A great financial principle is “Don’t buy anything you don’t understand."
If everyone lived by that adage, I have a hunch that very few reverse mortgages would be sold. Regular mortgages are confounding enough without being challenged to think in reverse. Just the term “payment" in a reverse mortgage can mystify the most savvy among us. The lender makes payments to the borrower and the borrower makes payments to the lender. Yet, we are told, the borrower needs not pay a penny as long as the home is his primary residence. See what I mean?
In this post (the first in a series of four), my goal is to demystify reverse mortgages by explaining the basics of how they work.
What is a Reverse Mortgage?
A reverse mortgage, as the name implies, is the opposite of a traditional mortgage. With a traditional mortgage, the borrower builds equity in his house by paying down a loan taken against the house. With a reverse mortgage, the borrower gives up home equity in exchange for payments from the lender.
Essential facts of reverse mortgages
- The home owner must be at least 62 years old to qualify for a reverse mortgage.
- The home must have substantial equity.
- Credit scores are irrelevant.
- Any previous mortgage will be paid off by the reverse mortgage.
- You can receive your payments by lump sum, monthly payments, line of credit or any combination.
- The borrower retains the title on the house, meaning that he is responsible for all taxes, insurance and maintenance
Understanding borrower payments
“What payments?" you ask, “I was told that the borrower is not required to make payments as long as he lives in the house."
You are right…sort of. A reverse mortgage does not require the borrower to come up with the cash to pay back the loan, but he is nevertheless making payments. How? With the equity of his house.
Still confused? Think of it this way: every “payment" the borrower makes reduces his equity by that amount. The less equity the borrower has in the house, the more the lender has. While the borrower is getting paid with cash, the lender is getting paid with equity.
What kinds of payments does the borrower make?
- Mortgage insurance premiums.
This insurance pays for a loss to the lender in case the home is worth less than the amount owed at the end of the loan.
- Monthly lenders’ fees.
Lenders typically charge borrowers a monthly fee (sometimes called “service fees") for disbursing the payments.
- Loan points and/or origination fee.
Upfront fees which will increase the lender’s return on investment.
- Normal closing costs.
Might include appraisal, title search, escrow, legal fees, recording fees, etc.
These fees are normally rolled into the loan, meaning that the equity in the house drops with each fee. Of course all upfront expenses immediately come out of the homeowner’s equity. For example, if the homeowner’s equity is $275,000 before closing, it will drop that day by the closing costs associated with the loan. A sample report on Wells Fargo site showed $5,500 origination fee and $2,080 closing costs, a total of $7,580 transfer in equity from the homeowner to the lender upon closing.
These fees and all ensuing fees, along with cash payments to the homeowner, will be gathering compound interest charges for the duration of the loan. The interest charges, of course, are paid by the borrower to the lender via transfer of equity in the house.
A reverse mortgage is a way to get cash payouts in exchange for the equity in your house. You can receive this cash in a variety of ways. Your loss in equity is your payment for this cash, so you will be charged compound interest for these payments and all associated fees.
Have you been considering a reverse mortgage? Have your parents? Check for upcoming posts on advantages, disadvantages, and summary of reverse mortgages.
Learn more about Reverse Mortgages – these links will help:
Have you or any of your family members had a reverse mortgage? Did you understand it? Any surprises? Would you recommend it to others?
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