How Reverse Mortgage Works ?
All of us are aware about the concept of traditional mortgage. A person buys a house and the bank pays on their behalf. Later when the person pays the bank, the title is transferred to their name by the bank. However, financial innovation in recent times has lead to the creation of a new type of product called the reverse mortgage. In this article, we will have a closer look at the concept of reverse mortgage.
What is a Reverse Mortgage ?
A reverse mortgage is an agreement between a bank and a borrower. The agreement states that the bank will pay the borrower some money and this loan will be secured by a property. This money along with the interest and insurance applicable will be due when the person liquidates their house. This could be the event of moving out of the house or the death of the borrower.
Who Uses a Reverse Mortgage ?
The law mandates that reverse mortgage only be used by senior citizens. The average person using a reverse mortgage is above 62 years of age. Usually reverse mortgage is used to pay off the traditional mortgage. Also, senior citizens who have medical conditions use these mortgages to pay their bills. Lastly, some senior citizens might simply use the reverse mortgage as a way to supplement their income in their retirement years.
The following steps are involved in a reverse mortgage loan process.
- Step #1: Determining the Loan Amount:
The maximum loan amount that can be given out depends on the value of the property. This is because property will be secured as collateral against the amount that is being given out as a loan. Usually only about 60% of the value of the property is given out as a loan. This is because real estate is prone to movement in prices. Banks want to ensure that they do not lend out more money than the security that they have on hand. Hence they keep some margin when they lend money.
- Step #2: Getting the Paperwork Clear:
Reverse mortgage is a special type of loan. It cannot be a second or a third mortgage. In fact second and third mortgage cannot exist along with reverse mortgage. It has to be the only type of loan that is secured against the property. Hence, as and when banks disburse reverse mortgage loans they ensure that the proceeds are first use to secure clear title of the property. Only once the title is clear, does the borrower receive any money.
- Step #3: Choose Your Loan Type:
The borrower can choose the different ways in which the loan will be disbursed. Here are the possible alternatives.
- Lump Sum: The bank can simply provide 60% of the value of the house upfront to the borrower in one single payment. It is up to the borrower to then decide how, where and when they want to spend the money. This type of arrangement is risky because there is a likelihood that the borrower may run out of money and soon they may not even have the title to their own home.
- Monthly Payments by the Lender: The other alternative is that the bank pays a monthly payment to the borrower. This is where the term reverse mortgage actually originates from. The role of the bank and the borrower gets reversed in this arrangement. This is a somewhat stable arrangement. However, it is not suitable to meet the unpredictable cash needs of senior citizens.
- Line of Credit: The best arrangement in case of a reverse mortgage is a line of credit. This is because it allows the borrower to choose how much money they need at what time. They could borrow more money in a particular month if their medical needs demand so. Alternatively, they could also take less money in the corresponding months when they do not need additional money. This arrangement is stable as well as flexible and hence preferred by most borrowers opting for a reverse mortgage loan.
- Step #4: Closing the Loan:
The loan was first made with the underlying property as collateral. Hence, it is usually liquidated when the property is liquidated. Most reverse mortgage loans close with the death of the borrower. However, the loan could also close if the borrower decided to sell the house.
The bank will typically give some time to the heirs to liquidate the property at market value. After such time limit is over, the bank will take the matter into its own hands. In both cases, the property will be sold and the balance left over after repaying the interest as well as principal is given back to the heirs.
One must understand that reverse mortgage loans work without recourse. This means that if the bank has lent out more money that they can recover from the sale of the property, that’s the bank’s problem. They cannot legally ask the borrower or his/her heirs to make up for the shortfall.
It is for this reason that a lot of reverse mortgage lenders took a huge haircut on their loans during the subprime mortgage meltdown.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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