How Does a Reverse Mortgage Work
A reverse mortgage, like a traditional mortgage, is a loan made by a lender to a homeowner using the home as security or collateral.
In a traditional mortgage, the bank may lend up to 90% of the property’s value to the homeowner and expects that the homeowner will use their income to pay down the debt over time. The way a reverse mortgage works is the lender loans less (usually 60%) and expects that the reverse mortgage balance will grow over time because the homeowner is not making payments.
A reverse mortgage generally does not require repayment until the last homeowner has passed away or moved out of the property. Consequently, life expectancy is a huge part of the lender’s calculation of how much to lend. That is why a 62 year old can borrow a substantially lower percentage of their property’s value than an 80 year old.
Example of how a reverse mortgage works
- A 70-year old single man owns a $200,000 property free and clear
- He is eligible for $120,000 from a reverse mortgage
- He wants to take out $40,000 initially (including fees) and then $5,000 per year for the next nine years.
- When he passes away, his heirs intend to sell the property
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- The homeowner spent $85,000 in proceeds from the reverse mortgage
- Total accumulated interest over the life of the loan was $38,045
- The estate sell the home for $200,000
- The estate uses the proceeds of the sale to repay the reverse mortgage balance of $123,045
- The estate inherits a net amount of $76,955
Time Cash withdrawals Interest accumulated (at 5%) Reverse mortgage balance Initial $40,000 $2,000 $42,000 Year 1 $5,000 $2,350 $49,350 Year 2 $5,000 $2,718 $57,068 Year 3 $5,000 $3,103 $65,171 Year 4 $5,000 $3,509 $73,679 Year 5 $5,000 $3,934 $82,613 Year 6 $5,000 $4,381 $91,994 Year 7 $5,000 $4,850 $101,844 Year 8 $5,000 $5,342 $112,186 Year 9 $5,000 $5,859 $123,045 Total $85,000 $38,045 $123,045 After ten years, the homeowner has passed away and the estate inherits the property.
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