Reverse Mortgages: A Beginner's Guide

Quick summary

At first glance, reverse mortgages -- loans that enable your parents to withdraw money from the principal they've paid off on their home -- seem like the perfect financial solution for older parents who own their own home and are in need of money. They get cash for daily living expenses or home improvement projects, they have no more monthly mortgage payments, and, best of all, they can live in their own home for the rest of their life. What could be better?

But it doesn't always work out that way. Reverse mortgages are an attractive option for many people -- but not for everyone. There can be hidden fees and costs, shady loan providers, and unforeseen consequences down the road.

Here's the basic rundown on reverse mortgages to help you decide whether they're the right choice for your parents.

How is a reverse mortgage different from a regular home loan?

Anyone with a home mortgage is familiar with the concept of a home equity loan: the lender loans a lump sum or gives access to a line of credit with the home as collateral. As your parents make monthly payments, they build up equity in the home, eventually owning the property outright.

As its name suggests, a reverse mortgage turns the concept of the traditional home equity loan on its head. Under a reverse mortgage, the homeowner converts the equity he has built up over time into cash, in the form of either a lump sum, a monthly payment to the owner, or a line of credit. Unlike a traditional home loan, a reverse mortgage has no monthly payments -- no repayment is required until the owner sells the home or is no longer using it as a principal residence. The lender recovers the principal plus interest (interest rates are tied to U.S. Treasury bond rates, and over the life of the loan they can range from 2 percent to 10 percent, depending on which type of reverse mortgage your parents choose). When the home is sold, the remaining equity in it goes to the homeowner or his heirs.

What kinds of reverse mortgages are there?

Basically there are three types: federally insured loans that follow rules set up by the U.S. Department of Housing and Urban Development (HUD), privately insured loans from nongovernment lenders, and uninsured private loans.

Federally insured loans are subject to stricter requirements and tend to have lower lending limits than private reverse mortgages, but they offer the security of government backing. Privately backed reverse mortgages may give your parents more options -- for example, allowing them to mortgage less than the full value of their house, which government-backed loans typically require -- but they may involve higher costs than government-insured loans.

Uninsured loans usually provide monthly payments for a fixed term. Unlike insured reverse mortgages, which are due only if your parents sell their house or in other strictly qualified circumstances, uninsured reverse mortgages are usually due in full at the end of the term.

Who qualifies?

When applying for a traditional mortgage, you have to demonstrate sufficient income and assets -- as well as overall creditworthiness -- to qualify for a loan. Because a reverse mortgage pays out based on the equity your parents have already built up in their home, they don't have to worry about monthly income or total assets (other than the residence in question).

To qualify for a reverse mortgage your parents must be over 62 years old and must have paid off all or most of their mortgage (the reverse mortgage will pay off whatever is left of their original mortgage before your parents receive any money, so if they have a large balance on that mortgage, a reverse mortgage won't work for them). They must also meet with a HUD-approved counseling agency before signing up. Their home can be any single-family residence, including a condominium or mobile home, as long as it's their principal residence.

How much money can they get?

The size of your parents' loan is generally determined by a combination of factors including their age, the available interest rate, and the value of their home. As a rule of thumb, the older they are, the larger a percentage of the home's value they can borrow. One important restriction for government-insured loans: a reverse mortgage amount is capped by the maximum Federal Housing Administration (FHA) mortgage limit for the area, which maxes out at $160,950. So homeowners in more expensive areas can't borrow as high a percentage of their total home equity as owners in less expensive areas.

How does the money from my parents' reverse mortgage get repaid?

The lender must be repaid when the borrower passes away, sells the home, fails to live in the house for 12 consecutive months (this includes time spent in a nursing home), fails to pay property taxes or insurance, or lets the property fall into disrepair beyond normal wear and tear.

When the loan is due -- generally when the last surviving borrower moves out of the house, sells the house, or dies -- the mortgage principal, interest charges, and closing costs are repaid from the proceeds of the house sale (or from estate assets, if the house isn't sold).

What are the benefits of a reverse mortgage?

Reverse mortgages can be a good financial solution for people over 62 who've paid off their mortgages or have significant home equity and want to spend the rest of their lives in their home. Reverse mortgages can provide tax-free income that shouldn't affect your parents' Medicare or Social Security benefits (check with a tax advisor, though, because this can vary).

They can use the payments for day-to-day living expenses, healthcare costs, emergency funds, or anything else they choose.

What are the risks of a reverse mortgage?

It's important to watch out for unscrupulous brokers who charge unnecessary counseling fees (reverse mortgage counseling is free through HUD) or exorbitant closing costs. As with any loan, reverse mortgage contracts can be confusing and may include hidden costs -- so read the fine print.

Another pitfall to keep in mind: because Medicaid is based on income level, Medicaid recipients also need to make sure the additional income they receive from the reverse mortgage doesn't disqualify them for those government benefits.

How does a reverse mortgage affect my parents' government benefits?

Because reverse mortgages are considered loan advances and not income, the IRS doesn't consider them taxable income, so reverse mortgage payments to your parents shouldn't affect their Social Security or Medicare benefits.

Can my parents lose their home?

Even if your parents sign up for a reverse mortgage, they -- not the lender -- retain the title to their home, so it shouldn't be at risk. The government insures HUD reverse mortgages, so if they eventually sell the house for less than the amount of the reverse mortgage, the government, not your parents, will pay the difference. They still own their home, and the government guarantees that they can't be forced to sell or move.

How will a reverse mortgage affect my parents' financial planning?

Your parents' home equity -- and the amount of home equity they can pass to their heirs -- is reduced by the amount of the reverse mortgage. Their estate will get whatever equity is leftover. Their children or other heirs aren't required to sell the house to pay off the reverse mortgage -- they can also pay back the loan with a traditional mortgage.

If your parents have set up a living trust as part of their estate planning and that trust includes their home, they can generally still qualify for a reverse mortgage, but they should consult with their estate planning advisor.

What fine print should they pay attention to?

With government-guaranteed reverse mortgages, HUD collects an insurance premium -- 2 percent of the home's value -- up front from all borrowers to provide this coverage, so your parents should factor those costs into the total balance of the loan. In addition to the insurance fee, most reverse mortgages have an application fee, an origination fee, closing costs, and monthly service charges. These charges will be added to the amount of the total loan, which makes the reverse mortgage a relatively cheap up-front loan, but does add to the total repayment costs. Your parents will still have to pay property taxes and buy homeowners' insurance.

If they have a second mortgage or home equity line of credit, they can still qualify for a reverse mortgage. But any cash they receive from the reverse mortgage ill first pay off the existing mortgages or loans.

Another tax fact to bear in mind: interest on reverse mortgages is not deductible on income tax returns until the loan is entirely paid off.

My parents want to sign up for a reverse mortgage. Whom do they talk to?

To receive free information and counseling, they can call HUD toll-free at 800-569-4287. You can find a reverse mortgage calculator, which will give you an idea of how much you can receive, at rmaarp.com/estimates.htm.