How Does a Reverse Mortgage Work?
On many cable channels you see the advertisements where a movie personality such as Henry Winkler (Fonzi in Happy Days) speak enthusiastic about the benefits of a reverse mortgage.
A reverse mortgage, like a traditional mortgage, is a loan made by a lender to a homeowner using the home as security or collateral.
In a traditional mortgage, the bank may lend up to 90% of the property’s value to the homeowner. However the mortgage does not call for monthly payments of principal and interest. Thus the mortgage loan balance will increase over time because monthly payments are not required and the amount of unpaid interest keeps increasing.
A reverse mortgage loan generally does not require repayment until the last homeowner has passed away or moved out of the property. Consequently, life expectancy is a huge part of the lender’s calculation of how much to lend. A 62 year old homeowner can borrow a substantially lower percentage of their property’s value than an 80 year old homeowner. The lender expects the outstanding loan to be paid though a sale of the mortgaged property.
Income instead of outflow
With a reverse mortgage, the borrower gets cash instead of making payments to the lender. The cash may be received through a lump sum payment, a line of credit, or regular monthly advance. The loan is secured by your home, so reverse mortgages may be practical for homeowners whose home is not currently subject to a mortgage, that is your equity value approximates the fair value of your home.
Reverse Mortgages Insured by the Federal Housing Administration
Most reverse mortgages are Home Equity Conversion Mortgages (HECMs), which are offered by private lenders and insured by the FHA; borrowers must be at least age 62.
The Federal Housing Administration (FHA) has imposed more stringent requirements on reverse mortgages, making them increasingly difficult to obtain. For qualified borrowers, though, continued low rates and the spread of so-called “purchase loans” can make it worthwhile to consider this type of debt.
The amount you’ll receive will be determined by current interest rates, your age, and your home equity. Interest rates are relatively low now (around 5% for a fixed-rate loan and under 3% for a loan with a variable rate that adjusts monthly), but you’ll pay an added 1.25% of the balance for mortgage insurance. The older you are and the greater your home equity, the more you’ll be able to borrow on a reverse mortgage.
Updated Home Equity Conversion Mortgage (HECM) disclosure requirements.
As of January 13, 2014 the FHA has issued new regulations for reverse mortgage lenders which include a credit history analysis, a cash flow residual income analysis, documenting credit, income, assets, and property charges, for borrowers, evaluating the results of the borrower financial assessment in determining HECM eligibility.
Why does the lender care about FHA Regulations?
Without FHA compliance, there is no FHA mortgage insurance, and the lender bears all the risk arising from mortgage defaults.
Borrowing to buy
Reverse mortgages are aimed at seniors who wish to stay in their home as they grow older. In effect, they can use their home equity for added cash in retirement so they won’t have to move into an unfamiliar place, perhaps one that’s away from friends and family.
Tax Aspects of Reverse Mortgages
Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable.
Any interest accrued on a reverse mortgage is not deductible until the interest is actually paid, which is usually when the loan is paid off in full. Such a payment might be made by the borrower, by an heir, or by the borrower’s estate.
For the party repaying the loan, the deduction may be limited because a reverse mortgage loan generally is subject to the limit on home equity debt. That limit caps deductions to the interest on $100,000 of debt.