A reverse mortgage allows a person to unlock equity in his or her house for spending. Unlike a traditional mortgage where the homeowner seeks to build equity by paying down the loan, a homeowner uses a reverse mortgage to convert the home’s equity into cash to be spent. As the credit line is tapped, equity ownership is effectively transferred from the homeowner to the lender.

Reverse mortgages are non-recourse loans. Payments are not required until the homeowner or his/her surviving spouse moves out (even if the spouse is a non-borrower in terms of the loan). Homeowners never have to leave the house because of a reverse mortgage as long as taxes and insurance are paid and maintenance is kept up. Furthermore, neither the homeowner nor the homeowner’s heirs have to repay any amount greater than the value of the house. Even in situations where the loan balance exceeds the value of the home, repayment is capped at the value of the house.

Distributions from reverse mortgages are loan advances. From a tax perspective, they are not income. They also do not impact Medicare premiums or the taxation of Social Security benefits. Interest on balances repaid can be deducted, though it is prudent to contact a tax professional to ensure the deduction is properly claimed.

The most common type of reverse mortgage in the United States is a home equity conversion mortgage (HECM). HECMs are regulated and insured through the Department of Housing and Urban Development (HUD) and the Federal Housing Authority (FHA). This article will focus on HECMs.

The eligibility requirements to be an HECM borrower include, but are not limited to, being at least age 62; having equity in the house; having the financial ability to cover property taxes, insurance and maintenance; and competency. The property must be the borrower’s primary residence, meet FHA property standards and flood requirements, pass an FHA appraisal and be maintained in accordance with FHA health and safety standards.

Key Terms

Before explaining how reverse mortgages work, some key terms need to be defined.

The principal limit is essentially the credit line provided by a reverse mortgage. It is the sum of the loan balance, line of credit and any set-asides. The principal limit, the loan balance and the remaining (not borrowed) credit grow at the effective rate.

The principal limit factor (PLF) is the HECM’s credit capacity, meaning how much can be borrowed against the home’s appraised value. PLF tables of percentage numbers are published by HUD. The maximum claim amount must be lower than the home’s value since the value of the home will be eventually used to repay any loan balance.

The expected rate determines the initial principal limit. The expected rate is determined by a 10-year benchmark rate plus the lender’s margin. The expected rate calculates the present value of a future outstanding balance. As such, it allows for a higher PLF when interest rates are lower (because there will be less projected growth in the loan balance).

The effective rate determines the pace at which the principal actually grows. Put another way, interest on the loan grows at the effective rate. The effective rate is determined by a one-month variable benchmark rate plus the lender’s margin and an annual mortgage insurance premium of 1.25%.

Key Costs

Though reverse mortgages can be useful for funding retirement, their costs are not insignificant. In addition to the aforementioned annual mortgage insurance premium, homeowners can expect:

• Origination fees of up to 2% for a home worth $200,000, or up to $2,500. The maximum allowed rises to $4,000 plus 1% of the home’s value above $200,000 for a home worth up to $400,000 and up to $6,000 for homes worth more than $400,000.
• An initial mortgage premium of 0.5% of the home value up to $625,000, if the homeowner takes out less than 60% of the principal limit factor in the first year. (It rises to 2.5% if more than 60% is taken out in the first year.) This premium is paid to the federal government and protects both the lender and the homeowner.
• Closing costs similar to those experienced with traditional mortgages. Estimates from AARP and the National Reverse Mortgage Lenders Association put the typical closing costs in a range of $2,000 to $3,000.
• The lender’s margin rate often will encompass ongoing servicing fees for the HECM. Reasonable margin rates currently run between 2.25% and 4%.

How Reverse Mortgages Work

Once the principal limit factor is determined, the homeowner has access to a credit line for the amount (e.g., 60% of the home’s value). This initial credit line grows throughout the duration of the loan and never has to be repaid as long as the homeowner (or his or her spouse—subject to certain rules) lives in the house.

If no loans are taken or if borrowed funds are voluntarily repaid, the credit line grows. This growth allows the homeowner to borrow even more in the future, while having the same loan balance as someone who borrowed immediately after taking out a reverse mortgage. This characteristic is an incentive to take a reverse mortgage early in retirement, but not to use the credit line until later in life. It is also an incentive to repay any borrowings taken in the early to middle part of retirement.

Repayment

Voluntary repayment of the loan balance can occur at any time without penalty. Repayment can also be voluntarily deferred until the borrower or the non-borrowing surviving spouse dies, moves or sells the house.

The title for the home stays with the borrower or his/her estate when the final repayment is due. Heirs seeking to keep the home can use other funds or take out a traditional mortgage to pay off the loan balance. The house can also be sold with any proceeds in excess of the loan balance going to the homeowner, the estate or heirs.

For more information about reverse mortgages, read “Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement” (Retirement Researcher Media, 2016) by Wade Pfau, which was the basis for this article.

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