The reverse mortgage is a taboo financial product. Dave Ramsey calls them a scam. They are confusing and prone to abuse. However, academic research supports their responsible use.
In this blog, we will explore how a reverse mortgage works, hopefully bringing clarity to this complex product.
The purpose of a reverse mortgage is to allow senior homeowners to access the equity in their house. Unlike a traditional mortgage, you don’t have to make payments on your reverse mortgage loan. While you’re able to pay back a reverse mortgage any time, the loan will ultimately be due once you no longer live in the house.
Who can get a reverse mortgage?
Homeowners 62 years and older are eligible. Additionally, a reverse mortgage can only be taken out on a primary residence. Vacation and investment homes are not eligible.
Similarly, there must be equity in the home. Your house doesn’t need to be free and clear, however—existing mortgages may be able to be financed into the reverse mortgage.
Finally, you must have the resources to cover future maintenance costs, property taxes, and homeowner’s insurance. A bank would have to foreclose on the house if these aren’t being paid.
How does it work?
The most common way to use a reverse mortgage is through a line of credit. The size of the line of credit is dependent on:
- The age of the youngest borrower
- Current interest rates
- Value of the house
- Amount of any existing loans that need to be paid off (if any)
Older borrows can get a higher loan amount. Likewise, lower interest rates support higher loan amounts.Using a sample calculator, a 62-year-old homeowner with a paid-off house worth $350,000 can get a $164,500 line of credit (1.81% 10-year LIBOR, 2.25% lender’s margin, $3,750 loan origination fee).
If this borrower takes out money from the line of credit, the loan balance will increase over time by a rate that is determined by future interest rates, the lender’s margin, and a small insurance premium percentage (0.5% in this example).
What’s important to understand is that this borrower does not have to “use” the line of credit. This can be kept in reserve. This unused line of credit will not only be available, but will actually grow, the longer it’s unused.
If interest rates stay the same in the example above, the line of credit in 20 years will increase to just over $400,000.
Paying off a reverse mortgage.
If this homeowner takes money from the line of credit, he’s not required to make payments, but he can choose to make them. This will decrease the outstanding loan amount and give him more funds available to take out of the line of credit later.
The loan is ultimately due when the borrower no longer lives in the house. If he moves, he’ll have to pay off the loan. Likewise, if he passes away, his heirs will decide what they want to do (get a mortgage in their names if they want to keep the house, pay off the loan, or use the house to pay off the loan).
A benefit to a reverse mortgage is that it’s a nonrecourse loan. This means the bank can’t go after other assets of the estate or heirs to satisfy the loan. If the value of loan somehow exceeds the value of the house, it doesn’t matter! The house will satisfy the bank.
Reverse mortgages tend to fall into the “black and white” category of finance. Either they are oversold, or people consider them a scam. But so much of personal finance falls into the grey area. Reverse mortgages aren’t for everyone! Don’t discount them because of what you’ve heard. Consider reverse mortgages on their own merit.