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Reverse Mortgage — Pros and Cons of Cashing In on Home Equity

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Feb. 17 2022, Published 8:39 a.m. ET

There are a few options for someone looking to capitalize on the equity of their home. They can refinance their home or they can sell it if they want to liquidate their assets completely. They can also take out a reverse mortgage on their home. A reverse mortgage is a way for a homeowner to receive a decent amount of money from their home. What are the pros and cons of a reverse mortgage?

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According to Debt.org, a reverse mortgage is “a type of home loan that lets you convert a portion of the equity in your house into cash.” A reverse mortgage allows homeowners to take money out of their home’s equity. In a typical mortgage scenario, the owners make payments to the bank every month for their home. In a reverse mortgage situation, the lenders pay the borrowers.

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What are the types of reverse mortgages and how do they work?

According to the FTC, the money given in a reverse mortgage operates as a type of advance payment on the home’s equity and the money is generally tax-free. People who are considered eligible for this type of mortgage are at least 62 or older. There are three types of reverse mortgages to consider—single-purpose, proprietary, and HECM (Home Equity Conversion Mortgage).

Single-purpose is the most inexpensive and can be offered by state and local government agencies. As the name suggests, this reverse mortgage can be used for one purpose and the lender is responsible for the details. For example, the single purpose might be home improvements and repairs. Generally, people with low to moderate incomes can qualify for this type of loan.

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A proprietary reverse mortgage is a private loan that's backed by a specific company. According to the FTC, if the home has a higher value, the borrower will likely qualify for more money. HECM are reverse mortgages that are backed by the U.S. Department of Housing and Urban and are typically more expensive with their own requirements.

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What are the interest rates on reverse mortgages?

Reverse mortgages work by allowing the borrower to receive the money on their home until they sell the home, no longer use it as a primary residence, or die. In any of these three scenarios, the loan needs to be repaid. These mortgages usually charge an "origination fee," closing costs, and service fees for the entire duration of the mortgage.

In some cases, the borrower will have to pay a mortgage insurance premium for HECMs that are federally insured. For the money received, interest is tacked on to the balance owed every month, which translates to higher interest on the loan as time passes. When considering interest rates, some are fixed, but even the ones that are fixed require the borrower to receive the loan as a lump sum.

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In other cases, when dealing with a variable rate, the amount a person can borrow tends to be less over time. The interest isn't tax-deductible until the loan is paid in full. Also, in a reverse mortgage, the owner retains the title and is still responsible for taxes, insurance, maintenance, and other costs related to the house.

A reverse mortgage has pros and cons to consider.

Reverse mortgages can be ideal for people who have struggled to save enough for retirement. As stated earlier, the IRS considers a reverse mortgage as a loan advance and not income, so it can’t be taxed. A reverse mortgage serves as an alternative option for liquidating assets. During a reverse mortgage, the owner is allowed to stay in their home. The money from a reverse mortgage can be used to pay down the existing loan on the home.

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If the home’s value is less than what's owed on the reverse mortgage, the borrower won't have to pay the difference.

The cons of this type of mortgage are that if a person fails to keep up on the fees incurred, they run the risk of losing their home to foreclosure. If the debt exceeds the market value of the home, whoever inherits the home might be stuck with a high bill. Also, the interest on taxes paid can't be deducted until the loan is paid off in full.

If the person seeking a reverse merger is already retired, the extra money might violate income restrictions in place by Medicaid or SSI (Supplemental Security Income) programs. If the owner of the home has to move to a nursing facility, it might complicate or violate the rules of the home being considered the primary residence.

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