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Mortgage Guide: Reverse Mortgage Loans Explained

By Staff

Reverse mortgage loans are an increasingly popular financial tool for older Americans wishing to tap their home equity without the burden of monthly repayments. Senior homeowners are using reverse mortgages to supplement Social Security payments, cover medical expenses, make major home repairs and for general use. This article explains what a reverse mortgage loan is and how a reverse mortgage works. It also provides information on types of reverse mortgage loans and rates, and outlines pros and cons you must consider to avoid potential reverse mortgage pitfalls.

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How a Reverse Mortgage Works

As the product's name suggests, the typical reverse mortgage loan-payment arrangement is "reversed" in that a lender makes payments to a borrower rather than a borrower paying a lender each month. Borrowers can take a lump-sum payment, fixed monthly payments or periodic draws on a line of credit. They are not required to pay back the principal amount or interest fees on the reverse mortgage as long as they live in the house.

When the home is sold, the lender recoups the reverse mortgage loan amount plus interest; the homeowners or their heirs receive whatever money is left. If the amount owed is more than the sale price -- due perhaps to an owner's extreme longevity and/or a collapse in home values -- the U.S. Department of Housing and Urban Development pays the reverse mortgage lender the difference from a public insurance fund maintained with premiums paid by borrowers.

Available since 1989, the FHA-backed Home Equity Conversion Mortgage (HECM) accounts for about 90% of the market. To qualify, all homeowners need to be at least 62 years old. Borrowers must have paid off their mortgages or be carrying a balance that they can retire with funds from the reverse mortgage or personal assets.

One's maximum reverse mortgage loan amount is based on a percentage of the property's present value, the prevailing interest rate and the homeowner's age, with the loan limit increasing the older an applicant is. For example, HUD says that based on a 9% interest rate, an 85-year-old could borrow up to 56% of a property's value. A 75-year-old could borrow 39% and a 65-year-old, 26%. Unlike a traditional mortgage, a borrower's income and overall financial assets have no bearing on reverse mortgage loan eligibility.

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Reverse Mortgage Borrowing Limits

The total reverse mortgage loan amount is linked to the FHA-mortgage limit for the area, which depends on regional housing costs. The HECM loan limits recently ranged from $200,160 to $362,790.

Owners of more expensive homes can avail themselves of newer programs such as Fannie Mae's Home Keeper and "jumbo" loans offered by private lenders that aren't federally insured but carry many of the same key consumer safeguards. The jumbo products have either no limits or $2 million to $4 million ceilings along with lower upfront costs than HECMs.

Homeowners are still required to pay their property taxes and insurance and not let the residence fall into disrepair. If they become financially unable to pay their taxes and insurance, the lender can create a set-aside fund from the reverse mortgage to cover those costs.

According to HUD, there are five ways to receive payments:

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Reverse Mortgage Borrowing Costs

Reverse mortgage lenders generally charge a variable, or floating, interest rate rather than a fixed rate that periodically resets based on an index such as the one-year Treasury Bill or the London Interbank Offered Rate (LIBOR), to which they usually add one to three percentage points.

The costs of a reverse mortgage are different than a traditional one and can be steep, though the fees can be paid out of the loan proceeds. For instance, borrowers under the HECM program are charged an upfront mortgage-insurance premium based on regional home prices of 2% of the maximum loan amount, which recently ranged from $4,003 to $7,256. They also pay an annual premium of a 0.5% of their outstanding loan balance. Both amounts support the insurance pool tapped when the price of sold homes don't cover borrowers' outstanding balances.

Reverse mortgage lenders can charge a loan-origination fee under HUD guidelines up to the same 2% of the maximum loan amount for a given area -- potentially another $4,003 to $7,256. After adding on an appraisal fee and other closing fees, the upfront cost of taking out a reverse mortgage can be $9,000 to $15,000 or more, which can make them costly for short-term borrowing, especially less than three years.

The types of properties eligible for reverse mortgages are single-family homes, townhouses, condominiums, two-to-four unit properties and manufactured homes built after June 1976. Cooperative housing generally doesn't qualify though some lenders developed private programs for New York City co-ops.

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Reverse Mortgage Refinancing and Purchase Options

While generally tapped to draw on home equity, reverse mortgage loans also can be used simply to retire an existing mortgage and escape its monthly payments. For instance, say you have an existing mortgage for $100,000. Even if you only qualify for a maximum $85,000 reverse mortgage, you could pony up $15,000, pay off the existing mortgage loan and eliminate the monthly payments. You still get to keep any appreciation in the property value beyond the interest and account fees for yourself and your heirs when you sell the house.

The Home Keeper program similarly would allow a 75-year-old man, for example, to take $120,000 profit received from selling a larger home and use it to buy a $145,000 single-story home near his children or in a warm climate. The Home Keeper reverse mortgage would cover the difference and he'd never have to make payments on it.

Because the elderly frequently are the victim of financial scams, HUD mandates that anyone interested in getting an HECM must first get counseling from a local HUD-approved counseling agency or national counseling agency such as AARP (800-209-8085), National Foundation for Credit Counseling (866-698-6322), and Money Management International (877-908-2227). These third-party counselors ensure that borrowers understand the reverse mortgage program and consider other home-equity borrowing options, tax consequences in terms of eligibility for federal and state programs, and the impact on their estate.

Due to the potentially steep upfront costs, HUD recommends borrowers consider other options if they plan to move out of their home within three years or intend to leave the house to their children because in many cases, the property must be sold to pay off the reverse mortgage.

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