A reverse mortgage is another financial instrument at a disposal of people to withdraw and use their home equity today. I already wrote about other ways to withdraw and use home equity here: Investing with your home equity. 4 ways to withdraw home equity from your property.
A reverse mortgage in some sense is resembling a HELOC. As with HELOC, it is a loan secured against the value of your home. As with HELOC, you tap into the home equity that you have in your property. The bank gives you money today that you have to repay later. There is only one key difference: you actually don't have to repay this money or the interest that it accrued until you decide to sell this property or all homeowners for this property die. Sounds unnerving. But let's examine it closer.
Home equity is the portion of your home that you’ve paid off plus any increase in its market value over time. In other words, it is the difference between what your property is worth and how much you still owe on your mortgage.
What is a reverse mortgage?
A Reverse Mortgage is a type of interest accruing mortgage that is typically provided to seniors. Different lenders that work with Reverse Mortgages will have different minimum ages for approval, but usually, you can get approved when you are 50-55 years old.
When you take a reverse mortgage, the lender will give you one of the following plans:
A Fixed-Rate Payment Plan. A lump-sum cash amount that equals a portion of your home equity (usually 55 to 60%).
Tenure Payment Plan: A monthly cash flow until the borrower decides to sell the property or all property owners pass away.
Term Payment Plan: A monthly cash flow for a set term (e.g. 10 years).
Line-of-Credit (LOC): You are given a line of credit that you can access anytime withdrawing money only when you need it.
Let's look at the example of the Fixed-Rate Payment Plan, which is the most common type of reverse mortgage.
Let's say you bought a home 25 years ago at $150,000. Today, this property is worth $500,000 in the open market. In the past 25 years, you paid off your mortgage completely. Thus, the amount you can get is 55% * $500,000 = $275,000. If you still have an outstanding mortgage, you would have to reduce the $500,000 by that mortgage amount, and then take the 55%. Over time, the money that you get in the reverse mortgage accumulates interest that eats into the remaining equity of your home.
Below are the answers to some of the frequently asked questions about a reverse mortgage:
You’ll maintain ownership and control of your home without the obligation to make regular mortgage payments until you move or sell.
You are free to do whatever you want with the cash you received, be it investing, renovations, spending on daily needs, or investing in a business.
In most financial institutions that offer reverse mortgages, this type of loan is a non-recourse loan, meaning that the borrower will never owe more than the home is worth. However, the borrower has an obligation is to ensure that the borrower pays property taxes, home insurance and that the property is well maintained.
The money that you get accrues interest. However, you don't have to repay the loan or the interest until you decide to sell the property or the last homeowner of the property passes away. At the moment of sale, you would have to repay the owned money (the original borrowed amount and any accrued interest). In case of the death of the last homeowner, it would be on relatives to do the same before they can take possession of the property. They can repay the outstanding amount either in cash or by selling the property.
Any appreciation of the value of your home goes to the borrower. With a reverse mortgage, you are must only pay the amount you borrowed and the interest on the amount borrowed.
When the borrower(s) pass away, the heirs will be responsible for the repayment of the reverse mortgage. Typically, the heirs would make the choice to sell the property in order to repay the Reverse Mortgage amount.
Before we talk about the benefits of a reverse mortgage let's look at its cons and risks (you likely have a couple in your mind).
Risks of a Fixed-Rate Payment Reversed Mortgage
❑ Reduced Equity. This mortgage may reduce in part or in whole the amount of equity remaining to be passed into the estate. In addition, the potential of reduced equity may be an issue if the homeowner decides to sell the property during his or her lifetime. On a positive note, most lenders will not increase your debt over the price of the house.
❑ Higher interest rates. Watch out for interest rates. Lenders usually charge higher interest rates on reverse mortgages than on usual mortgages. Given the compounding effect of the interest, you may exhaust the full equity of your home in a matter of 15 years.
❑ The issue with relatives. Leaving less equity for your heirs which they might not be happy about. In fact, you may end up leaving any equity from your property.
❑ Having received a lump sum, there is a chance that you run out of that money. With no proper planning, the borrower will not only have trouble paying living expenses but might end up in foreclosure. That is because continuing to pay homeowner’s insurance and property taxes—and keeping the home in good repair—are all conditions of being able to continue to have a reverse mortgage.
❑ Taking out a lump sum also puts reverse mortgage borrowers at greater risk of being scammed, as the large sum they’ve borrowed is an attractive target for thieves—or greedy relatives.
Benefits a Reversed Mortgage
❑ Cash Flow. As opposed to HELOC or a home equity loan, the Reverse Mortgage has no impact on the borrower’s cash flow.
❑ Repayment. Since the Reverse Mortgage is not due until the death of the remaining homeowner or the sale of the property, the borrower never has to repay the debt in his or her lifetime.
❑ The lump-sum money you get is tax-free.
❑ The lump-sum money may be invested to generate constant cash flow.
❑ A reverse mortgage is suitable for seniors looking to enhance their lifestyle, renovate their homes, or pay off their debts without having to use their savings.
Now, since we discussed the risks of the Fixed-Rate Payment reversed mortgage, you might think that the risks outweigh the benefits. Indeed, some of the risks are quite sizeable. However, the other types of reverse mortgages that we listed above can help mitigate some of those risks.
Tenure Payment Plan that provides a monthly cash flow until the borrower sells the property or passes away mitigates some of the risks with lack of planning your finances, risks of scam and relatives asking for money.
Term Payment Plan with a monthly cash flow for a set term adds another benefit to the above list. You can define when you want to stop draining your equity.
Line-of-Credit (LOC) allows for more control over your expenditures. You can access the loan only when you need it and limit the borrowed amount to your actual needs. This provides more control over the erosion of equity in your home.
To summarize, in any reverse mortgage type of engagement with the lender you have to be aware of the risk of draining the equity of your property, often to zero.
The other key risk that you have to keep in mind is making sure the money you get in a reverse mortgage is indeed enough for living. While a lump-sum payment or monthly payment may look like a lot, you have to factor in inflation and your life expectancy. To combat this risk you have to come up with a financial plan to prolong the time you will use the money. This can be done by either investing the cash into safe investments that provide stable cash flow or buying an annuity. Also, you should expect that with average inflation of 3% the money you get today will buy half of what you can buy today in 20 years.
However, if you are OK with the idea of not leaving a fully-owned property to your heirs and do need extra cash to support your happy retirement lifestyle, the reverse mortgage is a great solution. It can provide a good level of extra cash flow on top of your pension to allow better life. The key benefit here is that even when the equity of your home is fully utilized, you still don't have to pay a cent.