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Reverse Mortgage: How They Work & How They Don’t

December 16th, 2011
     

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reverse mortgages how they work

reverse mortgages how they work

Many people get very confused when they try to grasp the reverse mortgage and how they work. They look at the different interest rates, the mortgage insurance, the servicing fees, principal limits, net principal limits and before long, they just want to know the bottom line as they’re so confused they don’t want to try to understand anymore.

This will be possibly an over-simplified explanation for those who possess a great deal of “reverse mortgage savvy”, but for those who just want to get a basic idea of what this program is all about, this just might help.

Firstly, a typical loan that everyone is familiar with is now being called a “forward mortgage”. A forward mortgage is a rising equity, falling debt loan. In other words, as you pay the monthly payments, your equity in the property rises as your debt (the mortgage balance) decreases. A reverse mortgage operates as you might guess in the reverse of this.

Rather than paying money monthly to a lender, a lender pays money to you (in a number of different ways we will discuss later) and instead of making a monthly payment of principal or interest, the principal does not decrease and the interest is tacked onto the loan balance. Therefore your debt is rising and your equity in the property is decreasing.

There are adjustable and fixed rate reverse mortgages available today and each one has a different way of determining the interest rate at which you will accrue interest. The fixed rate is an easy concept for everyone, the lender quotes a rate and there is only one rate represented. However, with the adjustable rate mortgages, there are actually two rates listed; the initial rate and the effective rate.

The effective rate is never a rate at which you accrue interest. It does, however, affect how much money you may be eligible to receive. The reverse mortgage works differently than any other loan in this respect in that the effective rate is a rate that uses a completely different index. The initial rate is the rate at which you begin to accrue interest from the very first day and then your rate changes either monthly or annually depending on whether you opted for a monthly or annual adjustable rate program.

Your lender will input your property address, your age (dates of birth for the borrower and co-borrower) and property value into the HUD Calculator and the way the reverse mortgage works here is also very different than any other loan.

Rather than looking at your credit and income to determine how much loan you qualify for, the calculator will come back and determine a Principal Limit based on all the information and this is the gross amount for which you qualify. The Principal Limit is not to be confused with the HUD Lending Limit for the area, which is now $625,500 across the nation. From the Principal Lending Limit, there are then some items that require negative adjustments. The first adjustment to the amount is the Servicing Fee Set Aside.

In a forward mortgage, a borrower receives a rate that already has a portion of the interest rate included which will be used to cover the servicing costs. This is not how a reverse mortgage works. HUD requires the “Set-Aside” sufficient funds to service your loan through the expected term of the mortgage by deducting this amount and not making it available to the borrower. This is not a charge to the borrower up-front, but rather is added to the loan monthly to pay for the costs of the lender required to service the loan.

You only actually pay for the servicing fee for each month that the loan is actually being serviced and the monthly amount can vary, but cannot exceed $30.00 for an annual adjustable rate loan or $35.00 for a monthly adjustable rate loan. Every borrower has always paid for the servicing of their loans, forward or reverse, but the reverse mortgage is unique in the way it discloses and accounts for that cost.

The next unique way that a reverse mortgage works is in the amount of the fees charged and on what basis. Since the loans can start at next to nothing but grow throughout their term, the HUD mortgage insurance and fees are determined by the property value or HUD Principal Lending limit for the area, whichever is less rather than on the initial loan amount as in a traditional forward mortgage.

Also, since HUD is insuring that borrowers will always receive their money (and on time), the loan is non-recourse so no one can ever seek to collect more than the property is worth and that they can live in their homes for the rest of their lives no matter how long that may be without making a payment, the Up-Front Mortgage Insurance Premium is not inexpensive.

A forward mortgage does not give a borrower any of those protections. So the fees charged on a reverse mortgage include the typical third party costs (title insurance, appraisal, escrow/attorney closing costs, etc) and also an origination fee but typically the largest fee you will see on any reverse mortgage is the Up-Front Mortgage Insurance which is paid to HUD.

There can be no other liens on the property. If you owe money on a current first or second mortgage, those must be paid in full and then the remainder after all the described adjustments is the “Net Principal Limit”, and this is the amount left over for the borrower to use for other purposes. Another way a reverse mortgage works differently from a forward mortgage is that with these funds a borrower can choose several options as to how they can take their money. Borrowers can opt to keep the funds available to them in a line of credit (only this one can’t be frozen like many of today’s equity lines of credit are facing).

Borrowers can choose to receive a payment for life or for a set period of years if they know they have a specific need. Borrowers can also choose to take all the remaining funds at once or a combination of any or all of the above. And that’s another way a reverse mortgage works that is different that any forward mortgage!

A reverse mortgage works like no other loan instrument available. That may well be why so many people have such a hard time getting their arms around the concept and why every program mandates third-party counseling. For those who have mastered the concept and have had the chance to see what a positive influence the reverse mortgage has had in their lives, they’re just glad they took the time to learn all about it.

If you or a love one you know has been wrestling with this program, talk to your trusted financial advisor(s), your family, go to sources like AARP and the National Association of Reverse Mortgage Lenders and then talk to reverse Mortgage Specialists like the ones you’ll find at All Reverse Mortgage Company…you’ll be glad you did.

“Reverse Mortgages How They Work” by www.allrmc.com

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