For those not familiar with the term “reverse mortgage” they’re not alone. And even for those that have heard the term used it’s still a bit counterintuitive.
Officially it’s called the Home Equity Conversion Mortgage, or HECM (heck-um) and is an FHA program that has recently undergone some changes.
But to understand how a reverse mortgage will work in order to buy a home, let’s first explain what a reverse mortgage actually is and how qualifies for one.
The concept of a reverse mortgage has been around for quite some time in various formats but today the FHA’s HECM is the only reverse mortgage standing and has been around since 1988. A reverse mortgage is a vehicle that converts a portion of the borrower’s equity into a lump sum cash payment, a monthly annuity or a combination of both.
One might initially ask, “That’s the same thing as a cash-out refinance or a home equity line of credit, or HELOC” but that’s not the case. With a cash-out refinance or a HELOC the loan proceeds must be paid back each month with a mortgage payment. A reverse mortgage requires no such monthly payments.
The cash proceeds from a reverse mortgage is essentially a draw against a portion of the equity in the home owner’s primary residence and because the funds are considered and not income there are not income taxes required on reverse mortgage proceeds. Although borrowers with a reverse mortgage have no mortgage payments, interest does accrue over time based upon the terms of the loan and only becomes due and payable when the youngest borrower on the mortgage leaves the house for more than 12 months. This can be moving to a second home, selling it or the borrowers pass away. During the course of a reverse mortgage, the homeowners still retain title and they do not sell or otherwise transfer the property to the lender in any manner. Ownership does not change. Here are some basic guidelines on who qualifies for a reverse mortgage—
- At the date of the settlement and reverse mortgage proceeds are distributed all borrowers on the reverse mortgage application must be at least 62. Any others who are currently on title prior to the closing of a reverse mortgage who are under the age of 62 must be removed from title.
- There are various factors that come into play regarding how much homeowners can get but just like social security and pension payments, the older the borrowers the more they will be eligible for.
- The reverse mortgage can only be used to finance a primary residence and cannot be used to finance a second home or a rental property. However, a borrower can in fact purchase a duplex or 2-4 unit using a reverse mortgage as long as the borrower occupies one of the attached units as a primary residence.
Credit and Income
When qualifying for any traditional mortgage such as a conventional loan underwritten to Fannie Mae or Freddie Mac standards as well as government-backed loans such as FHA, VA and USDA loan types, credit and income are two of the most important features of the borrower’s loan application. Most such loans ask for a minimum credit score such as a down payment and may even require a higher score when the down payment is lower on a conventional mortgage.
Lenders verify credit by ordering a credit report as well as requesting credit scores from each of the three main credit repositories, Equifax, Experian and TransUnion. Lenders then use the middle score and the lowest middle score of all borrowers on the application is there is more than one applicant. With a reverse mortgage there is no credit score requirement. In fact, credit is much less of an issue. Reverse mortgage applicants can expect however a review of a credit report to determine the borrowers have shown a willingness to pay their bills on time but credit scores are not a requirement.
A traditional mortgage also requires the lender to verify the borrowers have enough monthly income to qualify for the new principal and interest payment along with a monthly amount allotted for property taxes and insurance. With a reverse mortgage, since there are no monthly payments, income verification such as pay check stubs, debt ratios and income taxes are not required. Instead, the reverse mortgage lender makes a reasonable determination there is sufficient monthly income to handle property taxes and insurance but since there is no mortgage payment made each month, typically a sizable amount of a borrower’s gross monthly income, this hurdle is easily met. Reverse mortgage lenders know that if homeowners fail to pay property taxes, the taxing authority has the authority to force the sale of the home to pay delinquent property taxes. As well, the property is still considered collateral and the lender must make sure the applicants have enough income to pay not just the property taxes but insuring the home as well.
The Reverse Mortgage Loan Amount
There are various reverse mortgage calculators that will display a maximum reverse mortgage loan amount based upon various factors. The first is the age of the youngest borrower who must be at least 62 years old at the time of settlement. If an individual borrower is 72 years old and will be the only person on title, the amount will be greater compared to that same 72 year old married to a 62 year old. The loan amount will be based upon 62. Essentially, the younger the borrower the lower the final loan amount.
The home will be appraised for both a reverse on an existing property as well as using a reverse mortgage to buy a home. When using a reverse mortgage to buy a home, the sales contract on the transaction will accompany the reverse mortgage application and used as reference alongside an appraisal. Sometimes the purchase price and the appraised value come in differently and a reverse mortgage lender will use the lower of the two values. If the sales price is lower than the appraised value the lender will use the sales price as a loan basis. If the appraisal comes in lower than the sales price the lender will use the appraised value to determine a loan amount.
