How does a reverse mortgage work?

First, in order to understand how a reverse mortgage works, you need to understand home equity. In real estate terms, equity is the current market value of your property minus the amount of all loans still owed on it.

For example, if your home is valued at $300,000 and you owe $100,000 on a mortgage, you have $200,000 in home equity.

If you’ve already paid off your mortgage (or didn’t have one in the first place), then the equity is equal to the total market value of the property.

When you take out a reverse mortgage, you borrow against a portion of that equity. The money you receive isn't taxable and you can receive it upfront in a single lump sum, in monthly payments or as a line of credit, depending on your needs and the type of loan you choose.

During this time, you can choose to make payments on the loan and reduce your debt, but you are not required to. You must, however, continue to pay property taxes, insurance and keep the house in good repair. Otherwise, you risk default and eventually, foreclosure.

Reverse mortgage loans become due once you die (in which case, your heirs become responsible for the loan) or no longer have the home as a principal residence, among other circumstances.

Keep in mind that reverse mortgages aren’t exclusively meant for single-family homes — you can also apply for one if you live in a condominium, so long as it's your primary residence.

Types of reverse mortgages

There are four types of reverse mortgages: home equity conversion, home equity conversion for purchase, proprietary and single-purpose reverse mortgage.

Much like a regular mortgage, these loans can have either a fixed rate or an adjustable interest rate. However, reverse mortgages tend to have higher interest rates than traditional mortgages.

Even though reverse mortgage borrowers are generally not required to make monthly mortgage payments, they must still pay property taxes, insurance and maintenance on the home as part of their loan obligations.

Home Equity Conversion Mortgage (HECM)

A Home Equity Conversion Mortgage is a federally backed loan subject to regulation by the Federal Housing Administration (FHA) and the U.S. Department of Housing and Urban Development (HUD). They're only available through lenders approved to disburse FHA loans.

The amount that can be borrowed is based on the appraised value of the property and subject to FHA limits. Some HECM lenders require two appraisals of the property. The lender will use the lowest appraised value for the loan.

Being subject to FHA regulations has another benefit — HECM loans are non-recourse loans, which means you'll never owe more than what your house is worth, even if its market value drops.

HECMs offer a number of payment options:

• A single lump-sum payment
• Tenure: a monthly annuity for a specific number of months or for as long as the house is your primary residence
• A line of credit: You have the option of withdrawing funds as you need them, but the unused principal balance grows over time according to the interest rate. For example, assuming you get a $200,000 line of credit with a 4% interest rate, if you don't use any of that money, the principal loan amount would go up to roughly $300,000 over the next ten years. While this does mean you owe more money than at the start, you also have access to a larger line of credit in the long run. This means that you can potentially receive a larger amount of funds than originally requested over the life of the loan.

These options can be combined to fit your needs.

In 2021, the principal limit for this type of loan is $822,375, and there are no conditions on how reverse mortgage borrowers can use the money. You’ll be required to attend a HUD counseling session through a counseling agency and pay a mortgage insurance premium (MIP).

Even though they are mandatory, mortgage insurance premiums can benefit both the lender and the borrower. For example, in the event that the heirs of a deceased borrower want to sell the home, they only have to pay the lender up to 95% of the home's appraised value, even if the loan balance is greater than the selling price. The mortgage insurance will cover any amount due that exceeds the 95% appraisal value.

Home Equity Conversion Mortgage (HECM) for Purchase

An HECM for Purchase lets adults ages 62 and up take out a reverse mortgage on their current home, and use the proceeds to buy a new principal residence. This is usually done when you want to move into a new home, but don't want to wait until your current home is sold to do so.

Just like a regular HECM, this type of mortgage is backed by the FHA. Also, like most reverse mortgages, it has a non-recourse clause, meaning that you can never owe more than your home’s value when the loan becomes due.

Like other reverse mortgage loans, this one also features flexible repayment, and so borrowers can pay as much as they choose each month, or make no payment at all — as long as they pay their property taxes and other obligations.

Since an HECM for Purchase involves buying a new primary residence, the down payment on the new home is subject to certain regulations. For example, if closing costs are financed, the minimum required down payment is usually between 29% to 63% of the purchase price.

The down payment amount also depends on the buyer or eligible non-borrowing spouse's age, when applicable. The remainder of the purchase funds come from the HECM loan.

