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What is a Reverse Mortgage? Things to Keep in Mind Before Getting One

  • August 15, 2020

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reverse mortgage

You must likely have heard of the term "reverse mortgage." And, maybe you're wondering about getting a reverse mortgage on your home. But before getting into that, it's always necessary to know about a product in depth before making any decision. Therefore, let's first figure out what a reverse mortgage is exactly.

What is a reverse mortgage?

Well, the best way to explain this is to give you an example. Let's say you buy a house, and it costs you $100,000. You're going to borrow all the money to pay for the house. That doesn't usually happen, but for simplicity's sake, let's assume that. Well, ten years later, two things are going to happen. The first is that your $100,000 of the principal amount that you borrowed goes down because you've been paying off the loan. After ten years, you've already paid off the amount of $50,000. And hopefully, your house goes up in value.

Related: Saving For Retirement: 2020 FAQ Guide

Let's say it's gone up to $200,000 in value. So what do you have now? You have the difference between $200,000 and $50,000, which represents $150,000 of equity you have in the house. The problem is you can't have this equity. You can't realize it unless you sell the house.

So this is where a reverse mortgage comes into play. If you're over 62 years old, you don't have to have any income verification. All you need to do is have that 150,000 of equity, and you can access the equity in your home through a reverse mortgage. Now, exactly how does that happen?

Well, you can get the whole $150,000, or you can get staggered payments of that $150,000. Another option is to have a line of credit that you can access.

How does a reverse mortgage differ from a home equity line of credit or a home equity loan?

So you may ask, well, how is that different from just getting a home equity line of credit or a home equity loan? Well, the first thing is you don't have to have good credit to get a reverse mortgage. It's not dependent upon your credit or whether you have a job or not. It just depends on whether you have more than 50% of the equity in your home.

Now, there's going to be different rules by each state, but generally, those are the requirements. And you must be living in that home as your primary residence. As long as you're 62 years or older, living in the home as your primary residence, and have more than 50% equity in your home, you can use this product.

Also, a reverse mortgage could be a great solution if the majority of your net worth is tied up in your home, and you have no plans to move anywhere else. A reverse mortgage could be a perfect product for anyone who's a little tight on cash and has all of their net worth tied in their home. In this case, a reverse mortgage can fix the cash flow problem.

Well, that sounds great, isn't it? But is it too good to be true? Therefore, let's cover the range of things one should keep in mind before getting into a reverse mortgage.

Things to keep in mind about a reverse mortgage

  • One particular thing everyone should keep in mind is this: once you passed away, the loan balance has to be paid in full. So in a reverse mortgage, that $150,000 of equity is being given to you as a loan by the bank has to be paid back. Therefore, for you to pass your home to your heir, they have to pay the equity back to the bank to own the house.
  • Another downside of getting a reverse mortgage is that if you pass away, this loan becomes due, and the value of your house went down in value. So your heir will be faced with this dilemma of the loan balance possibly being higher than the value of the home.
  • There's been a lot of scams because this is a fairly complex financial instrument. And the more layers of complexity you add onto something, the more opportunity for suspicious individuals to use it to take advantage of you.
  • While getting a reverse mortgage, you should also keep in mind that there's an interest rate associated with the money you borrow. The interest rates can be anywhere from two to three percent annually. One must agree to bear these interest rates to access these funds. And, for example, it can turn out to be a bad deal if you get a reverse mortgage worth $150,000 at age 62 and run out of money when you're 90 years old.

Additionally, you have to consider the logistics and the math of reverse mortgage. In a traditional mortgage, you own an asset-your home, and then you have a loan against it, which is the mortgage. Every payment you make goes down to reduce the principal and pay back a bit of interest to the bank.

Whereas in a reverse mortgage, the opposite happens. Payments are being made to you, and you're decreasing the amount of equity in your home. In essence, you are monetizing your equity right now. The whole point in building up equity in an asset is to monetize it eventually. The only way to truly monetize an asset is to sell it. But, in the case of a reverse mortgage, instead of selling your house, you're taking a loan against it.

Conclusion

So, in final considerations, if you're over the age of 62 and headed towards retirement and haven't saved enough for retirement, you're trying to fill that cash gap by monetizing the amount of equity in your home. This could be a solution for you. However, if you've got plenty of assets or money in a 401k and don't have much cash flow issues, then a reverse mortgage is probably not the product for you.

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