How Does a Reverse Mortgage Work?

Preparing for retirement is all about putting together a financial plan that can provide you with income when you are no longer working.  

Social Security, 401(k)s, IRAs and—for the lucky few—pensions tend to get the most attention in this regard. But it’s important to note that there are other ways to generate cash flow if needed during your non-working years. A reverse mortgage is one such possibility.  

Below, we take a closer look at what a reverse mortgage is, how it works and what it can look like. We also walk through how to apply for one and answer other common questions to help you decide whether or not a reverse mortgage belongs in your financial plan.  

What is a reverse mortgage? 

A reverse mortgage is a way for seniors (age 62 or older) to turn their home equity into cash flow (to supplement other retirement savings) by taking out a loan against the equity they’ve built in their home. Most reverse mortgages will not require any repayment as long as you live in the house, though they will accrue interest that’ll need to be repaid when you die or leave the home. While reverse mortgages come in a number of varieties, the most common is the Home Equity Conversion Mortgage (HECM).  

Do you qualify for a reverse mortgage? 

In order to apply for a reverse mortgage, at least one applicant must be 62 or older. You’ll need to own significant equity in your home—typically at least 50 percent—and it must be your primary residence.  

Additionally, a lender will require you to keep up with the financial obligations of home ownership like proper maintenance and payment of property taxes, homeowner’s insurance and HOA fees. You’ll need to demonstrate that you have the financial resources to pay for these expenses.  

Finally, it’s important to note that not all types of property are eligible for a reverse mortgage. If your home is a single-family or multi-family residence (where one of the units is your primary residence) then you should qualify. Manufactured homes and HUD-approved condos are also eligible. Vacation homes and second homes are not.  

How does a reverse mortgage work? 

As a homeowner, you’re familiar with how a traditional mortgage works.  

When you bought your home, you made a down payment toward the total price of the home and took a loan out to pay for the rest. Every month, you make payments toward both the principal (the amount you owe) and the interest (what your lender charges you for the loan). As you pay down your balance, you steadily build equity in your home.  

A reverse mortgage flips that entire process on its head.  

Available only to older homeowners, a reverse mortgage uses your home as collateral, converting some of the equity locked up in your home into cash. You keep the title and get to stay in the home while using the cash as you wish.  

Unlike a traditional mortgage, a reverse mortgage doesn’t typically require you to make any payments (though it does accrue interest) as long as you live in the home. However, when you die or leave the home, you (or your heirs) will be responsible for paying off the loan (and interest) with cash or by selling the home.  

When does a reverse mortgage become due? 

A reverse mortgage will typically become due when one of three scenarios occurs:  

• You (or any co-borrower) move out of the home for a period of at least 12 months 

• You (or any co-borrower) dies 

• You fail to pay your property taxes or carry homeowner’s insurance as required by your lender 

Who owns the property at the end of a reverse mortgage? 

When taking out a reverse mortgage, you retain the title to the home. By taking a reverse mortgage, you are not transferring any ownership of the home. Therefore, you’ll still own the property at the end of the reverse mortgage if you satisfy the conditions of the loan.  

Can you sell a house that is on a reverse mortgage? 

Because you own the house, you are free to sell it. Once you sell the home, you’ll need to repay the reverse mortgage (with interest and fees) first. Any remaining equity would be yours to keep.  

Can my heirs keep the house if I take out a reverse mortgage? 

This depends. When you and/or any co-borrower dies, the reverse mortgage becomes due. At that time, your heirs will receive a notice from your lender. They will have 30 days from receiving the notice to either buy, sell or forfeit the house to the lender. This timeline can vary. 

To buy the home, your heirs would need to pay off the reverse mortgage in full. If they cannot do this, they can sell the home and use the proceeds of the sale to pay back the loan (and keep any remaining earnings) or forfeit the home in lieu of payment. 

What are the 3 types of reverse mortgages?  

Reverse mortgages come in three varieties: home equity conversion mortgages (HECMs), single-purpose reverse mortgages and proprietary reverse mortgages.  

Home Equity Conversion Mortgage (HECM) 

This is the most common type of reverse mortgage. Because they are only available through a lender approved by the Federal Housing Administration (FHA), they are also known as Federal Housing Administration (FHA) reverse mortgages. They are federally insured and regulated by both the FHA and U.S. Department of Housing and Urban Development (HUD).  