If the HECM for Purchase results in a substantial enough amount, the homebuyer may even have some of the proceeds left over to use for other retirement goals.

According to the National Reverse Mortgage Lenders' Association (NRMLA), this type of reverse mortgage is often preferred by people living on a fixed income who are looking to downsize, move closer to family or whose current home no longer meets their needs.

Proprietary Reverse Mortgage

A proprietary reverse mortgage is a kind of loan offered by private reverse mortgage lenders. Some of these loans are referred to as jumbo reverse mortgages, as they can exceed the value limits set by the FHA for HECM loans.

As we said above, in 2021, the maximum amount that can be borrowed under an HECM loan is $822,375. The limit for a jumbo reverse mortgage, on the other hand, can be as high as $4 million.

Proprietary reverse mortgages aren’t insured by the federal government, and so borrowers aren’t required to pay a monthly insurance premium or to take financial counseling.

However, because they're not federally backed, these loans do tend to have a higher interest rates than a HECM loan.

Borrowers can get the money as a lump sum or monthly annuity and can use it for any purpose.

Single-Purpose Reverse Mortgage

Single-purpose reverse mortgages are backed by government agencies and non-profit entities and are meant for a specific, lender-approved goal, such as paying property taxes or making necessary improvements to the home.

Also known as a "deferred payment loan” or “property tax deferral loan,” this kind of reverse mortgage offers lower fees and interest rates. Eligibility requirements also tend to be less strict, so this might be one type of reverse mortgage low-income borrowers and homeowners can afford.

However, it's important to note that the proceeds can only be used for the purpose that your lender agreed to.

How much money do you get from a reverse mortgage?

The amount you will be able to borrow with a reverse mortgage depends on the type of reverse mortgage loan you select, the age of the youngest borrower, current interest rates and how much equity you have in the home. Much like when you take out a traditional mortgage, a reverse mortgage also has origination fees, servicing fees and other closing costs.

If you choose a federally backed option, you will also be required to pay mortgage insurance premiums. These expenses can be taken out of the loan amount, so you don’t have to pay them out of pocket, but they will reduce how much cash you receive after closing.

In addition, reverse mortgages tend to have higher interest rates than traditional mortgages.

Is a reverse mortgage right for you?

If you have considered getting a reverse mortgage on your home, but aren’t sure if it’s a good fit for you, consider the following points:

PROS Access a large amount of cash or a steady source of income in retirement Flexibility in how you receive the money. Options include a lump sum upfront, an annuity, a line of credit or a combination of the three You or your heirs don't need to make any payments on the loan until you move out, sell the house or pass away HECMs are non-recourse loans, so you will only owe what you borrowed even if your house loses value You do not pay income tax on money you receive from a reverse mortgage You have the right to change your mind for any reason and cancel the reverse mortgage within three business days of closing on the loan If one spouse should pass away, the surviving spouse will be able to stay in the house if they are a co-borrower

CONS If you have an existing mortgage, funds obtained from a reverse mortgage must be used to pay it off You must pay mortgage insurance premiums and homeowners insurance for the life of the loan on federally backed loans If you should move out of the home for more than 12 consecutive months, and there is no eligible co-borrower living in the house, the loan could become due Other expenses associated with reverse mortgages, like fees and closing costs, will reduce the amount of cash you get If you and your co-borrowing spouse die before paying back the loan, your heirs must pay off the full loan balance or 95% of the home's appraised value (whichever is less) if they wish to keep the house from foreclosure Falling behind on property taxes or insurance payments could trigger default and foreclosure The loan proceeds could affect your Medicaid and Supplemental Security Income eligibility, if you take them as a lump sum and these are unspent after thirty days

For single-purpose reverse mortgages, the money’s purpose needs to be reviewed and approved by the lending agency.

In the case of HECM mortgages, the house has to comply with HUD’s minimum property standards to qualify. Furthermore, you may be required to use some of the loan proceeds for home improvements if your home doesn’t meet HUD standards.

In order to qualify for a reverse mortgage loan, you (and your home) must meet the following requirements:

• Be at least 62 years old, own your home and live in it as your primary residence
• The home should have enough equity for the reverse mortgage amount you need
• You must be able to pay taxes and homeowners insurance premiums on the house
• You must keep the house in good condition
• In the case of a HECM, you have to attend financial counseling with a HUD-approved counseling agency

If you receive Medicaid or Supplemental Security Income (SSI) benefits from the Social Security Administration, consult a financial expert to determine if your benefits will be affected by this kind of home equity loan.

