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What is a reverse mortgage, and is it right for me?

If you have equity in your property but have limited income and are short on cash in the bank, you may be "house-rich, cash-poor", since most of your wealth is tied up in your home and cannot easily be spent. Or you may be simply "house-poor" if maintaining your home takes the lion's share of your income. A variety of options are available for drawing from your home's equity to free up cash flow.

3 ways to cash out home equity

There are three primary ways to convert home equity to cash:

  1. Cash-out refinance. Refinancing pays off your existing mortgage, gives you a cash loan, and rolls everything into a new mortgage.
  2. Home equity loan or line of credit. A home equity loan (second mortgage) or a home equity line of credit (HELOC) adds a new debt while keeping your first mortgage intact.
  3. Reverse mortgage. Unlike a traditional mortgage where you make regular payments to a lender, in a reverse mortgage a lender makes regular payments to you based on the available equity in your home. A reverse mortgage is a common name for an FHA Home Equity Conversion Mortgage (HECM).

The first two options will likely increase your monthly payments since you are borrowing against the value of your home and repaying your lender. Use a refinancing calculator to estimate your payments.

A reverse mortgage does not require any repayment until the home is sold by the homeowners or their estate.

Qualifying for a reverse mortgage

If you are age 62 and older you can qualify for a reverse mortgage on your principal residence based only on the equity in your home. No credit check is required. The amount available depends primarily on your age and the available equity in the property. The homeowners can have an existing mortgage on the property or own the home outright.

How a reverse mortgage works

You can choose to cash out your equity in a lump sum distribution, a monthly installment or a line of credit. You must keep the home in living condition and pay homeowners insurance and property taxes. You keep the title to your home until the home is sold, whether by you or by your estate.

All reverse mortgage borrowers must participate in a counseling session to be certain they understand all elements of the loan program.

Reverse mortgage advantages

  • Reverse mortgage proceeds can be used for daily living expenses, medical bills, home improvements or any other expenses.
  • Proceeds are generally not taxable as income.
  • No payments are made on the loan until the property is sold.
  • Your heirs can receive title to the home and can opt to pay off the reverse mortgage or sell the property to pay the loan.
  • If the home is sold, you (or your heirs) keep the profit after the reverse mortgage has been paid in full.
  • If the home is worth less than the reverse mortgage balance, the owners or the heirs are not responsible for paying the difference. The debt is the responsibility of the Department of Housing and Urban Development (HUD).

Reverse mortgage disadvantages

  • If you opt for a reverse mortgage, you need to realize you are spending the equity in your home, and creating a debt that you or your heirs will need to repay.
  • If you receive too much money from a reverse mortgage they could be subject to reduced Medicaid or Supplemental Social Security benefits. A counselor can assist you in determining the appropriate amount to borrow so as to avoid an adverse financial impact.

Reverse mortgage costs

The costs for a reverse mortgage include an upfront mortgage insurance premium (MIP) of two percent of the loan along with a monthly MIP charged at an annual rate of 1.25 percent of the loan balance. Lenders also charge a loan origination fee, typically about 2 percent of the loan. However, some lenders are willing to reduce or eliminate the origination fee.

The Federal Housing Administration (FHA) also offers a Home Equity Conversion Mortgage (HECM) Saver reverse mortgage that reduces the upfront MIP to 1.0 percent of the property value, although you will be restricted in your borrowing power with the Saver option.

If set up correctly, a reverse mortgage can be an ideal way to convert your home equity into cash. Be sure you and your loved ones thoroughly understand all terms of a reverse mortgage before committing to one.

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