What Is a Reverse Mortgage?
In short, a reverse mortgage is a loan. A homeowner who is 62 years of age or older and has a large amount of home equity can borrow based on the value of the home, and receive funds with a one-time, fixed monthly payment or credit line.
Unlike forward mortgages used to purchase houses, reverse mortgages do not require the homeowner to pay any loans. Instead, when the borrower dies, moves permanently, or sells the house, the entire loan balance will be due and repayable.
Federal regulations require the lender to arrange the structure of the transaction so that the loan amount does not exceed the value of the house, and if the loan balance is indeed greater than the value of the house, the borrower or the borrower’s estate will not be liable for the difference. One way this can happen is for the value of the home to fall, and the other is the long life span of the borrower.
The Cash in Equity
Reverse mortgages can provide much-needed cash to seniors whose net assets are primarily linked to the value of their homes. On the other hand, these loans can be expensive, complicated, and prone to fraud. This article will teach you how reverse mortgages work and how to protect yourself from pitfalls, so you can choose wisely whether it is right for you or your parents.
According to data from the American Reverse Mortgage Association, in the first quarter of 2019, homeowners aged 62 and over had home equity of $7.14 trillion. This figure set a record high since the measurement began in 2000, highlighting that the source of wealth and home equity applies to adults of retirement age.
Home equity is only available wealth when you sell the asset and reduce its value or borrow it. This is where reverse mortgages come into play, especially for retirees with limited income and few other assets.
How a Reverse Mortgage Works
For reverse mortgages, the lender will pay the homeowner instead of the homeowner paying the lender. The homeowner can choose how to collect this payment (we will explain the choice in the next section) and only pay interest on the proceeds received.
Interest is included in the loan balance, so the homeowner does not need to pay any fees in advance. The homeowner also retains the ownership of the house. During the loan term, the homeowner’s debt increases and the home equity decreases. Like forward mortgages, houses are collateral for reverse mortgages.
When the homeowner moves or dies, the proceeds from the sale of the house will flow to the lender to repay the principal, interest, mortgage insurance, and expenses of the reverse mortgage.
Any proceeds from the sale will exceed the borrowed portion and be sold to the homeowner (if still living) or the homeowner’s estate (if the homeowner dies). In some cases, the heir may choose to pay off the mortgage to keep the house.
Types of Reverse Mortgages
There are three types of reverse mortgages. The most common is the home equity conversion mortgage or HECM. HECM represents almost all mortgages offering homes worth less than $765,600, which is the type you are most likely to get, so this article will discuss this type.
However, if your home has a higher value, you can consider a giant reverse mortgage, also known as a proprietary reverse mortgage. When making a reverse mortgage, you can choose one of the following six methods to collect income:
- One-time payment: All the proceeds are obtained immediately after the loan is settled. This is the only option for a fixed interest rate. The other five have adjustable interest rates.
- Average monthly repayment (annuity): As long as at least one borrower is living in the house as the main residence, the lender will make a steady payment to the borrower. This is also called a tenure plan.
- Regular payment: The lender makes an average monthly payment to the borrower within a set period selected by the borrower (for example, 10 years).
- Line of credit: The homeowner can borrow money as needed. The homeowner only pays interest on the amount borrowed from the line of credit.
- Average monthly repayment amount and credit limit: As long as at least one borrower uses the house as the main residence, the lender provides a stable monthly repayment amount. If the borrower needs more money at any time, they can use the line of credit.
- Regular payment plus credit line: The lender provides the borrower with an equal monthly repayment within a set period chosen by the borrower (for example, 10 years). If the borrower needs more funds during or after that period, a line of credit can be used.
Would You Benefit From One?
A reverse mortgage sounds a lot like a home mortgage or a line of credit. In fact, similar to one of these loans, a reverse mortgage can provide a lump-sum or line of credit.
You can get a lump-sum or credit limit according to the number of houses you need to pay off and the market value of the house. However, unlike a home mortgage or line of credit, you do not need income or good credit qualifications to live, and you do not need to pay any loans if you use your home as your main residence.
Reverse mortgages are the only way to obtain home equity without selling the home to seniors who are unwilling to assume monthly loan obligations or are unable to qualify for home equity loans or refinancing due to limited cash flow or poverty credit.
If you are not eligible for any of these loans, what options are there for using home equity to fund your retirement fund? You can sell the house and reduce its size. You can also sell the house to your children or grandchildren to keep in the family. If you want to continue living in the house, you can even become their tenant.
There is only a one-time total reverse mortgage (with a fixed interest rate), which can provide you with all the proceeds immediately when the loan is closed. The interest rates for the other five options are adjustable, which makes sense because you have to borrow for many years instead of one at a time, and the interest rate is always changing.
Floating rate reverse mortgages are related to the London Interbank Offered Rate (LIBOR). In addition to one of the basic interest rates, the lender also added a margin of 1-3 percentage points. Therefore, if LIBOR is 2.5% and the lender’s margin is 2%, then your reverse mortgage interest rate will be 4.5%. As of January 2020, the lender’s profit margin is between 1.5% and 2.5%.
Interest will increase throughout the life of the reverse mortgage, and your credit score will not affect the reverse mortgage interest rate or eligibility.