What is a Reverse Mortgage and How Does it Work

A reverse mortgage is a financial instrument that allows homeowners to access some of the equity in their home.  For most people, their house is going to be their biggest financial asset.  For these people, they will need to be able to access the equity at some point during their retirement.  They have a few options with selling, taking out a second mortgage or a reverse mortgage is the most used.  The last two are very similar.  A reverse mortgage is essentially a different form of a second mortgage with a few key differences.

mortgageThe pro of a mortgage over selling is you can achieve the goal of unlocking the equity of your house without having to sell.

Now just looking at the two mortgage options.  If you have a regular mortgage, they bank loans your money and you pay them back with fixed payments.  Using a reverse mortgage you do not have to pay anything until you sell your house or you die.  So, in its simplest terms, a fixed mortgage is a mortgage where you do not have to make payments until an event happens.

 

How it works

The bank will allow you to borrow up to a certain amount of the equity in your house.  A quick search and 40% came up.  You can go to the bank and receive a lump sum of 40% of the equity in your house (say you needed to make a repair to your house) or payments over the next x amount of periods until you reach 40% of the equity (this would benefit retirees that need a monthly income).

If you do not pay it back beforehand, if you sell your house then you will pay the bank back they loan amount plus interest.  If you stay in your home then when you die the amount that you owe, loan amount plus interest, gets taken out of your estate.  Your house may be needed to be sold at that point if your other assets do not cover what you owe to the bank.

 

What’s in it for the lender?

 

The lender gets interest!  Their liability is very limited.  Because they only allow you to take 40% of the equity, the remaining 60% acts as collateral for the interest accumulated over the years.  The only risk they carry is if home prices go down.  In that case, the value of the asset (the home) could depreciate and be worth less than the value of the loan plus interest.

Example

Say someone full owns their home and it is worth one million dollars and they need money for retirement.  They borrow $400k at a rate of 10% using a reverse mortgage.  The $400k will cover their expenses for the remainder of their retirement.  Let’s say they live for 10 years.  Upon their death, their estate would owe $1,037,496.98.  The $400k principal plus the interest.