What we commonly refer to as a mortgage loan is also known as a forward mortgage. The word “forward” refers to the trajectory of equity in the home over the life of the mortgage. Specifically, as time goes on and the borrower makes principal and interest payments on the loan, their equity increases. A reverse mortgage, as the name would suggest, works in the opposite direction. The figure below depicts how forward mortgages work compared with reverse mortgages:With a reverse mortgage, instead of making payments to a lender, the homeowner receives payments from the lender. However, in return for these payments the lender receives portions of the homeowners equity. Therefore as time goes by and the homeowner receives these payments, their equity in the home decreases. These mortgages work in the reverse fashion of traditional mortgages hence the name.
Overview of Reverse Mortgages
Similar to a traditional or forward mortgage, with a reverse mortgage homeowners are borrowing money while using their home as collateral. But with a reverse mortgage the money being borrowed is against the homeowner’s home equity. As noted above, it works in an opposite fashion to traditional mortgages. Over time, the homeowner receives payments from the lender instead of making payments on their reverse mortgage. Also, over time, the homeowner’s equity declines instead of increasing. A consequence of this is that with a reverse mortgage, the loan balance increases which means the principal and interest payments required will also increase. Only eligible individuals can qualify for a reverse mortgage in the United States.
Eligibility Criteria for Reverse Mortgages
In order to be eligible for a reverse mortgage borrowers must meet fairly strict criteria. This includes but is not limited to:
- Borrowers must be 62 years of age or older.
- Borrowers must have “sufficient” equity or 100% equity in their homes.
- The property against which the reverse mortgage is issued must be the borrowers primary residence. This means the borrowers must reside at the property.
- The property against which the reverse mortgage is issued must have any existing mortgages paid off at or before closing of the reverse mortgage.
- Certain standards must be met in terms of housing quality per the Federal Housing Administration (FHA).
- Borrowers cannot be delinquent on any federal debt.
- Borrowers must demonstrate that they have financial resources to meet their ongoing obligations related to the property. Examples would be home insurance and property taxes.
The above is in addition to the usual eligibility criteria such as being in good standing on your financial obligations and passing a credit check. But the first of many criteria is related to age. As should be obvious, reverse mortgages are for senior citizens in the United States. The idea is to allow this segment of the population to be able to convert a portion of the home equity they have built into cash. This provides the homeowner with liquidity while still allowing them to continue living in their homes.
Typical Conditions with Reverse Mortgages
In addition to stringent requirements to be eligible for these mortgages, borrowers also have to adhere to certain conditions. As noted previously the property in question has to be the primary residence of the borrower. Since the borrower retains ownership of the property, they are responsible for continuing to pay the related obligations. These include paying property taxes each year (or accruing it each month) and homeowner’s insurance. The borrower must also maintain the property “in good repair”. These conditions have to be met or the borrower risks giving the lender the opportunity to foreclose on the property.
Prevalence of Reverse Mortgages
The vast majority of reverse mortgages are home equity conversion mortgages (HECMs) which are federally insured by the U.S. Department of Housing and Urban Development. According to research by the U.S. Government Accountability Office, as of the end of 2018 the FHA had insured over 1 million HECMs, of which approximately 50% had been terminated. The same research indicated that the total insured balance for outstanding reverse mortgages was roughly $100 billion as of the end of 2018.
The growing aging population in the United States makes reverse mortgages especially relevant. According to data from the U.S. Census Bureau, the eligible proportion of the population has increased from 16% in 2010 to 20% in 2019. An old but albeit relevant study on this topic indicated that more than 80% of individuals aged 62 or older, own their own homes. This means that almost 1 in 5 homeowners could meet the age eligibility requirement for an HECM.
3 Major Types of Reverse Mortgages
There are typically three types of mortgages available to eligible homeowners:
- HECMs: this is the most common type of reverse mortgage as we noted earlier. HECMs are federally-insured and backed by HUD. These are usually more expensive than the other two types of reverse mortgages. In addition, HECM has a maximum loan amount.
- Single-purpose Reverse Mortgage: these are offered by state and local government agencies and non-profit organizations. They are often the least expensive of the three types. They are called single-purpose reverse mortgages because the loans can only be used for one purpose. The lender specifies what this purpose is. For example, it could be for property taxes or home renovations.
- Proprietary Reverse Mortgage: unlike the other two types of mortgages, these loans are privately operated. These lenders still have to operate in accordance with requirements of the state they are based in. For example, in New York, proprietary reverse mortgages have to be made in accordance with the requirements of the New York Real Property Law Section 280, or 280-a.
Benefits of Reverse Mortgages
1. You Retain Title of The Home
Borrowers under reverse mortgages get to remain in their home while receiving payments from the lender. The benefit of this is that borrowers don’t have to find a place to live while getting access to capital for other living expenses. However, the borrower has to continue to adhere to the conditions of the loan or risk losing the home.
