What is a reverse mortgage and how does it work?

A reverse mortgage is a type of loan older homeowners can use to turn the equity of their primary residence into income. Instead of taking out a large loan to buy a home and slowly paying it back, these financial products operate in the opposite direction — you’ll trade equity that you have in your home for cash, but won’t have to make any payments until you either sell your home, change its status as your primary residency, or pass away.

“They’re promising products for people that have high levels of housing equity and little other assets on which to draw,” says Ben Harris vice president and director of economic studies at Brookings Institute. But reverse mortgages can be, “quite expensive both in terms of fees and potentially in terms of interest rates,” he says.

If you’re a homeowner looking for ways to augment your retirement income, here’s what you need to know about how reverse mortgages work, when it makes sense and what are some alternative options.

A reverse mortgage is a type of home loan that allows owners to turn their home equity into cash. With this type of mortgage, you don’t make monthly payments, instead, the lender pays you. The amount you can borrow is based on your age, mortgage rate and the value of the home (up to a limit depending on the loan type).

A reverse mortgage is due when the owner or owners pass on, sell the home or it is no longer their primary residence. It’s important to note that although you don’t make regular payments on a reverse mortgage, the loan balance grows. Interest and fees are typically added to the loan balance that’s due when you (or your estate) pay back the loan.

Otherwise, a reverse mortgage allows you to live in your home without having to pay back the loan as long as you continue paying ongoing homeownership costs, such as property taxes and homeowners insurance.

You can choose to have your property taxes and homeowners insurance paid by your reverse mortgage lender with a Life Expectancy Set Aside (LESA). With a LESA, the lender earmarks a portion of what you are eligible to borrow to cover these expenses. And sometimes, you might not have a choice. “If there’s been a history … of trouble paying taxes and insurance then it … will be required by the lender,” says George Morales, reverse mortgage product manager at Mortgage Cadence, a mortgage origination software company.

All reverse mortgage loans are non-recourse loans, which is a feature that protects the borrower if home values drop. With a non-recourse loan, a borrower (or borrower’s estate) won’t be responsible for paying the difference if the mortgage balance exceeds the home value when they sell the home. And you’re allowed to stay in your home indefinitely without having to pay the loan back. “The caveat is that you have to maintain the home and you have to continue making property tax payments,” Harris says.

Just like with standard purchase or refinance loans, there are various types of reverse mortgages. You can have a fixed or variable mortgage rate, and the payment can be issued as a lump sum, monthly payments, a line of credit or a combination of payments and a line of credit. Because of how complex a reverse mortgage can become, you should always talk to a financial professional before taking one on.

But no matter the structure of the individual loan, all reverse mortgages tend to fall under two major categories: Home Equity Conversion Mortgages (HECM) and proprietary reverse mortgages. The biggest difference between these two categories is one is insured by the FHA and must meet the FHA’s requirements, while the other does not.

Home Equity Conversion Mortgages (HECM)

HECM loans are the most common type of reverse mortgages, and these loans are insured by the Federal Housing Administration (FHA). A HECM has an FHA mortgage limit that the amount you can borrow is based on and you’ll pay an upfront and ongoing mortgage insurance premium.

Proprietary reverse mortgages

A proprietary reverse mortgage is not insured by the government and can allow you to borrow based on a home value that exceeds the HECM limit. This type of loan tends to have higher mortgage rates and may not be available in your state.

HECM loan requirements are set by the FHA which is part of the U.S. Department of Housing and Urban Development (HUD). HECM loans are only available through FHA-approved lenders, and have these requirements:

• You are at least 62 years old
• The home is your primary residence
• You own the home without a mortgage or have “paid down a considerable amount” of your loan
• You can afford to continue paying property taxes, homeowners insurance, etc.
• You are not behind on any federal debt, such as federal income taxes or student loans
• You must meet with a HUD-approved HECM counselor

As part of the application process, your financial information will be verified, including your credit history, income, assets and expenses. The property must also meet all of the FHA’s standards and can be a multi-family home of up to four units as long as one unit is owner-occupied.

The HECM loan limit is increasing to $1,149,825 for 2024 (up from $1,089,300 in 2023). This limit applies to all HECM loans regardless of where the property is located. What this means is, the amount you can borrow is based on your home’s value or the loan limit, whichever is smaller.

Proprietary reverse mortgages may not be available in your area, and the requirements differ. For example, you may be able to qualify at age 55 and borrow based on home values that exceed the HECM loan limits.

Reverse mortgage loans are a way for retired homeowners to access home equity without taking on a monthly payment. This can help pay the bills or fund a more comfortable retirement, and the payments you receive from a reserve mortgage don’t count as income, so the money you get isn’t subject to income taxes.

On the other hand, a reverse mortgage can make passing your home to your family more complicated or expensive. And because a reverse mortgage exposes the lender to the risk of losing money if the home value drops, it’s usually a more costly type of loan in terms of fees and interest rates.

Pros

• No monthly payment
• Tax-free payments
• Protected if the home value drops

Cons

• Typically higher fees than other types of loans
• Potentially higher interest rate
• It may be harder to pass on the home to family

A reverse mortgage isn’t the only option for pulling equity from your home. Depending on your situation, you may prefer to use a cash-out refinance mortgage, a home equity loan, or a home equity line of credit (HELOC). These types of loans are available to all eligible homeowners.

Cash-out refinance

A cash-out refinance loan is a type of mortgage that replaces your existing home loan with a larger loan and you pocket the difference. For example, if you owe $100,000 on your existing mortgage, you may be able to get a cash-out refinance for $150,000. After you pay your current loan, you’d still have $50,000 in the bank. With any mortgage refinance, your interest rate and repayment schedule are reset. And with a cash-out refinance you’re increasing your loan balance. So your mortgage payment will usually increase.

The amount you can borrow with a cash-out refinance depends on your home’s value and the maximum loan-to-value ratio (LTV) allowed by your lender or mortgage type. Most mortgages allow an LTV max of 80%-90%, however, if you qualify for a VA loan, you may be able to cash out at 100% LTV. If you’re looking for a lender with a wide variety of loans to choose from, you may want to consider PNC Bank, which is CNBC Select’s best mortgage refinance lender for loan availability. It offers conventional loans, FHA loans, USDA loans and VA loans.

Home equity loan

A home equity loan is a second mortgage that typically has a fixed interest rate. Since this type of loan is secured by your home, it usually offers a lower interest rate than an unsecured personal loan or a credit card. A second mortgage allows you to keep your original loan, which is an advantage if the interest rate on your mortgage is lower than the current rates. Of course, you’re adding another mortgage payment to your monthly expenses, so make sure there’s room in your budget before taking one on.

Rocket Mortgage is CNBC Select’s best lender for low credit scores and offers second mortgage loans on both primary and secondary homes.

Home equity line of credit

A HELOC is a secured line of credit that allows you to borrow money as you need it for a specified amount of time known as the draw period and normally has a variable interest rate. During the draw period, you are typically only required to make interest payments. Once the draw period expires, you’ll start repaying the loan and the repayment period usually is 10 to 20 years.

We rank SoFi as one of our top lenders for saving money and they offer a range of financial products including HELOCs, bank accounts, personal loans and mortgages. So it’s a great option if you want to keep all of your financial accounts with one institution.

A reverse mortgage is a tool seniors can use to tap into their home’s equity. This can give you a new source of income, and as long as you continue maintaining the home and paying taxes and insurance, you don’t have to repay the loan (during your lifetime) unless you move or change your primary residence. However, reverse mortgage loans can be expensive and could place a financial burden on your family after you pass away.

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