Reverse Mortgages: What They Are and How They Work

For most individuals, a house will be the largest asset they will ever own. It also happens to be a highly illiquid one, with equity generally locked away until it is sold. However, there are options to extract value from your house prior to selling it, such as a reverse mortgage. Understanding the ins and outs of this financial product can help you understand if it could be appropriate for you.

There are a number of stipulations that must be met in order to qualify for a reverse mortgage, including being above the age of 62. For this reason, a number of individuals tend to use them during their retirement years.

What Is a Reverse Mortgage?

Similar to a regular mortgage, a reverse mortgage is a form of financing that is secured by a home asset. However, instead of repaying a loan and building up equity over time, a reverse mortgage works in the opposite direction.

The amount you are eligible to borrow is based on the equity that you own in your home. You will essentially borrow against this equity when you gain access to this financing.

In other words, instead of accumulating additional equity every month as you make your mortgage payments, you will be essentially drawing down on the equity that you own. In practice, a bank or financial institution will generally provide the financing through monthly payments or a lump sum.

You will owe both principal and interest on the funds that you withdraw, though you will not need to repay the money unless you move out, sell the house, or pass away (in which case your family will repay the loan). If your family members do not have the cash to repay the reverse mortgage, they will be forced to sell the home in order to repay the loan.

Because you are essentially borrowing against the value you have accrued in your house, reverse mortgages share a number of similarities with home equity loans and home equity lines of credit (also known as HELOCs).

Who Qualifies for a Reverse Mortgage?

There are a number of criteria that individuals need to meet before they can qualify for a reverse mortgage.

(1) Age restrictions: Individuals must be at least 62 years of age.

(2) Primary residence: The home that is being used for the reverse mortgage must be the primary residence of mortgage holder. If they move, sell the home, or pass away, the reverse mortgage must be repaid.

(3) Equity accumulation: Because the loan is based on the equity in the home, the owner of the reverse mortgage must own a certain amount of the house outright (generally at least 50%).

(4) HUD approval: The U.S. Department of Housing and Urban Development requires those interested in pursuing this financial arrangement to meet with a counselor to ensure that they understand the implications of a reverse mortgage. This is a requirement for Federally-insured Home Equity Conversion Mortgage (HECM).

(5) Good financial standing: The individual applying cannot have any outstanding federal debt (i.e., unpaid taxes) and must demonstrate that they have sufficient capital to pay for the upkeep of the house, including property taxes, maintenance costs, and any relevant homeowner association fees. (This is also a requirement of an HECM.)

What Are the Benefits of a Reverse Mortgage?

The primary benefit of a reverse mortgage is the cash that the individuals entering this arrangement will receive. This can supplement their revenue, especially for retired individuals who might not otherwise be able to support their desired lifestyle.

Because the money is a loan, it is not considered to be taxable income. Another advantage is the ability to stay in your home while you access this cash (in fact, this is a requirement).

In a somewhat ironic fashion, you can use a reverse mortgage to make your monthly mortgage payments. In this way, the equity you have built up can be used to pay the debt you have left, decreasing your monthly expenses.

Reverse mortgages are generally non-recourse loans, meaning that the debt can never rise above the value of the house (even if the housing market tanks).

What Are the Downsides of a Reverse Mortgage?

The most straightforward drawback of a reverse mortgage is that you will gradually lose ownership of the asset that you have been paying for. For many, this can make a reverse mortgage a non-starter.

This is, therefore, not a good strategy to pursue if you intend to leave the property to your heirs, who will either have to figure out a way to secure financing or need to sell the home once you pass away.

In addition, the financing is not free. There are upfront fees and transaction costs to secure the reverse mortgage, as well as interest payments that will grow every month as you access the funds.

Lastly, you will remain responsible for paying any taxes and maintenance fees while you own the property. Making these payments is a stipulation of your reverse mortgage contract, and if you are not able to meet this requirement, your home could be foreclosed upon. For this reason, it is paramount that you fully understand the ins-and-outs of this contract–as well as your financial standing–before signing on the dotted line.

Conclusion: Understanding the Implications

A reverse mortgage can serve as one option for those who are looking to access some cash in their later years, especially if they are not planning on leaving their house to their descendants.

That being said, this is not such a simple calculation, as you will decrease the amount of the asset that you own. If you are worried about cash flow, it might therefore make more sense to downsize than to take a reverse mortgage.

Whatever you elect to do, it is always important to understand your options and fully internalize the implications of any financial decision.

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