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How Does a Reverse Mortgage Work? Pros and Cons

A reverse mortgage is a unique type of loan which flips the script on a typical mortgage, as the lender pays the homeowner. The way a reverse mortgage works is that a homeowner will borrow money backed by the value of their home. Below, we’ll go over the details of how a reverse mortgage works, along with the pros and cons.

What is a Reverse Mortgage?

A homeowner with most of their net worth tied up in the value of their home can use a reverse mortgage to gain access to a flow of cash. You can look at a reverse mortgage as trading some of the future value of a home to gain immediate access to the equity that has been built up.

Unlike other loans, there are no payments to be made on a reverse mortgage. Instead, homeowners can receive a lump sum or gain access to a line of credit. The loan does not have to be for the entire value of the home either. It can be for whatever amount you deem necessary. Reverse mortgages will only be practical options for those who own their home outright or have built up considerable equity.

The balance of the loan then becomes due upon the borrower’s death or the sale of the home. And the way these loans are structured, the balance of the loan can never exceed the value of the house. So even if the home drops in value, it will always remain the entire collateral for paying back the loan.

Loan Limits

You may not always be able to get a loan for the entire sum of your home’s value, even if you own the home outright. The amount you can borrow will depend on the age of the home’s youngest household member. There is also a current cap of $726,600 as of April 2020 on a Home Equity Conversion Mortgage or HECM.

Ultimately, the amount of money you can take out will depend on how low current interest rates are, how much your home is worth, and your age, as older borrowers can receive a higher principal amount.

What is Home Equity?

Home equity is the value of your home that has been paid off. The amount of equity you have accrued can be calculated by taking your home’s current value and subtracting the outstanding principal you owe.

Often, the equity in someone’s home is the most significant portion of their net worth. But there are only two ways of accessing this money: selling your home or by borrowing against it.

Types of Reverse Mortgages

There are three primary reverse mortgage options you can choose from:

  • Single-Purpose Reverse Mortgage
  • Federally Insured Reverse Mortgage
  • Proprietary Reverse Mortgage

Single-Purpose Reverse Mortgage

One of the fewer-used options, a single-purpose reverse mortgage will be issued through your state or local government. And true to the name, this loan can only be used for one specific purpose, such as to pay property taxes or make home repairs.

Federally Insured Reverse Mortgage

An example of a federally insured loan is the Home Equity Conversion Mortgage (HECM), which is the most popular type of reverse mortgage. Part of the reason for its popularity is that there are zero medical or income requirements to apply. But a Home Equity Conversion Mortgage will cost more on the front end than other types of loans.

With the HECM loan, you have the option of choosing a fixed interest rate or a variable interest rate. With a fixed rate, you gain access to one large payment. But if you go with a variable rate, you have many more options, including monthly payments, a line of credit, or a combination of both.

Proprietary Reverse Mortgage

An example of a proprietary loan is a jumbo reverse mortgage, which would be necessary if your home is worth more than the HECM maximum of $726,600. This type of loan is not federally backed, which also means that there are fewer upfront costs.

Pros and Cons of a Reverse Mortgage

A reverse mortgage can be an excellent option for some, but others should take caution before signing up for what can appear to be free money.

Pros of a Reverse Mortgage

The most significant advantage of a reverse mortgage is gaining immediate access to cash without a monthly payment tied to it. And for the homeowner who may not outlive the home, you never actually pay back the loan. For seniors with the majority of their net worth tied up in their home, a reverse mortgage is a great option to go live the life they want to live.

For the estate that inherits the home, the biggest pro is that the balance of the loan cannot exceed the value of the house. This practice gives peace of mind to both the homeowners and their families.

Cons of a Reverse Mortgage

For someone who has a longer life expectancy or lives long enough that they want to leave the house, a reverse mortgage could have damaging consequences. When you sign up for a reverse mortgage, the value of your home goes down, while the amount of your debt goes up.

Instead of a steadily increasing net worth that you can pass down to your heirs, a reverse mortgage lowers your net worth and leaves you with fewer assets to pass down. Signing up for a reverse mortgage is a decision that can affect many people beyond the homeowners and should ideally be discussed with the family.

Bottom Line on Reverse Mortgages

A reverse mortgage is not for everyone, but it can be an effective way of providing cash flow in your retirement years. While the prospect of receiving payments from the bank rather than the other way around may sound appealing, you should always avoid taking on new debt if you can afford to. A reverse mortgage is a helpful tool for some, but ultimately it will lower the amount of wealth that you can pass down to your heirs.

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