How Does a Reverse Mortgage Work
Understanding how does a reverse mortgage work.
The way a reverse mortgage works is by allowing you to use the equity in your home as a way to supplement your retirement income. There are no payments that need to be made, and you can never be thrown out of your home.
The thing to keep in mind is that a reverse mortgage is just a loan, and you are using your home as collateral. It works exactly the same as a conventional mortgage. You own the home and you are just using it as security for the loan.
The biggest difference when you are looking at how does a reverse mortgage work is that you will not have to make any payments on the loan. It is a pretty big difference, but it is the only one that really matters.The lender is required to lend you the money, and then you pay it back only upon no longer living in the home. If there are two borrowers, then after both are gone, the loan needs to be repaid. One passing away or moving into a higher care facility does not have any bearing on the loan.
In the event your home appreciates in value, then you could do a refinance and get additional funds. Of course there needs to be sufficient equity, but over the years, we have seen people do it.
So to recap some points across this site, you will notice that you get to keep the home, and you don’t have to make any payments on that loan. The reason the lender is willing to make a loan like this is because they earn compound interest. The text below will go into greater definition of how that works.
This is going to get into some of the math required to understand how a reverse mortgage works. If you are looking for more basic reverse mortgage information, go back and read that first.
Reverse mortgages allow for you to borrow on the equity of your home and not make any monthly payments. Why would any lender do this? It is not a trick or scam. It is basic math called compound interest. Everyone loves earning compound interest, but what happens when you pay it? Let me give you an example using $100,000 as the loan amount on your reverse mortgage. We will use the current interest rate of 5.56% fixed.
Doing the math on how does a reverse mortgage work.
Please keep in mind that the rates on this page are from the 2010 time frame and rates have changed quite a bit. To get current reverse mortgage interest rates, please click the link.
$100,000 after 1 year at 5.56% interest = $5,560 in interest owed to the lender. since you don’t make any payments, the lender will add that amount to your loan amount. Now you owe the lender $105,560.
$105,560 after one more year at 5.56% interest = $5,869.14 in interest owed to the lender. you will notice that the amount of interest that you owe on year 2 is a little more than year one. This is because the lender earned interest on the interest. This is compound interest. Earning interest on interest. If you ever had a savings account or retirement account, you have earned it. Now instead, the lender is loaning to you and charging the compounding interest.
Phew, we made it through the math. Now you might be thinking what happens as this interest is accruing and compounding and using up my equity? Will I run out of equity and get kicked out of my home? The answer is no. This is one of many reverse mortgage misconceptions. Reverse mortgages are designed to allow you to live there for as many years as you are able. No one can kick you out because of what you owe them. Not only that, but the banks don’t want to. Remember they are earning (compound) interest, and they are willing to wait to get paid.
Let me make one thing clear here, you do not actually pay any payments. You do accrue interest, but there is no monthly payment options.
What about the heirs?
So what happens if you need to sell or your heirs have inherited the home and they plan on selling it? There is nothing different about a reverse mortgage than any other mortgage. Take the amount you borrowed, add the interest owed (and any other fees) and that’s what will need to be paid back to the lender. In the above example, that would mean you need to pay back $111,429.
Now, if several years have passed and the balance owing is more than the home is worth, I have great news. One of the fees you paid, called mortgage insurance, covers you. You (or your heirs) only have to pay back an amount equal to the market value at the time of the sale. Now there are some exceptions to this, but as long as it is a legitimate sale, you won’t have to worry.