With a standard "forward" mortgage, a buyer borrows money to be used to purchase a home. It is also known as a "declining debt" loan. The loan amount is equal to the purchase price minus any down payment. At the onset, the down payment represents the total equity the owner has in the home. Amortized monthly payments made to the lender consist of both interest and principle. As the principle is paid down, the owner's equity rises. It also increases as the property appreciates over time. The loan amount declines while equity increases. When the final payment is made, the loan balance is zero and the owner's equity equals the current value of the home.
Just as when you look into a mirror, your right hand appears to be your left hand, a "reverse" mortgage is a mirror image of a forward mortgage. In the beginning, the homeowner has equity. This equity is used to get cash. With a reverse mortgage, the owner makes no payments. Interest accrues to the balance of the note. This is why reverse mortgages are also known as "rising debt" loans. The loan is repaid when the house is sold or the homeowner dies. Any sale proceeds in excess of the loan balance go to the owner or owner's estate.
With either type of loan, the borrower maintains title to the property.
The proceeds of a reverse mortgage are typically received as periodic payments, but can also be received in a lump sum or as a credit line against which the owner may draw as needed. Proceeds may be used for any purpose. They are commonly used to pay off an existing mortgage, to fund home repairs, to pay for long term care insurance, or to pay off debts. The loan balance increases with each cash payment to the homeowner and as interest accrues. Unlike a forward mortgage where income is a key determiner for approval, a reverse mortgage approval depends on the amount of equity and the owner's age. The older you are (you must be at least 62) and the more equity you have, the more cash you can get. Since the owner makes no payments, income is not required.
The loan amount can never exceed the value of the home. The home's value represents a non-recourse limit. The lender cannot take recourse against the owner or the owner's heirs for any deficiency that results when the sale price is less than the loan balance. With a reverse mortgage, the declining equity may be partially or totally offset by appreciation in the property's value. Monthly loan advance - $1,000iginal home value - $200,000
Why is the mortgage industry likely to exploit the reverse mortgage market? There are trillions of dollars locked up in homeowner equity and an aging population. Unlike subprime mortgages whose risks become apparent during the initial years of the life of the loan, reverse mortgage risk is back-ended. Risk becomes evident only later in the loan's life when the loan balance approximates the property's value.
Notes of caution:
- Beware of efforts to sell reverse mortgages for the sole purpose of buying another financial vehicle. In one case a salesman talked an 80-year-old lady into getting a reverse mortgage to fund a deferred annuity. Annuities typically provide the seller with a high commission but may not make payments for years. She would have had to wait until her 100th birthday to see a cent of her money.
- Loan costs are high. AARP reports that a 74 year-old borrower with a $300,000 home (equity) would pay about $30,000 in fees. This is likely to come down as more competitors enter the market.
As with any major financial decision, be informed, ask questions, and seek qualified advice. And educate your parents.
Toby Tobin is a real estate commentator and Publisher of GoToby.com, the popular real estate news, information, and analysis website for the City of Palm Coast, Flagler County and Northeast Florida