At breakfast this morning my wife had a great question, “what is a reverse mortgage?”
We see them advertised all the time, with happy old people enjoying life because of their reverse mortgage. A mortgage is something that helps you buy a house, so what the heck does a reverse mortgage do?
A reverse mortgage is a financial product designed to let people borrow against their paid off home, such that they will never be forced to sell or leave it.
Ok, So How Does That Work?
A homeowner who owns their house outright would talk to a reverse mortgage lender. The lender would first ensure that the homeowner is old enough – there is a minimum age for getting a reverse mortgage typically – and that they must own their house outright.
The homeowner then can either: take money as a lump sum payment, get paid a monthly amount, or draw against the home equity as needed – much like a line of credit or a credit card. No payment needs to be made against this debt. At some point, the homeowner will hit the maximum debt called the principal limit. This will be between 30-65% of the value of the home. At this point, the homeowner can no longer borrow against it.
Since no payments are made against the debt, every month the interest gets added on to what is already owed. Often the reverse mortgage company will add a monthly fee to this payment, as well as fees when the reverse mortgage is first set up. This can eventually exceed the principal limit and may exceed the value of the home itself.
Despite the amount of debt, the homeowner is allowed to continue living there. This is the biggest selling point of a reverse mortgage – you never get kicked out of your house.
Eventually, the homeowner will move, sell, or die. Any of these events trigger repayment of the debt. If there is still equity in the house after the mortgage is repaid, the homeowner (or their estate or beneficiary) gets it. Typically if the reverse mortgage amount exceeds the value of the house, the excess is forgiven, this is a big part of why companies will only provide these to homeowners above a certain age and have the principal limit.
Who Should Get A Reverse Mortgage?
This product is primarily for someone who has a paid-off house, hasn’t saved enough for their retirement, but still wants to live in their home. It lets them use equity from the house, hopefully for living expenses, without being forced to sell.
To a degree this is a form of being “house poor”, and it would be a better situation if they had the income to cover their expenses without having to use their home equity. At the point where someone is considering a reverse mortgage, it is probably too late to change their financial situation.
Any Other Alternatives?
A home equity line of credit functions similarly to a reverse mortgage. The 2 disadvantages are that every month there will be a monthly minimum repayment amount and it’s possible that your house could be foreclosed on if the balance gets too high. One way around the minimum repayment amount is that you can just withdraw extra money from the line of credit, then deposit the minimum back into the account.
Another option is to take out a traditional mortgage. This would involve a lump sum of money, rather than being able to draw against your house over time. As long as the homeowner was comfortable managing this lump sum of money – and make sure that the mortgage payments would be made, this could have lower fees than reverse mortgages.
The best alternative, in my opinion, is for the homeowner to downsize. Sell their home and either rent or buy a cheaper property. If their house was big enough for a family and now there is just a couple living there – or a single person – I think the smart choice would be to move. If you really want to benefit from this, move to an area with a lower cost of living and stretch the sale of your property even further.
Is This Thing A Good Idea?
Reverse mortgages typically have high fees, both during the origination and during the monthly payments which make them a bit of a bummer. They are fairly sophisticated financial instruments, and it’s important that people understand what they’re getting into when they take one out.
Some people don’t understand (or claim they didn’t understand) that at the end of the process YOU LOSE YOUR HOUSE! I don’t know why they thought the nice company was giving them money all along, but there have been situations where elderly homeowners had a reverse mortgage and promised the house to a child, who was then surprised and angry that the house was taken away by the company who provided the reverse mortgage. The people selling reverse mortgages will sometimes let a customer misunderstand to make the sale. There was a sad news story about a widow in California who was fighting to keep her house after misunderstanding a reverse mortgage.
Compounding is tons of fun when you’re accumulating assets and you see the rate of growth increasing the value. It’s a lot less fun when you have a debt that is compounding and growing. It would be a downer to me seeing my equity getting devoured every month by a reverse mortgage, but for people who haven’t planned their retirements carefully, it may be the best of their bad options.
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Have you, or do you know anyone who has, gotten a reverse mortgage? What was the experience like? Any regrets?