To qualify for an HECM, you must be at least 62 years old and complete a counseling session where you will learn about repayment options, borrowing requirements and how a reverse mortgage might impact your taxes or federal benefits.  

Cash from the loan can be used for anything the homeowner wishes and can be paid out as a line of credit, fixed monthly payments or a lump sum. With an HECM, you’ll never owe more than the amount that your house ultimately sells for, no matter how long you live or how much interest accrues over the life of the loan.  

Single-purpose reverse mortgage 

These loans are offered by nonprofits, as well as some state and local governments.  

Like HECMs, single-purpose reverse mortgages are only available to homeowners who are at least 62 years old and only become due once the borrower dies, moves or sells the home.  

Unlike HECMs, however, proceeds from the loan can only be issued as a lump sum and must be used for a single purpose, which was approved by the lender. Usually, this will involve paying property taxes or completing necessary home repairs or maintenance. Single-purpose reverse mortgages also often carry lower interest rates and fees than HECMs.  

Proprietary reverse mortgage 

These loans are made available through private lenders without government oversight. As such, lenders can set their own terms, including age requirements and maximum loan amounts. Proprietary reverse mortgages are also called jumbo reverse mortgages due to the fact that they can be larger than HECMs.  

These reverse mortgages often come with higher interest rates compared to HECMs and single-purpose reverse mortgages, because the lack of government backing forces the lender to take on more risk. The heightened risk is passed on to the borrower in the form of higher interest payments.  

HECM Reverse Mortgage Process 

The process of taking out a reverse mortgage against your home equity loan consists of six steps:  

1. Initial application 

During the initial application, you will be asked to provide certain information which the lender will use to determine whether you are eligible for a reverse mortgage. Then, they will also provide you preliminary non-binding terms.  

2. Counseling 

Before you are allowed to borrow, you are required to complete an HECM counseling course with a HUD-approved counseling agency. This course is designed to educate you about how reverse mortgages work as well as your rights and options.  

3. Home Appraisal 

Your home must then be appraised by an FHA-approved appraiser to determine your home’s value and how much equity you own on it. This will determine the size of your loan.  

4. Underwriting 

The lender conducts a title search to ensure that you own the property and determines if the property is subject to liens or bankruptcy. This is also the point where the lender will formally pull your credit report and set the final terms of your loan. 

5. Closing 

On the closing date, you’ll sign the final closing documents in the presence of a notary or attorney. After signing, you have three days during which you can cancel the application with no penalty if you have changed your mind.  

6. Funding 

After the three-day waiting period, the loan is funded and the loan will be made available to you.  

What to know before you apply for a reverse home mortgage 

Under limited circumstances, a reverse mortgage can work as part of your financial plan during retirement. Here are some factors you’ll want to keep in mind:  

How much money do you actually get from a reverse mortgage? 

The loan’s size depends on your home’s market value, your age, your spouse’s age and current interest rates. Don’t assume you’ll be able to borrow against the full equity of your home—it'll probably be less. Most borrowers leveraging a reverse mortgage are limited to borrowing 40 – 60 percent of the appraised value of their home.  

How much does a reverse mortgage cost? 

Reverse mortgages typically cost more than traditional mortgages. You’ll face closing costs and fees that may be around 4 percent of your home’s value. Some lenders allow you to roll these fees into the loan so you don’t pay them out of pocket at closing (though this can be more costly).  

How does a reverse mortgage affect Medicaid?  

While a reverse mortgage doesn’t count as income, it can sometimes count as an asset, which can push some borrowers over the limit necessary to qualify for certain government benefits like Medicaid and Supplemental Security Income (SSI). Receiving cash from a reverse mortgage could mean forfeiting those benefits. A reverse mortgage will not impact Social Security or Medicare. 

Is a reverse mortgage a good idea for seniors?  

A reverse mortgage can be an effective way of turning your home equity into cash flow during retirement, while still letting you live in the house. But they don’t come without expenses or risks, and they’re not for everyone. While reverse mortgages are often seen as a last resort to generate income for someone who may not have other savings available, this isn’t always the case. If you don’t have heirs and don’t intend to leave a legacy, it’s possible to use a reverse mortgage to generate additional income during your retirement. 

When identifying sources of income in retirement, you’ll want a mix of investments—like retirement savings, annuities, life insurance cash value and investments—to achieve the level of financial security you want in retirement. A Northwestern Mutual financial advisor will keep the full financial picture in view when planning for retirement, carefully balancing your assets and helping to make sure you get the most out of them.