How Do HECM Reverse Mortgages Work?

The Home Equity Conversion Mortgage (HECM) is an ingeniously constructed financial instrument that can meet a wide variety of needs of homeowners 62 or older. In addition to its versatility, HECMs are also extremely flexible, permitting changes in the ways in which seniors receive funds as their needs change over the years.

Inevitably, however, the HECM is also very complicated, which prompts the need for this article. It is organized around the 21 questions that I receive most often from seniors.

1. What Is a HECM Reverse Mortgage?

It is a loan to a senior secured by a mortgage lien on the senior’s house, with most of the loan proceeds usually paid out over time rather than upfront, and with no repayment obligation so long as the senior lives in the house.

2. What Are the Requirements For Obtaining a HECM Reverse Mortgage?

You must be 62 years of age or older, and have significant equity in either a home that is your permanent residence, or one you plan to purchase using the reverse mortgage. The house must be single family, in a 2-to4 family structure, in an FHA-approved condominium, or an approved manufactured home

Any existing mortgage on the home must be paid off when you obtain the HECM. Hence, it cannot be larger than the maximum cash draw available on the reverse mortgage unless the senior wants to tap other funds to make up the difference. Some seniors might find it advantageous to do this in order to eliminate the payment on the existing mortgage.

During most of its history, HECM borrowers were not subject to any credit worthiness or ability-to-pay standards. Because many borrowers were becoming delinquent on their property taxes, however, HUD imposed some modest requirements of that type in 2015.

3. How Do HECM Reverse Mortgages Differ From Standard Mortgages?

This is the core question. Most seniors have some understanding of how standard mortgages work, because they probably had one for some years, so understanding how HECMs are different may be the best way to understand HECMs.

Purpose: The major purpose of a standard mortgage is to facilitate the purchase of a house, or to refinance a mortgage that had been taken out earlier for that purpose.

A reverse mortgage is designed to provide an elderly homeowner with spendable funds that can be used for a variety of purposes, including home purchase. More commonly, the funds are borrowed against a home the senior already owns and occupies as a permanent residence, and used in many different ways.

Eligibility Requirements: To obtain a standard mortgage, borrowers usually must demonstrate that they have sufficient income to make the required payments, that their credit rating is good enough to meet lender requirements, and that they have enough financial assets to cover the down payment and settlement costs.

On a reverse mortgage, borrowers must be 62 or older, and have significant equity in either a home that is their permanent residence, or one they plan to purchase using the reverse mortgage. The house must be single family, in a 2-to4 family structure, in an FHA-approved condominium, or an approved manufactured home. If they have an existing mortgage, it must be paid off with proceeds from the HECM.
The income and  credit requirements imposed in 2015 are much less restrictive than those on standard mortgages.

Lender Protection: On a standard mortgage, lenders look to the borrower to repay the loan, and view the property collateral as their last resort in the event the borrower defaults.

On a reverse mortgage, lenders depend wholly on proceeds from eventual sale of the property to be repaid. If the debt balance grows to exceed the property value, the lender will suffer loss, though on HECM reverse mortgages the FHA will assume all or most of it. HECM borrowers pay a mortgage insurance premium to cover such losses.

Factors Affecting the Loan Amount: On a standard mortgage, the amount that a home purchaser can borrow depends on the value of the property, and on the borrower’s income and available assets.
On a reverse mortgage, the amount a borrower can draw depends on his age and his equity in the home. In both cases, there may be legal and/or regulatory limits imposed on loan amounts.

Payout of Funds: On a standard mortgage, the entire loan amount is disbursed at the outset, as part of a sales transaction or a refinance.
On a reverse mortgage, the homeowner may receive funds in a variety of ways: as a lump sum at the outset; as a monthly tenure payment, which continues until the borrower dies or moves out of the house permanently; as a monthly term payment over a period specified by the borrower; or as a credit line on which the homeowner can draw at her own discretion.

Repayment Requirements: Standard mortgages usually require periodic payments that reduce the balance, or at least cover the interest. Most are fully amortizing, meaning that the payments reduce the balance to zero over the term of the loan. Those that are not fully amortizing require that the balance be repaid in full at the end of the term, called a “balloon”, or after a specified period.
Reverse mortgages, in contrast, have no required payments, but borrowers are free to make voluntary payments to reduce their balance.

Debt Changes Over Time: On standard mortgages that require amortization, the debt outstanding gradually declines over time. On those that require only interest payments, the balance is constant until the date when fully amortizing payments begin, at which point the balance begins to decline. Standard mortgages on which the balance rises, referred to as “negative amortization loans”, disappeared after the financial crisis.
On reverse mortgages, in contrast, debt tends to rise over time as interest accrues, since there are no required payments.

The table below summarizes the major differences between HECM reverse mortgages and standard mortgages:

Characteristic HECM Reverse Mortgage Standard Mortgage
Purpose Provide spendable funds to existing homeowner of advanced age Facilitate purchase of a house
Eligibility Requirements
  1. Minimum age
  2. Equity in owner-occupied home
  3. Ability and willingness to pay property taxes and insurance
  1. Capacity to make required payment
  2. Capacity to make required down payment
  3. Acceptable credit record
Lender Protection Property collateral only Borrower's ability/willingness to repay Property collateral as backup
Loan Amount Determinants Equity in the property
Borrower's age
Property value
Borrower's income
Borrower's credit
Borrower's financial assets
Payout of Funds
  1. Cash withdrawal at outset, and/or
  2. Monthly payment, and/or
  3. Future draws under credit line
Withdrawal at outset used for home purchase
Repayment Requirements No periodic payments required
Balance due on death of borrower or permanent move-out
Monthly periodic payments usually required
Payments of balance outstanding ("balloon") may be required
Debt Changes Over Time Rises over time as interest accrues Declines over time from principal payments