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What is a Reverse Mortgage?

You’re most likely already familiar with one type of home loan: the mortgage. A mortgage is secured against the property its funds are used to purchase. However, there’s a somewhat lesser known type of home loan that has been growing in popularity in recent years: the reverse mortgage. Here’s the scoop on how a reverse mortgage works and for whom it may be appropriate.

How Does It Work?

A reverse mortgage is a loan secured against home equity. However, unlike other home loans, the borrower is not required to make monthly payments. Instead, the accrued interest is simply added to the balance of the loan. The loan generally comes due upon any of three conditions: The borrower sells the house, moves out of the house or passes away. Funds from the loan are typically distributed as a lump sum at settlement or as monthly payments.

If the purpose of a reverse mortgage isn’t clear yet, examine the following situation. Suppose a couple owns a home but realizes that their retirement fund isn’t going to cover the expenses for as long as they’d hoped. The traditional option might be to sell the home and downsize to an apartment, effectively “cashing in” on their equity. Instead, a reverse mortgage would allow the same couple to employ their equity to cover basic living expenses until they relocate to assisted living or pass away. In the meantime, they can stay put in the home they’ve grown accustomed to.

A Checkered Reputation

While that may sound like a good deal, there are some serious drawbacks. A common criticism of reverse mortgages is that they target the vulnerable. Those in their later years may not be so keen when examining term sheets, especially if they’re facing an immediate need for cash to pay the heating bill or to buy groceries. The Consumer Financial Protection Bureau cites a high risk for fraud. Even when you’re dealing with an honest company, if you have plans to pass the property on to your heirs, things can get very complicated.

Further, it may simply be a worse deal financially than if the couple were to simply downsize. In a 2006 AARP survey of reverse mortgage borrowers, 12% responded that the loan only “partly” covered their needs, while 2% reported “not at all”¾ mostly because they couldn’t get enough money. Admittedly, moving is a hassle, but the inconvenience needs to be weighed against the seriousness of pressing financial need.

For Some, a Good Idea

While criticism of reverse mortgages is fairly widespread, the AARP survey indicated that most borrowers were pleased. 93% of respondents believed the reverse mortgage had a mostly positive impact on their lives, while only 3% reported a negative impact.

In the U.S., 90% of reverse mortgages are Federal Housing Authority (FHA) insured Home Equity Conversion Mortgages (HECM). An HECM is a non-recourse loan, meaning that if the size of the loan exceeds the value of the home, the FHA picks up the tab for the difference. Other assets in your estate are not at risk, and your heirs will not be responsible for the debt. If you don’t have kids or are not planning on leaving anyone your house, an HECM could be a great way to increase your cash flow. Just remember, you might not get the best deal unless you take the time to consider all your other options!