The maximum value for any appraisal used for a purchase or a refinance however is limited to $625,500. Even if the home being purchased is $800,000 the reverse mortgage loan amount will be based upon the $625,500 figure. This is referred to by FHA as the Single National Maximum Claim amount and applies everywhere.
The interest rate at the time of closing can also impact the loan amount. If interest rates are relatively high a lower loan amount will be approved as the interest rate on the reverse mortgage will affect accrued interest over the years. A lower rate will provide a larger amount compared to a higher rate.
Using a Reverse Mortgage Scenarios
David is 78 years old and his wife Cindy is 72 and they are applying for a reverse mortgage. Since Cindy is the youngest, the reverse mortgage lender will use Cindy’s age as the qualifying age and they live in San Diego. They want a reverse mortgage for both a lump sum payment and a $50,000 line of credit.
Their reverse mortgage lender orders an appraisal and the property is determined to be worth $500,000 based upon recent sales of similar homes in the area and the home is currently mortgage-free. In this scenario, the maximum loan limit is $295,500 with an adjustable rate mortgage and approximately $165,000 for a one-time lump sum payment using a fixed rate reverse mortgage. $50,000 will be set aside for the line of credit and closing costs will be subtracted from this amount as well.
Now let’s take a look at that same set of figures for David and Cindy but this time both are 78 years old. Since the age of the youngest borrower is 78, the reverse mortgage amount is just over $300,000 along with the $50,000 line of credit. What if both were 62 years old, what would the amount be then? The principal limit is now 4262,000.
Let’s take this one more step and say that David and Cindy currently have a mortgage on their home in the amount of $75,000. Because there can be no other mortgages on the property along with a reverse mortgage, proceeds from the reverse must not only pay associated closing costs but also retire the existing mortgage. In this scenario, the $75,000 is deducted from the maximum principal amount before any proceeds or lines of credit are established.
As you can already tell, getting a reverse mortgage loan is more than completing the application because there are so many variables involved. An online reverse mortgage calculator can give you a general idea but speaking with an experienced loan officer who specializes in reverse mortgages can provide a more accurate figure. For example, if the homeowners select an adjustable rate mortgage, the amount of funds issued must be into a line of credit or taken out in monthly installments. For a fixed rate loan, you’re only able to withdraw 10 percent of the principal limit which leaves what is called “unusable funds” and remain as home equity and not cash proceeds to you.
Reverse Mortgage Closing Costs
Just as with any mortgage there are closing costs on a reverse mortgage just as well and they can vary slightly from lender to lender so it does pay to shop not only for a lender experienced with reverse mortgages but also with competitive fees.
For a time, reverse mortgage closing costs were extremely high, so much so that FHA revised the closing cost requirement specifically as it relates to the Upfront Mortgage Insurance Premium, or UFMIP. This is a one-time fee that is used to finance the insurance program that covers losses by the FHA should the loan be foreclosed upon or otherwise go into default, just as with any FHA mortgage used to purchase a property yet with a reverse mortgage there is no monthly mortgage insurance payment.
There is also a lender origination fee expressed as a percentage of the loan amount but cannot exceed $6,000. There are also third party fees such as lender charges, a required counseling session for the applicants, appraisal fees, title insurance and other charges. Your reverse mortgage loan officer will provide you with a cost estimate which will outline charges you may see at the settlement table. Besides a fee for the appraisal and perhaps a credit report, closing costs on a reverse mortgage are deducted from the maximum principal amount.
Purchasing a Home with a Reverse Mortgage
Most reverse mortgages are taken out on an existing property, turning home equity into usable, tax-free cash and no monthly payments. But as of 2008, a reverse mortgage can also be used to purchase a property and is reviewed and approved in much the same manner as a reverse mortgage on an existing home with a few differences.
The reverse mortgage used to buy a home is placed upon the home being purchased, not the existing property. Getting approved for a reverse mortgage is much easier than getting an approval for a traditional mortgage as income, assets and credit are less of an issue.
When buying home with a reverse mortgage, remember the maximum principal loan limit less fees is based upon the borrower’s age and other factors so that can vary but there will be a shortfall as a reverse mortgage cannot be used to cash out 100 percent of the purchase price. The buyers must come up with the difference between the proceeds from the loan and the sales price. Most often this shortfall is from the sale of the existing home. In this manner, the buyers can choose to take all or part of the reverse proceeds and not use all of the proceeds from the sale of their existing home or from savings.
