A reverse mortgage is much like it sounds. In a traditional mortgage we pay monthly to reduce the amount owed while increasing the equity in our home. In a reverse mortgage, we receive money, the amount owed increases, and the equity in our home decreases.
A reverse mortgage is a home loan available to homeowners age 62 and older who have substantial equity in their home. It is especially useful to someone who does have a home with a zero, or small mortgage, but has limited cash flow.
The home is usually our largest asset, but may not be considered by a retiree trying to increase cash flow to meet normal living expenses. A reverse mortgage can provide valuable financial flexibility for someone retired, however there are costs and risks that should be completely understood before signing on the dotted line. For instance, the loan balance increases over time because fees are added to the loan at the beginning and interest grows over the life of the loan.
History of Reverse Mortgages
Reverse mortgages can be traced back to the 1970s and 1980s. Before Congress became involved 1n 1987 there were substantial abuses. Some lenders sold reverse mortgages to elderly home owners without explaining costs and risks so that borrowers did not understand that they were borrowing money that had to be paid back.
Some lenders encouraged using proceeds to buy high commission products such as annuities and other insurance or investment products.
People lost their homes because they did not understand that they were still responsible for paying insurance and property taxes.
Misleading advertising that minimized costs and risks while implying reverse mortgages were government benefits rather than loans.
Congress took action in 1987 to federally insure reverse mortgages and develop the Home Equity Conversion Mortgage (HECM) administered by the Federal Housing Administration.
How a Reverse Mortgage Works
A homeowner with substantial equity can convert part of that equity into cash through:
- A lump-sum payment
- Monthly payments
- A line of credit
- A combination of these options
The homeowner retains title to the property.
The borrower must continue to:
- Pay property taxes
- Maintain homeowner’s insurance
- Keep the property in good condition
- Occupy the home as a primary residence
Failure to meet these obligations can trigger loan default.
When the loan becomes due, the home is typically sold. Sale proceeds are used to repay the loan balance, with any remaining equity going to the homeowner or heirs.
Advantages of Reverse Mortgages
1. Access to Home Equity Without Selling
Many retirees have substantial wealth tied up in their homes but limited liquid assets. A reverse mortgage converts part of that equity into spendable cash while allowing the homeowner to remain in the residence.
2. No Required Monthly Mortgage Payments
Borrowers generally do not make principal and interest payments during the life of the loan.
This can improve cash flow for retirees living on fixed incomes.
3. Flexible Payment Options
Borrowers can choose:
- Monthly income payments
- A line of credit
- A lump sum
- Combinations of these methods
The line-of-credit feature is particularly attractive because unused credit may grow over time.
4. Tax-Free Loan Proceeds
Reverse mortgage proceeds are loan advances, not income. Therefore, they generally are not subject to federal income tax.
5. Non-Recourse Protection
HECM loans are non-recourse loans. Neither the borrower nor heirs owe more than the home’s value when the loan becomes due, even if the loan balance exceeds the home’s market value.
Disadvantages of Reverse Mortgages
1. High Costs
Reverse mortgages often have significantly higher upfront costs than conventional mortgages.
These costs may include:
- Origination fees
- Mortgage insurance premiums
- Closing costs
- Appraisal fees
- Servicing fees
- Interest charges
Many of these costs are financed into the loan, causing the balance to grow immediately.
2. Erosion of Home Equity
Because interest accrues on the outstanding balance, equity typically declines over time.
A homeowner who remains in the property for many years may leave substantially less equity to heirs.
3. Reduced Inheritance
Children and other heirs often inherit less because the reverse mortgage balance must be repaid before any remaining proceeds are distributed.
4. Potential Foreclosure Risk
Although no monthly mortgage payment is required, borrowers must continue paying:
- Property taxes
- Homeowners insurance
- Required property maintenance costs
Failure to do so can lead to foreclosure.
5. Complexity
Reverse mortgages are complicated.
Many borrowers do not fully understand:
- Compounding interest
- Future loan balances
- Effects on heirs
- Long-term equity reduction
6. Impact on Certain Benefits
While reverse mortgage proceeds generally do not affect Social Security or Medicare, they may affect eligibility for certain need-based programs such as Medicaid or Supplemental Security Income (SSI) if funds are retained beyond allowable limits.
Typical Costs
Although costs vary, borrowers may encounter:
| Cost Type | Typical Description |
| Origination Fee | Compensation to lender |
| FHA Mortgage Insurance | Protects borrower and lender |
| Appraisal Fee | Determines home value |
| Title and Settlement Fees | Closing expenses |
| Recording Fees | Local government charges |
| Interest Charges | Accumulate over life of loan |
Over a long period, interest accumulation often becomes the largest expense.