Additionally, there are other options available if you don’t meet the age requirements but are interested in a similar type of loan, including home equity loans and home equity lines of credit (HELOCs).

Check out our guide to the best home equity loans to explore those other options.

How do you pay back a reverse mortgage?

A reverse mortgage becomes due once all borrowers have died or moved permanently out of the home, among other circumstances.

When the borrower of a reverse mortgage dies, the bank will discuss loan payment options with the heirs and inform them of the current mortgage balance. The heirs will generally have 30 days to decide what to do with the loan and with the property.

These are some of the options available for you or your heirs to pay a reverse mortgage:

• Sell the home and use the proceeds to pay off the balance on the reverse mortgage loan
• If the heir wishes to keep the property, pay the loan balance or 95% of the home's appraised value, whichever is less
• Take out a loan — either a traditional mortgage loan or another reverse mortgage — on the property after the borrower has died to cover the balance on the mortgage

If the heirs decide to sell the property or pay back the loan, they have 30 days from the date of the borrower’s death to pay off the loan.

The lender might approve a 90-day extension if the heirs can provide documentation that proves they are trying to sell or repay the loan in good faith. In some cases, it may even be possible to extend the timeline for up to a year. This information mainly applies to federally backed loans, though lenders may make exceptions for proprietary loans.

If the heirs do not pay back the loan within the agreed-upon timeframe, the lender may proceed with foreclosure.

When do you pay back a reverse mortgage?

In most instances, you don’t have to pay back the reverse mortgage loan as long as you live in the house. However, the loan will become due and payable in any of the following situations:

• Death. When you die, your heirs become responsible for paying back the mortgage or reaching an arrangement with the financial institution.
• Selling the property. The loan is paid off with the sale proceeds.
• Living outside the home for one straight year. If you live away from the house for more than 12 consecutive months, you might need to start paying the loan. If your spouse is a co-borrower or an eligible non-borrowing spouse, they could stay in the home without paying back the loan.
• Not paying property taxes or homeowners insurance. All reverse mortgages require that the borrower pay taxes and homeowners insurance. Failure to do so will result in foreclosure. If you are unable to pay, seek a reverse mortgage counselor right away.
• Not maintaining the house. The home needs to be kept in livable condition.

Once the loan is due, you or your heirs need to speak with your lender to determine a time period to settle the loan balance. This time period varies depending on the situation, but it could be as little as 30 days in some cases before the lender begins the foreclosure process.

How to avoid reverse mortgage scams

Unfortunately, the promise of reverse mortgages has also been used to scam homeowners.

Because HECMs are federally backed, some unscrupulous lenders have tried to target cash-strapped seniors with the promise that a reverse mortgage is a safe way to access money for retirement. In many cases, the targeted individuals are not told that property taxes, insurance and home repairs must continue to be paid for, causing them to default on the loan and results in an easy payday for the unethical lender.

Other scams include convincing borrowers that they should invest the loan proceeds in risky investment schemes.

Here are some red flags you should be aware of when it comes to reverse mortgage loans:

Warning Signs

Lenders that don’t explain the fine print or try to rush you through the loan process

Companies that use aggressive sales tactics — like fear-mongering and cold calling

Lenders who claim you can use a reverse mortgage to purchase a home without a down payment — HECMs for purchase will still require you to pay around 50% of the home’s value out of pocket.

Contractors who say that the best way to pay for costly home repairs is to take out a reverse mortgage

Anyone who suggests risky stocks or schemes (like house-flipping) or signing over the money to a third party

The best way to avoid being a victim of a reverse mortgage scam is:

• Speak with a HUD-approved independent reverse mortgage counselor
• Read the fine print before signing any loan documents
• Be aware that you have a right to cancel your reverse mortgage loan within three business days of closing for any reason whatsoever. You’ll need to send a request in writing to your lender, who will then have to return any loan expenses you have already paid
• Don’t respond to unsolicited marketing or cold-calling

If you or someone you know is a victim of a reverse mortgage scam, submit a tip to the FBI, file an online complaint with HUD-OIG, or call their hotline at 1-800-347-3735. You can also submit a complaint through the Consumer Financial Protection Bureau by calling 1-855-411-2372.