2. Most Reverse Mortgages Are Non-Recourse
Because of the way these mortgages work, over time the equity of the property declines. This means that there could be situations where the value of the home at the termination of the loan is less than the outstanding mortgage. Under normal circumstances a lender would be able to seek repayment for the full about of this loan. However, the non-recourse nature of reverse mortgages means that lenders cannot seek to recover amounts above the value of the home from the borrower’s other assets. The amount owned in the mortgage above the value of the home is instead covered by FHA insurance.
3. Payment Flexibility
Borrowers can opt to receive their cash payments from reverse mortgages in a variety of ways. This includes a single lump sum, periodic payments (e.g. monthly) or a line of credit. Some borrowers might choose a combination of all three options. The benefit of this flexibility is that you can access the cash on an as-needed basis.
4. Access to Tax-Efficient Capital
The last but certainly not least benefit of reverse mortgages is that it allows borrowers to access cash during retirement. As mentioned earlier, the vast majority (if not all) borrowers will be nearing or into retirement. This means that many might not have a regular source of income for every day expenses. Being able to access equity they have built up in their homes over time provides a source of income for living expenses. Finally, this income that you receive is not taxable. The IRS considers reverse mortgage payments as loan proceeds and not income. Therefore borrowers do not have to pay federal taxes on the income they receive from these mortgages.
Disadvantages of Reverse Mortgages
1. Variable Interest Rates
The above chart is from a study by the Brookings Institution. As it shows the overwhelming majority of HECMs issued in recent years have been variable rate mortgages. The disadvantage of this is that borrowers can face higher costs if interest rates increase over time.
2. Risk of Foreclosure
This is easily the most significant disadvantage of a reverse mortgage. If a borrower fails to meet the conditions of the loan, they could risk foreclosure. Given that most borrowers are at or near retirement, losing your home would clearly be a particularly devastating outcome.
3. They Can Be Expensive
These mortgage loans tend to have higher interest rates than traditional mortgage loans. In addition to this, there are upfront costs borrowers will have to pay. These include origination fees, real estate closing costs and an initial mortgage insurance premium. For example with origination fees a lender can charge the greater of $2,500 or 2% of the first $200,000 of your home’s value plus 1% of the remainder above $200,000. The resulting amount is capped at $6,000. Therefore if your home is valued at $300,000, the lender can charge you $5,000 for an origination fee. Clearly as you can see, these costs easily can run into the $5,000 and higher range.
4. It Can Complicate Estate Planning
Because of how these mortgages work, over time the value of your estate can shrink. This is again the result of the fact that with these mortgages the equity in your home shrinks over time. Therefore, if your home is a meaningful portion of the estate you plan to leave to your beneficiaries, a reverse mortgage could impact the ultimate value of the estate.
Who Provides Reverse Mortgages?
There are a long list of lenders, many of whom are FHA-approved, that provide reverse mortgages. Focusing on HECM loans specifically, there are over 300 lenders that have originated reverse mortgage loans in the last 3 years. But after going through the data we found that 5 entities originated almost half (45%) of the HECMs over the last 3 years. The below chart summarizes our findings.
- American Advisors Group – AAG is by far the largest HECM originator, at least over the past three years. They have been responsible for almost 30% of HECM originations over this time frame. The company boasts an A+ accreditation from the Better Business Bureau in addition to generally positive reviews. As a side note, AAG has been a big user of celebrities to promote its reverse mortgage product. You’ve likely seen their ads on TV!
- Reverse Mortgage Funding – RMF was established in 2012 and services more than 84,000 reverse mortgage borrowers. RMF also has an A+ accreditation from the Better Business Bureau and offers five different types of reverse mortgages.
- Mutual of Omaha Mortgage – Mutual of Omaha is a long established player in the mortgage industry. The company offers traditional mortgages in addition to reverse mortgages.
- Fairway Independent Mortgage Corporation – Fairway is also a broad mortgage loan provider with offerings beyond reverse mortgages, including conventional and FHA loans. The company funded more than $65 billion of mortgages in 2020 and in 2021 has averaged $6.1 billion of mortgage originations each month as of this writing.
- Finance of America Reverse – FAR specifically focuses on reverse mortgages and as a result emphasizes financial planning around one’s retirement. FAR has an A+ accreditation from the Better Business Bureau and also a 4.5 star rating from ConsumerAffairs.
Why Do People Get Reverse Mortgages?
The short answer: for a lot of different reasons. Admittedly we had to do a good amount of digging to get an answer to this question. So far, the best we could find was a fairly dated survey that was conducted by the AARP in 2007. Above we have displayed the results. Few of these reasons are surprising, but it should give you a decent sense of why people actually get reverse mortgages in the first place.