the loan, there will be no choice but to sell the home. Given that most individuals deciding to take out a reverse mortgage would not have access to that amount of capital, most individuals have no choice but to sell their home when the time comes.

Federal regulations prohibit lenders from loaning individuals more than the home’s appraised value to help prevent borrowers from being underwater on their loan. Additionally, laws stipulate that the borrower (or their heirs) will never have to pay back more than the home’s sale price, should the balance of the loan become higher than the home's value. This helps secure families against fluctuations in the real estate market.

When the home is sold, the homeowner or heirs retain any proceeds beyond what is owed back on the reverse mortgage.

What are the risks of reverse mortgages?

Reverse mortgages can sound like a tempting solution, but they carry a lot of risks that should be carefully considered before a decision is made. 

Reverse mortgages can eat up a lot of your home’s equity, not only through the loan income but also through the fees and interest. This means fewer assets for you and your heirs, which can put many families at risk. Additionally, there might come a time when you will need to access your home’s equity and could find that it’s completely gone.

Family caregivers are put at tremendous risk through reverse mortgages. Many caregivers have put their own income and asset accumulation on the back burner to live with and care for loved ones. As a result, many family caregivers do not own their own homes since they live with their care recipient. While there are rules in place to ensure that a borrower and their spouse won’t lose their home through a reverse mortgage, the same security is not passed onto other heirs or relatives. Unless you, as the caregiver, have a large sum of money to pay back the reverse mortgage loan when the homeowner dies, you could lose the home you live in when your care recipient passes away.

Another problem that can arise is outliving the reverse mortgage income proceeds. Depending on the specific type of reverse mortgage that’s taken out, it is possible to run out of proceeds — as well as equity in the home — before the end of the borrower’s life.

Finally, the reverse mortgage regulations require borrowers to stay current on homeowner’s insurance and property taxes and to keep the home in good repair. If a borrower violates any of these terms, the lender could choose to foreclose on the home.

While a reverse mortgage can provide a much needed retirement income supplement, please consider the longer term implications for you and your family.

Who can benefit from reverse mortgages?

While reverse mortgages carry many risks, they can be viable solutions for many families. A reverse mortgage might be a good fit if:

  • Most of an individual’s net worth is tied up in their home.
  • The home’s value far exceeds their monthly income requirements (enabling them to access the benefits without putting their homes at risk).
  • Only the homeowner and their spouse live in the home.
  • The homeowner does not have dependents to whom they want to leave the house.
  • The homeowner can’t qualify for a home equity loan due to low income or poor credit.

Like all loan industries, there are many predatory actors in the reverse mortgage industry. Many lenders use high-pressure sales techniques geared at older homeowners. Fortunately, there are nonprofit agencies that offer reverse mortgage counseling so that potential borrowers can feel secure in their decision. If you are considering a reverse mortgage, please consider working with a nonprofit counselor and getting multiple quotes before making a decision.

Photo by Kelly L from Pexels

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