For example, a couple have identified a home they want to buy and finance with a reverse mortgage and the sales price is $300,000 and their loan officer has told them they could qualify for a $150,000 reverse. Again, depending upon the age of the youngest borrower, the loan will be somewhere near 50% of the appraised value. There are no payments on the reverse mortgage and because there can be no other mortgages on the property with a reverse mortgage on it, the buyers must come up with the additional funds for the shortage.
Potential buyers who intend to use a reverse mortgage to buy a home will first speak with an experienced loan officer who can walk them through the process. It’s critical to work with someone who specializes in reverse lending and doesn’t just have a reverse mortgage because they’re an FHA lender. There are too many moving parts that are foreign to loan officers that aren’t familiar with reverse loan. If there is any loan where experience counts, this is it.
The buyers then complete a qualified reverse mortgage consultation. This is more than just getting general information from loan officer but an approved counseling process the buyers must complete. Some lenders charge for this counseling session but the fee is minimal.
The buyers complete an application and provide any documentation the lender requests. The lender will then order various third party services needed to compete the reverse mortgage application. A title insurance policy will be ordered and escrow opened and settlement date set that is listed on the sales contract. Other services such as flood certificates and tax service as well as title insurance will be needed, very much like a traditional loan.
The appraisal is then ordered through an appraisal management company which handles the appraisal request, places the appraisal order with an independent appraiser then forwards the report to the reverse mortgage lender. The appraisal will determine the value of the home which will be used to establish a maximum reverse mortgage amount and not the sales price of the home.
Once the appraisal has been reviewed and approved and the loan amount is established, the loan documents will be prepared and sent to the settlement table. The sellers will sign their set of closing papers and the buyers theirs. The buyers will then provide the closer with the additional funds needed to close on the sale that will accompany the reverse mortgage amount. The loan closes and is recorded in the county recorder’s office. The sale is complete.
It’s important to point out that eligible borrowers can buy another home with a mortgage or even pay all cash and later on get a reverse mortgage to tap into that equity payment-free, but another advantage of using a reverse mortgage to buy a home is there is only one set of closing costs associated with a reverse purchase transaction.
Reverse Mortgage Myths
Reverse mortgages are different from a traditional mortgage in a number of ways, primarily because there are no monthly payments but let’s address some of the most common misconceptions about the program.
You don’t lose ownership of the home. Because the homeowners receive funds from the reverse mortgage lender it seems as if the lender is buying the property from the owners and just letting them live there and pay off the note when they leave the property. That’s not true at all. Ownership doesn’t change and the only difference on the new title report is the reverse mortgage lender has a new lien on the property and any previous mortgage has been released.
Should the homeowners leave the house, sell it or pass away, the heirs aren’t responsible for repaying the accrued balance of reverse mortgage. A reverse mortgage is considered “non-recourse” and regardless of the value of the property compared to what is owed, even if the reverse amount is greater than the sales price of the property, it is the lender that takes the hit but is compensated for any loss using proceeds from the mortgage insurance policy.
The homeowners retain complete control of the disposition of the property and do not have to pay off the loan. Because there is no prepayment penalty, there is no restriction on when the reverse mortgage can be paid off. Doing so leaves more to the heirs of the estate.
The maturity date on the loan is written into the trust deed at the 150th birthday of the youngest borrower and there is no date required when the borrowers must sell or pay off the reverse mortgage balance as long as one of the original borrowers occupies the property.
Because the proceeds are not considered income by the IRS, the proceeds are income tax free and will not affect any social security or Medicare benefits.
A reverse mortgage is an ideal way for seniors to transfer their home equity into usable cash. Many seniors who are retired may find their retirement income and savings isn’t quite enough to comfortably take care of any mortgage payment and still others find themselves extremely cash-poor but house-rich.
A reverse mortgage used for a purchase may not be for everyone but for those who fit the parameters there may not be a better way to finance a home. Primarily it saves cash and buyers don’t have to qualify in the same way they would for a regular mortgage. If you or someone you know is reverse mortgage eligible, talk to a financial planner to discuss the impact and the advantages of a reverse compared to tapping into retirement savings to buy a final home.
Again, it can’t be emphasized enough—make sure you work with an experienced reverse mortgage lender. At first the process may be a bit confusing but once the program is explained and how the buyers will benefit, many might wonder why they didn’t think of a reverse mortgage before.
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