How Does A Reverse Mortgage Work?

Reverse mortgages work by permitting a borrower to take out money with no immediate requirement for repayment (the house is offered as security for the reverse mortgage lender’s loan).

There is nothing particularly unique about a reverse mortgage that separates it from other real estate transactions except for the fact that the date upon which the bank collects repayment is less definite than traditional loans that involve real estate.

Typically, these types of mortgages come with three variations. Some lenders provide borrowers with an immediate lump sum payment, others provide smaller lump-sum payments in a manner that mimic a home equity line of credit, and the third option—which is most recently discussed, involves a lender paying the borrower a fixed monthly income.

In my view, it would be a disaster to ever consider the first two options. If you reach a point in life where taking out a reverse mortgage is your most rational option, it is a signal that the sum of your life decisions to that point have not led to the accumulation of significant capital. This is not immoral, or an insight that I offer with any sense of judgment, but it is how I assess the prospect of borrowing a six-figure sum from your house at a late age in life because you have no other financial options.

The most rational option, particularly for someone who purchased a home in a house commensurate with your income and saw that home value appreciate significantly throughout their life, is the fixed monthly option. If your medical expenses and/or other expenses exceed your monthly cash flow without a reverse mortgage, I can understand why taking out a loan against your home late in life is the most rational course of conduct even if it is emotionally painful.

So how does a reverse mortgage work from the perspective of a lender? Well, the lenders protect themselves in a variety of ways to make sure that they are going to make a significant profit.

First, they limit the pool of applicants to only those that that either own their home outright or have a significant amount of equity in their home. This guarantees the lender will be able to have something of value that will ensure repayment.

If you have $350,000 appraised that you own without any liens or mortgages against it, a lender wouldn’t hesitate to give you a loan in the amount of $1,000 plus interest. If you live in it for twenty years at an 8% interest rate, the bank would have a $589,000 claim against your property (this hypothetical is simplistic in that it assumes a fixed interest rate throughout, and the fixed monthly payment typically carry a variable interest rate). If your home appreciated at a rate of 3.5% annually over that time, it would be worth $704,000 at the end of the twenty-year period. The bank would collect the $589,000, and the remaining $115,000 would belong to your estate.

A similar analysis could occur if you still had a mortgage or some other lien against your home before applying for the reverse mortgage. If you have a $250,000 property with a $60,000 mortgage remaining, a bank may be interested in letting you borrow $750 per month because once that first mortgage is paid off, there is still a lot of remaining value in the home that they can be confident they’d be able to reach upon payment time.

On the other hand, if you owe $175,000 on a pre-existing mortgage on a $220,000 home, you’re not going to be eligible for a reverse mortgage because the prospect of reaching that value is too attenuated. A downturn in the housing market, or issues paying your pre-existing mortgage, would make the property unattractive from the lender’s perspective because there is not enough collateral to support the loan.

Secondly, they charge substantial fees (in the thousands of dollars) to execute the loan, and it is not unusual for the interest rates on the loan to be in the 8-12% range (though some consumer conscious states are passing laws that limit the interest rate on reverse mortgage to no more than five percentage points above the then-existing prime rate. So if the prime rate is 4.25%, those states limit the lenders to a ceiling of either charging 9.25% as a maximum interest rate and if they conclude that the borrower’s risk demands a higher interest rate than that, they must deny the loan.)

And thirdly, the triggering events that enable the mortgage lending back to collect are highly favorable. Typically, the balance on a reverse mortgage becomes due in full if: (1) the home that is offered as collateral for the loan is sold; (2) the home is no longer the borrower’s principal place of business, e.g. the borrower moves into a nursing home; or (3) the borrower dies.

The execution of this type of mortgage creates a lien against your house that dramatically limits your flexibility because of this immediate payment factor. When this immediate payment factor is triggered, you or your beneficiaries/heirs have the choice to either come up with the cash payment in full or to watch the lender sell the property and take their share of the proceeds.

The upside of this is that a triggering event that occurs early in the loan’s life will still entitle you or your heirs to a significant amount of the proceeds.