For example, a homeowner borrowing $100,000 may ultimately owe substantially more than that amount after many years because interest compounds on both the original loan and financed fees.
Who Might Benefit Most?
A reverse mortgage may be appropriate for homeowners who:
- Are age 62 or older
- Intend to remain in their home for many years
- Have substantial home equity
- Need additional retirement income
- Have limited liquid assets
- Understand the costs involved
Who Should Be Cautious?
A reverse mortgage may be less appropriate for homeowners who:
- Expect to move within a few years
- Wish to maximize inheritance for heirs
- Have difficulty paying taxes and insurance
- Have alternative sources of retirement income
- Do not fully understand the loan’s long-term consequences
Here is an example of a 67-year-old person getting a reverse mortgage on a home worth $400,000.
The exact numbers vary by lender, interest rates, the borrower’s age, and FHA lending limits. The following example uses reasonable estimates for a 67-year-old homeowner obtaining a federally insured HECM reverse mortgage on a home worth $400,000.
Assumptions
- Age: 67
- Home value: $400,000
- Existing mortgage: None
- Reverse mortgage type: HECM
- Initial principal available: approximately 45% of home value
- Initial loan amount available: about $180,000
- Interest rate: 6.5%
- Annual mortgage insurance charge: 0.5%
- Effective annual loan growth rate: approximately 7.0%
The borrower chooses to establish a reverse mortgage and immediately withdraws $100,000.
Initial Costs
| Cost Item | Estimated Cost |
| Origination fee | $6,000 |
| Initial FHA mortgage insurance premium (2% of value) | $8,000 |
| Appraisal | $600 |
| Title, settlement, recording, legal fees | $1,900 |
| Other closing costs | $500 |
| Total financed costs | $17,000 |
Because these costs are typically financed into the loan, the borrower does not usually pay them out of pocket.
Initial Loan Balance
| Item | Amount |
| Cash received by borrower | $100,000 |
| Financed costs | $17,000 |
| Starting loan balance | $117,000 |
The homeowner receives $100,000 but immediately owes $117,000 because the costs are added to the loan.
How the Loan Grows Over Time
Assuming an effective annual growth rate of approximately 7%:
| Year | Approximate Loan Balance |
| 0 | $117,000 |
| 5 | $164,000 |
| 10 | $230,000 |
| 15 | $322,000 |
| 20 | $452,000 |
| 25 | $634,000 |
Notice that the loan balance almost doubles between years 10 and 20 because interest compounds.
Effect on Remaining Equity
Assume the home appreciates by 3% annually.
| Year | Home Value | Loan Balance | Remaining Equity |
| 0 | $400,000 | $117,000 | $283,000 |
| 5 | $464,000 | $164,000 | $300,000 |
| 10 | $538,000 | $230,000 | $308,000 |
| 15 | $624,000 | $322,000 | $302,000 |
| 20 | $722,000 | $452,000 | $270,000 |
| 25 | $836,000 | $634,000 | $202,000 |
Even though the house is appreciating, the growing loan balance gradually consumes a larger share of the equity.
If the Borrower Dies After 20 Years
Assume the borrower dies at age 87.
| Item | Amount |
| Home sale price | $722,000 |
| Reverse mortgage payoff | $452,000 |
| Remaining proceeds to heirs | $270,000 |
The heirs could either:
- Sell the home and keep the remaining $270,000.
- Refinance and keep the home.
- Pay off the reverse mortgage with other funds.
If Home Values Fall
Suppose the home is worth only $400,000 after 20 years while the reverse mortgage balance has grown to $452,000.
| Item | Amount |
| Home value | $400,000 |
| Loan balance | $452,000 |
| Shortfall | $52,000 |
Under HECM rules, the borrower and heirs generally do not owe the $52,000 difference. FHA insurance covers the shortfall. This “non-recourse” feature is one of the most important protections in a reverse mortgage.
Conclusion
Reverse mortgages can be valuable financial tools when used appropriately. They allow older homeowners to convert home equity into cash while remaining in their homes and avoiding monthly mortgage payments. For some retirees, this can improve financial security and quality of life.
However, reverse mortgages are not free money. They are loans that accumulate interest and fees over time, often reducing home equity substantially. The products have a history that includes aggressive sales tactics, misleading marketing, and consumer misunderstandings, although federal regulations and counseling requirements have improved protections in recent years.
Before obtaining a reverse mortgage, homeowners should carefully compare alternatives, consult trusted family members and financial advisers, and fully understand both the benefits and the long-term costs.
To be approved for a reverse mortgage you must receive counseling by an independent HUD-approved third-party to confirm you understand your obligations and responsibilities with a reverse mortgage.