This article focuses on explaining the basics of how does a reverse mortgages work. If you are looking for more detailed information about reverse mortgages, try: Who Qualifies for a Reverse Mortgage, Is a Reverse Mortgage Right for You or A Complete Guide to Reverse Mortgage Rates and Fees.
Let’s Start the Explanation of How Does a Reverse Mortgage Work by Defining Some Important Concepts
Home Equity: Home equity is the amount you could sell your home for today minus the amount you still owe to the bank for your mortgage, second mortgage or any other liens (loans) on your home.
So, if your home could sell for $250,000 today and you owe the bank $50,000, then you have $200,000 in home equity.
Your home equity can grow in two ways:
- 1) By paying down your mortgage so that you owe less to the bank and own more of your home, and
- 2) By seeing the value of your home increase in value so that it is worth more than you originally paid.
Mortgage: A home mortgage is a legal agreement that uses the home as collateral for a loan. Since most people do not have enough money in cash to buy a home outright, they borrow the money from a bank and pay interest on the money – these loans are called mortgages.
When you agree to a mortgage, you agree to a set of provisions about how much you will pay the bank monthly. Your monthly payments are usually set by a formula that takes into consideration:
- Loan Amount
- The amount you are borrowing from the bank.
- Interest is the money the borrower pays to a lender for the privilege of using the lender’s money.
- Interest Rate
- The interest rate defines how much interest the borrower will pay to the lender and is usually expressed as an annual percentage of the loan amount. So if you borrow $100,000 at a 10% interest rate, you would pay the lender $10,000 in interest in the first year of the loan.
- The amount of time it will take you to pay back the loan to the bank, including the interest. With a 30 year term, you will pay more interest at usually a lower monthly payment. A shorter term – like a 15-year term – generally means a higher monthly payment, but less money will be spent on interest since the loan will be paid off in a shorter time period.
Home Equity Line of Credit: If you have built up home equity in your home, you can sometimes work with the bank to establish a line of credit – money that is available for you to withdraw and use. You do not pay interest on the money available to you – only on the funds that you withdraw.
How Does a Reverse Mortgage Work Compared to a Traditional Mortgage?
When you buy a home with a traditional mortgage, you own, get to live in and use your home while:
- Paying down the amount you owe on your mortgage to the bank
- Paying interest to the bank
- Paying taxes, insurance, and maintenance on your home.
- Hopefully seeing the value of your home grow
When you get a reverse mortgage on your home, you also own, get to live in and use your home while:
- Immediately paying off your traditional mortgage (if applicable) with the reverse mortgage and thereby eliminating ongoing monthly mortgage payments
- If you have adequate home equity, you can also access money to use in any way you want. Some borrowers want the money for added security, paying medical bills, funding in home care, improving their lifestyle. Money can be used on anything important to you. This money can be made available to you as cash or in a line of credit.
- You accumulate the amount of interest you owe. There are no monthly interest payments on a reverse mortgage, but interest is charged and added to the balance of your reverse mortgage loan – so the amount of the loan grows over time instead of getting paid down. However:
- You only pay interest on the amount you actually use (the money to pay off your traditional mortgage or cash you withdraw) not on money available to you in a line of credit.
- Even though the loan will grow over time, the amount you owe on the Reverse Mortgage will never be more than 95% of the appraised value of your home when the loan becomes due (when you no longer live there).
- If you take your reverse mortgage loan as a line of credit, then you do not pay interest on the money that is available to you and the money in the line of credit actually collects interest and it might even appreciate faster than the value of your home itself.
- Paying taxes, insurance, and maintenance on your home.
- Hopefully seeing the value of your home grow.
How a Reverse Mortgage Works When You Don’t Have a Mortgage
So, if you do not currently have a traditional mortgage, your full loan amount can be accessed as either cash or a home equity line of credit.
- If you take your loan amount as cash, then you will start accumulating interest owed to the lender.
- If you take your loan amount as a line of credit, then no interest accrues until you access it AND the amount you can eventually borrow grows.
Reverse Mortgage Explained – When You Have a Traditional Mortgage
If you already have a mortgage and secure a reverse mortgage, then part of your loan amount will be used to pay off your traditional mortgage. This will eliminate your monthly mortgage payments – which will probably greatly improve your monthly budget.
- You will start accumulating interest owed to the bank on the amount used to pay off your traditional mortgage. However, none of that loan amount is paid until the loan becomes due which is when you move out or sell your home.
- If your loan amount is sufficient, then you may also access cash or a home equity line of credit.
- If this money is taken as cash, then you will start accumulating interest owed to the lender.
- If you opt for a line of credit, then no interest accrues until you access it AND the amount you can eventually borrow grows.
How Other Organizations Explain How a Reverse Mortgage Works
In summary, a reverse mortgage is a loan for people ages 62 and over that enables you to retain home ownership while using your home equity to help fund retirement.
Here is how other people explain how a reverse mortgage works:
- The U.S. Department of Housing and Urban Development’s Federal Housing Administration created the HECM Reverse Mortgage. They explain how a reverse mortgage works as “a federally insured loan that enables you to withdraw some of the equity in your home or use the loan proceeds to buy a new primary residence that you will occupy.”
- AARP offers this quick description: “With a reverse mortgage you can turn the value of your home into cash without having to sell the property, move out of it, or repay a loan every month.”
- In their “Ultimate guide to retirement,” the editors at Money Magazine explain a reverse mortgage this way: “Here’s how they work. So long as you’re 62 or older, you get to draw down your home equity without repaying it as long as you stay in your house. You get the money up front, but the interest is deferred until you move out (in most cases, when you move to a nursing home or die).”
How Actual Reverse Mortgage Borrowers Explain How a Reverse Mortgage Works
And, below is how some actual Reverse Mortgage borrowers explain their Reverse Mortgage loan:
- When you get a reverse mortgage it is like having your cake and eating it too – you can live in your home and spend your home equity. California borrower
- A reverse mortgage is simply the ability to use what equity you have in your home and not have to pay it back — unless you want to. I could pay it back if I wanted to. But just letting it sit there gives me security. Alabama borrower
- A reverse mortgage is a way to access the equity in the home and help pay bills so that the person can stay in their home. Michigan borrower
- How I afford retirement. Florida borrower
- A way to stay in my home and improve my monthly budget. New York borrower
Have more questions? A reverse mortgage lender could answer these for you with no obligation on your part. Get in touch with a lender here.
Or, get an instant estimate of your Reverse Mortgage loan amount now. Seeing the numbers on your own home could help explain the product to you in more meaningful ways.