A reverse mortgage is a relatively simply financing arrangement that allows elderly homeowners to remain in their home until they die or move and sell their property. For some borrowers, it allows for home repairs while an elderly resident remains in the home. This can mean less reliance on savings for emergencies or even day to day living.
The main reason a reverse mortgage can be confusing is that many people have never even heard of them. How does a mortgage go in reverse?
If they confuse you, I suggest you forget the name “reverse mortgage” just for a minute and consider the idea from the point of view of equity.
When you take out a loan to buy a home – generally called a mortgage – you usually borrow a substantial sum of money that is paid back in monthly installments over the course of 15, 20 or 30 years.
The lending company (usually the bank), of course, wants its money back. The amount they loan you is called the principle, while the profit they expect from you is paid in the form of a percentage of the loan, which is generally referred to as the interest on that principle.
So, if you borrow $100,000 at 5 percent interest over the course of 20 years, the bank will figure out your monthly payments for those entire 20 years based on a formula that leans heavily on paying the lender (the bank) interest on the loan first. This is because the lender does not want to be repaid the $100,000 up front with no profit in it for them – at which point the homeowner might just stop making payments. But, the lender does allow you to build up equity in the home, so a portion of your payment early in the payback years will go towards reducing the principle while most will go to paying the interest.
Over time that principle to interest ratio in your payments reverses itself. Eventually, as more and more of the interest is paid off, the amount that pays off principle increases.
Early payments on mortgages are mostly interest and a little principle while later payments are mostly principle and a little interest.
By paying down the principle that you borrowed, you build up more and more ownership of the house. The term for that is equity. If you have paid down half of that $100,000, then you own $50,000 in equity in the home – although the figure could change if home prices go up or down, because equity is a term that refers to market value.
In most cases, over the course of 20 or 30 years, the homeowners becomes the principle owner of the home, while the lender’s share shrinks. As the loan nears the end of the payment period, the homeowner will own 70 percent, 80 percent or 90 percent of the home or more. That’s a lot of money tied up in equity that homeowners cannot use, under normal circumstances, until they sell the home.
But, let’s say you don’t want to sell the home? You have $70,000 or $80,000 or $90,000 tied up in the home that you can’t use just at the same time that many people consider retiring, which will certainly reduce their income considerably.
Now that you are retired and growing older, you still may be healthy enough to remain in the home you have lived in for so long. For many reasons, you might want to stay, but find that your income now can no longer keep up with those monthly bills, including the remaining installments on your mortgage.
A reverse mortgage is a lender’s response to all this, allowing elderly residents to stay where they are. Since you have – let’s just pick a number – $65,000 in equity, a lender that handles reverse mortgages will offer you a loan based on that value.
Here’s where the term reverse mortgage comes into play. The lender will make payments to the resident, sometimes monthly to meet bills and sometimes in a lump sum to make needed home repairs. Now, the equity you have been building up over the years will go the other way. Now, instead of owning more on your home every month, you will own a little less.
Yes, a reverse mortgage is a type of loan, which means it comes with a cost, including smaller ownership of the home. This means you will have a smaller inheritance for your family members. But staying in the home is so important to an elderly resident’s quality of life and well-being that many families quickly see the sense in the arrangement.
There are three main types of reverse mortgages. These are the single-purpose reverse mortgage, the proprietary reverse mortgage and the federally-insured Home Equity Conversion Mortgage. They each have different pros and cons.
The single-purpose reverse mortgage is the least expensive, says the U.S. Federal Trade Commission. “They are offered by some states and local government agencies, as well as non-profit organizations, but they’re not available everywhere,” the FTC says on their Web site.
These are set up as one-purpose loans, generally for items like home repairs or to pay property taxes.
The proprietary reverse mortgages are private loans that are based on the market value of your home. As such, residents do well when the market value of their home has gone up. “If your home has a higher appraised value and you have a small mortgage, you might qualify for more funds,” the FTC says.
The final type is the HECM. These are insured by the U.S. Department of Housing and Urban Development and they can be used for any purpose.