Reverse mortgage

A reverse mortgage is a variation on the traditional mortgage concept. Reverse mortgages and traditional mortgages are legal claims against the property as security for a loan. In a traditional mortgage, the debt is usually repaid in monthly instalments over many years. A reverse mortgage enables the homeowner to convert equity into cash without selling the home or repaying the debt immediately. The homeowner retains ownership and possession of the home while using the equity in the property. The homeowner receives the equity as an amount of cash: in a lump sum, in regular payments, or in a combination of these two options. No repayment of the reverse mortgage takes place until a specified time in the future: when the homeowner sells, when the homeowner moves permanently, when a preset period-perhaps 5 or 10 years-ends, or when the homeowner dies.

While reverse mortgages and traditional mortgages share the many similarities, the differences between them are of greater significance. The key differences outlined below highlight the main advantages and disadvantages of reverse mortgages compared with traditional mortgages.

Traditional Mortgages in Reverse

Traditional mortgages: As the homeowner (borrower) makes regular repayments of principal and interest to the lender, the balance owing on a traditional mortgage gradually decreases. At the same time, the homeowner's share of the equity in the home gradually increases. The traditional mortgage terminates, usually 10 to 25 years later, when the original debt, including all accumulated interest and any penalties, has been completely repaid. At this point, the homeowner possesses all the equity in the property.

Reverse mortgages: Here, things happen in reverse. Since the homeowner receives payments from the lender, the balance owing on a reverse mortgage increases. At the same time, the homeowner's share of the equity in the home decreases. The reverse mortgage terminates at a specified time in the future: when the homeowner sells; when the homeowner moves permanently; when a preset term ends; or when the homeowner dies. When the reverse mortgage terminates, the total accumulated debt of the reverse mortgage, including any fees or penalties, must be repaid to the lender.

The equity in the home may be completely depleted even before the reverse mortgage terminates, as interest accumulates against the debt. In this case, the mortgage debt, including accumulated interest, will exceed the value of the property. However, the borrower is usually limited to repaying the portion of the debt equal to the value of the property; the lender must absorb the extra debt. The homeowner is not required to sell the home to repay the reverse mortgage debt. However, sale of the property may prove to be the most common method of paying off a reverse mortgage. Any funds from the sale left after the mortgage debt is settled, belong to the homeowner or the estate.

Basis for Qualification

Traditional mortgages: Qualification for a traditional mortgage is based on the borrower's ability to repay; that is, on the borrower's income. Most lenders dictate that the combined payments for principal, interest, and taxes should not exceed approximately 30 percent of the family's total gross income. The traditional mortgage will be set at a percentage of the appraised value. The appraised value of the property represents 100 percent of the lending value. A homeowner may be eligible to borrow up to 90 percent of the appraised value of the property from most lenders. However, mortgaging up to or more than 100 percent of the value may also be possible.

Reverse mortgages: In contrast, the borrower's income is not a factor in qualifying for a reverse mortgage. In fact, a homeowner with no income at all can arrange a reverse mortgage. Qualification for a reverse mortgage is based on:

• the appraised value of the property
• the age and sex of the homeowner(s)

Lender policy establishes the maximum lending limit for the reverse mortgages the lender offers. This limit is set as a percentage of the appraised value of the property. Most lenders keep their upper borrowing limit under 50 percent of the appraised value, for instance, a maximum of 30 percent to 40 percent of the appraised value of the property. This is to ensure that, as interest accumulates, the mortgage does not exceed 75 percent of the appraised value. Using the lender's borrowing criteria, a limit is established for each borrower that is at or under the lender's maximum lending percentage.

Age is an Asset

Traditional mortgages: As the lender's security is tied to the homeowner's ability to repay the mortgage, older homeowners may be at a disadvantage when applying for a traditional mortgage. Lenders are very aware of the decrease in income that is associated with retirement, and of the limited employment opportunities that may be available to older homeowners.

Reverse mortgages: Here, age is a positive factor. In fact, reverse mortgages are designed for the older homeowner. Often, the minimum qualifying age is set at 60. Furthermore, the lender's payments to the homeowner are based on projections of the homeowner's life expectancy. Therefore, the older the homeowner, the greater the reverse mortgage payments possible from the lender.

On the Receiving End

Traditional mortgages: The responsibility of making regular, usually monthly, repayment can reduce the advantage gained by arranging a traditional mortgage for some homeowners. A few may even have to resort to using the mortgage money they borrowed to make the required regular repayments.

Reverse mortgages: One of the most attractive differences between these two types of mortgages is that with reverse mortgages, homeowners receive payments instead of making them. The equity in the home is converted into cash by the reverse mortgage. The homeowner receives this cash in a lump sum, in regular payments, or in a combination of these two options. The payment period for the homeowner may last a few years or a lifetime, depending on the terms of the reverse mortgage contract.

Interest on the Interest

Traditional mortgages: Most residential mortgages are repaid in blended monthly payments of principal and interest. With blended payments, the Federal Interest Act restricts the frequency of compounding interest to either semiannual or annual calculations. For most traditional mortgages, interest is compounded semiannually and charged against a decreasing balance.

Reverse mortgages: While semiannual compounding is common in reverse mortgages, the frequency of compounding in these mortgages has no legal limit. In contrast to the interest charged in traditional mortgages, the interest in reverse mortgages is compounded against a steadily increasing balance. For instance, if the borrower receives the payment in a lump sum, interest compounds against the total principal as well as against the accumulating interest, from the date the mortgage is signed.

Borrower Default and Lender Risk

Traditional mortgages: The most common cause of borrower default, or breach of the mortgage contract, is the borrower's failure to make the required principal and interest payments. To protect lenders against loss, the National Housing Act stipulates that all mortgages over 75 percent of the appraised value of the property, called high-ratio mortgages, must be insured against borrower default. As lender risks are reduced, lenders are more receptive to offering high-ratio mortgages. The federal housing agency, provides mortgage insurance for lenders and pays off the debt if the borrower defaults on the mortgage. The premiums are paid by the borrower.

Reverse mortgages: Since reverse mortgages are not repaid until some future date, default could occur at the termination date if the homeowner refused or was unable to move at the end of the term, so that the home could be sold to repay the debt. However, the lender could take power of sale action against the borrower to force the sale of the property, or the lender could sue for foreclosure to take over ownership.

Default could also occur if the borrower failed to maintain the home in good repair, keep the property insured, or pay the property taxes. While the same remedies would be available to resolve these default situations as with the failure to repay the mortgage debt, the lender may decide on less drastic default remedies. For each of these default situations, the lender could step in and solve the problem for the borrower, and then add any costs incurred in the process to the mortgage balance.

There is, however, a lender risk peculiar to reverse mortgages. Because the mortgage balance is growing constantly as the interest compounds, if property values stay the same or decrease, the mortgage debt could exceed the value of the property. The reverse mortgage could also consume all the equity in the property if the homeowner outlives the lender's estimates of life expectancy. Obviously, if these two situations occur at once, the mortgage debt will probably exceed the value of the home. Provided the mortgage contract carries a clause to limit the homeowner's liability, the borrower has to repay only the portion of the mortgage equivalent to the value of the home. The lender must absorb debt that exceeds the value of the property. Lender insurance for reverse mortgages would cover the lender against this potential loss.

Types of reverse mortgage
How much will a reverse mortgage pay?
Home equity conversion in perspective
When does a reverse mortgage ends?
Qualifying for a reverse mortgage
The disadvantages of reverse mortgages

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