A New Kind of Loan: In Reverse

A "reverse" mortgage is a loan against a borrower's home that they do not have to pay back for as long as they live there. With a reverse mortgage, you can turn the value of your home into cash without having to move or to repay the loan each month. The cash they get from a reverse mortgage can be paid to them in several ways:

• all at once, in a single lump sum of cash;
• as a regular monthly cash advance;
• as a "creditline" account that lets you decide when and how much of their available cash is paid to the borrowers; or
• as a combination of these payment methods.

No matter how this loan is paid out to your borrowers, they typically don't have to pay anything back until they die, sell their home, or permanently move out of their home. To be eligible for most reverse mortgages, they must own their home and be 62 years of age or older. The home can have a mortgage on it, but equity is needed in order for the conversion.

Qualifications

To qualify for most loans, the lender checks your borrower's income to see how much they can afford to pay back each month. But with a reverse mortgage, they don't have to make monthly repayments. So they don't need a minimum amount of income to qualify for a reverse mortgage. Your borrowers could have no income and still be able to get a reverse mortgage.

With most home loans, they could lose their home if they don't make their monthly payments. But with a reverse mortgage, there aren't any monthly repayments to make. So your borrowers can't lose their home by not making them. Most reverse mortgages require no repayment for as long as they — or any co-owner(s) — live in the home. So they differ from other home loans in these important ways:

• Borrowers don't need an income to qualify for a reverse mortgage; and
• Borrowers don't have to make monthly repayments on a reverse mortgage.

"Forward" Mortgages

You can see how a reverse mortgage works by comparing it to a "forward" mortgage — the kind borrowers use to buy a home. Both types of mortgages create debt against the property. And both affect how much equity or ownership value the borrowers have in their home. But they do so in opposite ways.

"Debt" is the amount of money you owe a lender. It includes cash advances made to your borrowers or for their benefit, plus interest. "Home equity" means the value of a home (what it would sell for) minus any debt against it. For example, if a home is worth $150,000 and a person still owes $30,000 on their mortgage, their home equity is $120,000.

Falling Debt, Rising Equity

When a borrower purchased their home, they probably made a small down payment and borrowed the rest of the money they needed to buy it. Then they paid back your traditional "forward" mortgage loan every month over many years. During that time:

• Borrower's debt decreased; and
• Borrower's home equity increased.

As they made each repayment, the amount they owed (debt or "loan balance") grew smaller. But the borrower's ownership value ("equity") grew larger. If they eventually made a final mortgage payment, the borrowers then owed nothing, and their home equity equaled the value of their home. In short, their forward mortgage was a "falling debt, rising equity" type of deal.

Rising Debt, Falling Equity

Reverse mortgages have a different purpose than forward mortgages do. With a forward mortgage, a borrower uses their income to repay debt, and this builds up equity in your home. But with a reverse mortgage, they are taking the equity out in cash. So with a reverse mortgage:

• Borrower's debt increases; and
• Borrower's home equity decreases.

It's just the opposite, or reverse, of a forward mortgage. With a reverse mortgage, the lender sends your borrowers cash, and they make no repayments. So the amount they owe (debt) gets larger as they get more and more cash and more interest is added to their loan balance. As their debt grows, their equity shrinks, unless their home's value is growing at a high rate.

When a reverse mortgage becomes due and payable, borrowers may owe a lot of money and their equity may be very small. If they have the loan for a long time, or if their home's value decreases, there may not be any equity left at the end of the loan.

In short, a reverse mortgage is a "rising debt, falling equity" type of deal. But that is exactly what informed reverse mortgage borrowers want: to "spend down" their home equity while they live in their homes, without having to make monthly loan repayments.

Exception

Reverse mortgages don't always have rising debt and falling equity. If a home's value grows rapidly, a borrower's equity could actually increase over time. Or, if they only get one loan advance and no interest is charged on it, their debt would never change. So their equity would grow as their home's value increases. But most home values don't grow at consistently high rates, and interest is charged on most mortgages. So the majority of reverse mortgages end up being "rising debt, falling equity" loans.


- Source: http://www.aarp.org/money/revmort/