Assume that you own a $300,000 home outright and take out a reverse mortgage for fixed monthly payments of $1,200 per month at an interest rate of 8%. After receiving proceeds for three years, you die. At this point, your estate owes the lender $48,600. Your heirs/beneficiaries will be promptly confronted with a choice. They can either pay the lender $48,600, have the lien/mortgage removed, and then take ownership of the house, or, if they do not elect this option, the lender will execute upon their lien/mortgage and have the home sold.

Assuming modest appreciation, let’s say the home sells for $315,000. The lender would take the $48,600, and the remaining $266,400 would go towards the estate. When people say that taking out a reverse mortgage means that you will lose your home when you die, they are making some implicit assumptions. They are assuming that you do not go to a nursing home or otherwise sell the property, and they are assuming that you live another 15-25 years after the loan is taken out such that the amount owed to the lender is so substantial that it effectively exhausts the property’s full value.

On the other hand, the popular advertisements that promise you guaranteed income for life is also misleading. In some states, a bare-bones reverse mortgage will entitle the lender to foreclose upon the home in the event that the amount due on the loan exceeds the appraised value of the home. Theoretically, it is possible that a borrower could live thirty years, there could be a real estate financial crisis or the home could be located in an area that does not appreciate with time or even depreciates, and the lender could have the right to stop making monthly payments to you and foreclose upon the home.

Because of the extreme unattractiveness of this possibility, 39 out of 50 U.S. states require that the lender give the borrower a statement stating that counseling and independent consultation about the wisdom of taking out a reverse mortgage should be considered before applying for the loan, and a borrower has to sign a statement confirming that the lender has provided them with this information.

If the reverse mortgage is affiliated with the U.S. Department of Housing and Urban Development (HUD), then there will be an insurance component to transaction. In exchange for paying a $2,000-$5,000 upfront, plus having $25-$125 per month be included in the calculations in addition to interest, a borrower can receive insurance against the possibility of receiving funds that exceed the value of their home. There are also private insurers that provide this option for non-HUD borrowers.

Under a HUD or private insurer scenario, there is no risk for the borrower of outliving their homes. In this case, the loan continues to accrue and, upon a triggering event such as death, the lender is able to take the house and sell it. If it doesn’t fully recapture the value of the outstanding loan balance, then they turn to the insurer for compensation rather than your estate.

The misleading aspect of reverse mortgage commercials is that they pretend there are certain types of loans that prevent the borrower from getting kicked out of their home. But it is not the loan that triggers this, but rather, the entry of an insurer into the equation that affirmatively agrees to pay in the event that the borrower outlives the moment when the loan balance exceeds the appraisal value of the home.

But you must either take out a mortgage that requires such an insurer, or you must demand that one join in the transaction. Otherwise, there is nothing that guarantees that you get to live in your home until you die.

Because it is a loan—you either have to pay it back or forfeit a portion of the proceeds from your property until you pay it back—the monthly income you receive are legally regarded as loan advances and are not taxable and do not affect your Social Security benefits. It could affect the calculation of your available resources that determine your Medicaid eligibility. In some states, you are required to spend the proceeds that your reverse mortgage lender advances you in the calendar month in which the advance was made.

If you receive the funds on the 1st of May, you have to spend them by May 31st otherwise your state has the authority to modify or deny your eligibility for Medicaid. States that put this requirement on borrowers have different provisions for what happens if you receive your payment towards the end of the month (though, as a practical matter, nearly every lender provides the borrower with proceeds between the 1st and the 5th of the month.)

The lump sum reverse mortgage option, as well as the options that exclude insurance in the event that the borrower receives more money than the value of their home, seem like a recipe for trouble. If someone has minimal resources late in life, and cannot cover medical expenses, such a mortgage can make sense if they elect the fixed monthly option and have it insured. If you can’t pay your bills late in life, and aren’t able to work or find another source of income, the fixed monthly insured reverse mortgage is one of the few ways to get your hands on regular cash flow.

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