In a previous post we tackled some of the pre-conceived notions attached to Reverse Mortgages. In this post we will look into how Reverse Mortgages work and the payment options available.
• In order to open a Reverse Mortgage, the youngest borrower must be at least 62 years old.
• You must own the home.
• It must be your primary residence.
• If there is a mortgage on the property, it must be paid off with the loan proceeds.
• There is a financial assessment to determine if you have the resources to cover taxes, insurance, and maintenance.
• You must attend a counseling session with a HUD approved counselor. They will discuss your options with you.
• Recent changes brought by the government have put a cap on how much reverse mortgage proceeds can be used in the first year. It has also put in protections for non-borrowing spouses.
• Distributions from a reverse mortgage are tax-free.
Similar, in some ways, to an annuity/pension. You receive a fixed monthly payment for as long as you remain in your home. If you were to move, pass away or sell the home, the payments would stop.
Just as it sounds, the term is a fixed monthly payment that lasts for a fixed period of time (e.g. 20 years).
You receive just one up front payment of the loan proceeds.
Line of Credit
When you open a reverse mortgage you do not need to use the proceeds right away (or ever for that matter). The line of credit allows you to draw on the loan whenever you would like. You can draw on it at any time and for any amount until the line of credit is exhausted. You will pay interest only on the money you take out of the credit line.
An interesting feature to the Line of Credit is that the credit line grows. This means that you can have access to more money later. The line of credit grows at a variable interest rate, which is usually the same rate that applies to the loan balance.
The line of credit is one of the more challenging aspects to understand with reverse mortgages, however it’s also arguably one of the greatest features. Below is a very general example which may help clarify how this line of credit option works:
Joe is 62 and recently retired. He has a home worth $300,000 with no mortgage and he would like to stay in his home for as long as he can. Joe doesn’t need any additional funds today as he can live off his investments. However, he is interested in learning more about the reverse mortgage line of credit as he heard it may help improve the long term success of his retirement plan. He gets a quote on a Reverse Mortgage and it says that he has a line of credit option available for $155,000. Joe likes the idea and decides to sign up for the Reverse Mortgage.
At this point, all Joe has really done is given himself the option of accessing some of this equity either now or in future years. As was mentioned above, the reverse mortgage line of credit grows every year. The $155,000 grows by a variable interest rate, meaning that if Joe doesn’t touch the line, he will have access to more money in the future. For instance, if the interest rate in the first year is 6.5%, then next year Joe will have access to a credit line of $165,380 ($155,000 x 6.5% interest rate compounded monthly).
Let’s imagine that Joe decides to take out $20,000 from the Reverse Mortgage Line of credit. At that point Joe will have a mortgage balance of $20,000, which accrues interest. You only owe interest on the amount you actually borrow. So Joe will pay interest on $20,000, not on the entire credit line. Joe can pay off the balance if he wants, but he doesn’t have to. A reverse mortgage does not require any payments. The interest rate is most often the same rate as the rate on the line of credit. So, from our example above, Joe would be charged 6.5% interest on the $20,000 loan.
Now lets say that unfortunately Joe passes away next year, what happens then? Once Joe passes the reverse mortgage loan balance comes due, meaning that his heirs will need to pay off the $20,000 balance plus whatever interest may have accrued. This is the same as if there were a regular mortgage on the property. The heirs have numerous options for paying off this balance. One option would be to pay off the balance with other resources. Another option is to sell the home. The heirs would keep any equity in the home above the $20,000 loan. The bank isn’t due anything above the mortgage balance. This point is important as most people think that once they have a reverse mortgage the bank owns the home. That is not true.
So why would Joe even bother of looking at the Reverse Mortgage in the first place? There are a number of reasons and we will touch on them in more depth in future posts, but one potential reason could be to pay for any unexpected expenses in the future. Another option is to use the reverse mortgage line of credit in years where his investment portfolio has declined. Instead of selling investments after they have lost money, he can use the line of credit while he waits for his portfolio to (hopefully) rebound. Joe may even use it as a way to bridge a gap before he starts collecting Social Security at 66. There are a number of options, but a reverse mortgage, if used appropriately, can help improve a retirement plan for some retirees.
In order to try and convey the basic message, this example is meant to be very general. The numbers I have listed aren’t actual quotes and the amounts will vary. The example is intended to help illustrate how a reverse mortgage line of credit works conceptually.