How Does a Reverse Mortgage Work?

A Reverse Mortgage, the most common of which is known as a Home Equity Conversion Mortgage (HECM), is a widely unknown Federally Insured Program to aid Seniors with supplementary income. In short, a reverse mortgage gives seniors access to the value of their home without having to sell it. The U.S. Department of Housing and Urban Development works in conjunction with the Federal Housing Administration to insure HECM Loans and have been doing so since 1988. HUD and the FHA work together to make changes to the program to make sure that it meets seniors’ needs.

A Basic Understanding of a Reverse Mortgage

A Reverse mortgage works exactly how it sounds: A reverse mortgage works in reverse to a traditional mortgage. In a traditional mortgage the borrower receives money from the bank and through mortgage payments the owner builds the equity in their house. A reverse mortgage capitalizes on the equity in the home and transfers it into cash available for everyday use. The borrower can receive money in a variety of different ways, but we will get into that later.

Below are two examples of how a reverse mortgage works and how it is different from typical mortgage.

A very basic example of a traditional loan is when one goes to buy a house, they borrow money from a lender. To make the example easier to follow we’ll give the buyer the name of Sarah. Slowly Sarah pays off the remaining balance that she owes to the bank and eventually after many small payments Sarah owns the house in its entirety.

A reverse mortgage is appropriately named because it works nearly the same way as a traditional mortgage but in reverse. Now Sarah is 62 and qualifies for a reverse mortgage. She wants to supplement her income with a reverse mortgage and does this by using the equity, or in Sarah’s case the entire value of her home since it is completely paid off. The Lender pays Sarah the amount of money given to Sarah is equivalent to the equity available in her home. In Sarah’s case, her house was completely paid for so it is likely she can receive payment for what the house is worth. However, if Sarah still needed to pay off part of her house she would receive the full value of her house minus the amount left she still owed.

How to Receive Funds from a Reverse Mortgage

Following the earlier example, Sarah is now qualified to take out a reverse mortgage. Sarah can accept her money in a variety of different ways, from a line of credit to a lump sum to even receiving monthly payments. Sarah could even choose a combination of the options. She could choose to receive a $10,000 lump sum at closing, a $500 per month monthly payment, and a $50,000 line of credit, as long as she has enough equity in the home to do so. There are many different reverse mortgage payment plans.

Distribution and Use of Payments

There are many benefits to a reverse mortgage. The most shocking is that the funds are tax free and can be used for almost any application, however, there is interest building on the amount that is currently being used. Money that is in a line of credit or has not yet been disbursed to the borrower is not charged interest.

The borrower has the option to repay the building interest and the borrower does not receive any prepay penalties if they decide to pay off the loan early. The borrower can also choose to use their line of credit like a traditional HELOC line of credit, where they draw and make payments. If the borrower chooses to do this, the same funds are available to be re-drawn like a HELOC or a credit card, as this is a revolving line of credit.

How to Qualify for a Reverse Mortgage

There are some basic qualification requirements that you must meet in order to qualify for a reverse mortgage:

  1. One borrower on the loan must be over the age of 62. Example – Sarah is only 59, but her husband is 63. Her husband can still obtain a reverse mortgage with her.
  2. There must be enough equity in the home to pay off the mortgage. The specific percentage varies with age, so use a reverse mortgage calculator to see what you are eligible for.
  3. Borrowers must be able to complete counseling with a HUD-approved reverse mortgage counselor.
  4. Borrowers must meet a basic financial assessment to ensure that they will be able to pay for their homeowner’s insurance and property taxes after obtaining the reverse mortgage.
  5. The home must be in good condition, and any safety hazards should be fixed before closing.

As you can see, the qualification requirements for a reverse mortgage are quite loose, and this is why the program has been able to help so many Americans. HUD and the FHA have designed the program so it can help as many Americans as possible, and many times exceptions are available to borrowers who have undergone extenuating circumstances like the death of a spouse or a disaster.

The Math Behind the Reverse Mortgage

The HECM program was designed to help seniors and thus one must be 62 years old or older to qualify. The borrower and Property requirements for borrowers are listed here on the HUD website. The following factors determine how much a borrower can receive:

  • The age of the youngest borrower
  • The current interest rate. Interest rate varies by age.

And the lesser of:

  • The appraised value of the home
  • The HUD Lending limit which is currently $765,600 as of 2020.

The loan is determined by the lesser of the lending limit or the appraised value of the home. For example, if the value of the home qualifies you for $900,000, the lending limit restricts how much you can borrow. Therefore, the home value of $765,600 is used. This is technically known as the maximum claim amount. The maximum claim amount is multiplied by a percentage in HUD’s table to provide the amount of proceeds available to the borrower.  While it is theoretically possible to calculate all of this manually, it is much easier to use a reverse mortgage calculator which can provide an accurate calculation of the available proceeds.

For homes valued over $765,600, there are still many great options. There are a lot of jumbo reverse mortgage products that are now available for borrowers with homes worth more than $765,600.

Steps to Obtain a Reverse Mortgage

Obtaining a reverse mortgage generally occurs in five simple steps:

  1. Talk to a trusted reverse mortgage advisor
  2. Obtain counseling from a HUD-approved reverse mortgage counselor
  3. Sign initial application documents
  4. Obtain an appraisal of the home
  5. Sign final closing documents for the reverse mortgage

Overall, most homeowners are able to obtain their reverse mortgage in about 30 days.

After the Reverse Mortgage

The reverse mortgage ends when the last borrower stops occupying the home. This can occur when the borrower sells the home, moves, or passes away. In any of these cases, the borrowers or heirs to the borrower have the option to pay the lesser of 95% of the appraised value of the house or the loan balance. They can pay the loan off by refinancing, selling the home, or they can simply decide to walk away from the home if they have no interest in the property.

For example, if the home is worth $500,000 and the loan balance has increased to $600,000, the loan can be paid off for either $600,000 or $475,000 (95% of the home’s value). Because the heirs can choose to pay off the loan for $475,000, this is generally the best option.

If the heirs have no interest in the property, they can choose to simply sign the property away and walk away, but doing so may mean that they are losing a substantial amount of equity. For example, if the heirs choose to sign away a property worth $500,000 and a loan balance of $300,000, the heirs can choose to sell the property on their own. In this case, the heirs would be able to keep approximately $200,000 that they would miss if they chose to simply sign the property away and walk away.

If both spouses were borrowers on the loan, then the loan will continue as normal, but with only one borrower. However, if there was a non-borrowing spouse, then the spouse can continue to live in the home as long as they maintain the property. Note that the spouse will not receive any more money from the HECM as long as they were not within the loan agreement, but the non-borrowing spouse can always seek to refinance the loan to become a borrower and therefore obtain access to the proceeds.

In conclusion

Reverse mortgages were created for seniors to create a liquid asset from the equity in their house. Reverse mortgages work in the opposite ways as a traditional home. A reverse mortgage borrower takes the equity built up in their home and converts it into usable cash. There are many benefits to reverse mortgages such as the funds are tax free and the flexible payment plans. HECM’s specifically are backed by the federal government, which means funds are available whenever the borrower needs it.

Now that you know how a reverse mortgage works, read our previous article to see why a reverse mortgage could be the right choice for you.

Tyler Plack

About the Author, Tyler Plack

South River Mortgage is one of the nation's top reverse mortgage originators. With a focus on reverse mortgages, South River Mortgage's trustworthy advisors are able to help thousands of seniors each year.

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