photo credit: LordFerguson
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.
In future posts, I will discuss advantages of a reverse mortgage, disadvantages of a reverse mortgage, and conclude with a summary post, including my recommendations.
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.
Concluding thoughts
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?
This post has been included in the following Carnivals:
Baby Boomers Blog Carnival hosted by Baby Boomers US
When my mother-in-law passed away a few years ago the loss of her social security income left my father-in-law without enough income to live comfortably.
They owned a 3-bedroom home free and clear with a large amount of equity so he took out a reverse mortgage.
I think financially, it would have been better for him to downsize to a condo and then supplement his income from the excess equity.
Bucksome,
That is what makes this entire reverse mortgage discussion so exasperating. Sometimes the best financial solution isn’t the best for the individuals involved. For example, if living in the family home was extremely important to your father-in-law, then, for him, the reverse mortgage was probably the right decision. I hope it worked out all right for him.
I am curious: did he fully understand what he was getting into? Were there any surprises?
Joe, I think you hit the nail on the head. Even though the home is really too big for him and requires a lot of maintenance he wanted to stay in the home they’ve lived in for over 45 years.
I think he didn’t understand how expensive it would be. He also thought the equity in his house would continue to rise and of course it’s gone down significantly (we’re in California).
I am learning not to bank on equity. We bought our home four years ago, at that time it was increasing in equity at about a 5% per year clip. Now? It is back to the exact amount we sold it for- doh! If I was 80 and needed some cash- i would think about it. But I hate to see any program that targets senior citizens that is not in their best interest for the most part. Desperate times call for desperate measures I guess.
@Bucksome,
Thanks for filling in some gaps. Yes, reverse mortgages are expensive and I wonder how many senior citizens really understand just how expensive. Looking back, if he had sold the house before the equity plummeted, he would have been better off, but so would anyone who had considered selling at that time. Like I said before, I hope the RM worked out for him.
@Ted,
It used to be that homeowners took it for granted that their houses would go up in value. Of course that is not holding true right now, so you are wise to not “bank on equity”. Still, you are getting something for your money…a place to live. Hopefully, the market will rebound. But who knows?
I have more to write on reverse mortgages, so I don’t want to tip my hand just yet about programs that “target senior citizens that is not in their best interest.” I appreciate your view point though.
Very comprehensive and well written blog and you discus on very important point which is really beneficial for senior person..