October 10, 2012

Reverse Mortgage

A mortgage is a loan obtained from a lender by a borrower to purchase real estate when the borrower is unable to fully pay the purchase price in cash. Over time, the borrower makes periodic payments with the hope that the home's equity will increase because of principal and interest reduction and appreciation.

Of note, in California we do not have "mortgages" instead we utilize a "deed of trust" to finance the purchase of a home. Still, from my land finance professor in law school, "there is basically no legal difference between a mortgage and a deed of trust in California." Since mortgage is more familiar than deed of trust I use that term.

In contrast, a reverse mortgage is where the the homeowner taps into the equity they have built up in their home over the years by borrowing against it. Equity is defined as the fair market value less encumbrances. Consequently, if a home is worth $500,000 with a $100,000 mortgage the house would have $400,000 in equity. 

The following is a hypothetical situation involving a reverse mortgage. Assume Senior Doe owns a home free and clear worth $500,000. That is, there is no mortgage or other lien on the property. Senior Doe may borrow against his $500,000 in equity by taking out a reverse mortgage. The lender may issue Senior Doe a lump sum of money, a revolving line of credit, periodic payments or a combination of the three. Senior Doe decides to receive a monthly payment of $2,000 for the rest of his life. The amount of money paid out to Senior Doe would be recouped by the lender when the property is sold or Senior Doe passes away.

The exact terms of a reverse mortgage are dictated by the (1) the age of the borrower (2) the value of home and (3) the method of payment, amongst other factors. 

The example mentioned above is a gross simplification of the process. In the real-world, Senior Doe would need to have his house appraised, besides pay origination, servicing and insurance fees. Despite these costs, a reverse mortgage can be an attractive method for senior citizens to enhance their income. Typically a senior citizen lives on fixed income, i.e. social security and/or a pension, and their home is often their most valuable asset. Naturally then, tapping into the value of the home to produce an infusion of income seems like a prudent maneuver. The alternatives for enhancing income are usually not as attractive, e.g. selling or renting the home, because both avenues involve moving which many seniors are uncomfortable with doing due to long tenure at their home.

Reverse mortgages also place a restriction on the type of realty eligible for such. For instance, the home must be the borrower's residence. 12 USC §1715z-20(d)(3); 24 CFR §206.39.

Furthermore, the amount of the loan is subject to a cap. There are various websites which will tell you how much you can borrow. You can Google to find one that suits your needs.