Quick - Name who's on the $50 bill!
What are reverse mortgages? In what situation would I need one or use one? How do they differ from a home equity loan?
I got the question above via email from a reader. I know the basics of what a reverse mortgage is, but, being a man who owns a bunch of old law textbooks that have very little value to me now that I’m out of law school (other than looking cool on my shelf), I turned first to my Nelson/Whitman text, Real Estate Finance, Transfer and Development.
It’s an excellent book, and has a wealth of legal knowledge. In fact, when I was in school I would have told you with a straight face that it would tell you everything you needed to know to be a practicing attorney in the area of real estate law. That’s a very naive thing to think, but it is a very good text if you’re in the market (and why would you be). The book doesn’t have much to say abut reverse mortgages, just a couple pages (out of over 1200).
According to the book, a reverse mortgage, or a reverse annuity mortgage (RAM), (also known as a home equity conversion mortgage) allows retired people with lots of equity in their homes to borrow from that equity on a regular basis to pay living expenses. The lender basically makes monthly disbursements to the homeowner, which essentially bleeds the equity they’ve built. The lender predetermines the maximum amount they are willing to lend out of the house, preserving enough equity to ensure that eventually they can sell the house and get their money back.
The book says this as well, “The balance will ultimately reach the maximum level acceptable to the lender, at which time the loan will have to be repaid, presumably requiring the sale of the property.”
These guys know more about this stuff than I do, but I think that’s misleading. That seems to suggest that as soon as you reach that maximum level, the loan has to be repaid – and that the house will be sold. This would be based on the specific terms of the agreement that you enter into, but I think most reverse mortgages are predicated on the fact that you can take the money until you reach the limit (they’re not going to give you an endless supply of money), and then you can stay in your house until you die or vacate it. I doubt this is an error on the part of Professor Whitman (who taught my Property law bar class a little over a year ago and a leader in this field) or his coauthor. I think this is probably just worded in a way that’s a little bit ambiguous;)
There are multiple ways these sorts of agreements work. Sometimes an annuity is purchased from a lump sum disbursement. Sometimes they just make monthly payments. In either case, you’re borrowing money, and the money you’ve borrowed is accruing interest. That’s one way the people making these loans. The other way is through closing the loans (here’s a guide to some of the different types of payment options). When one of these loans is made, there are closing costs just like with any other loan. Before you consider taking one of these, ask for a term sheet with all of the estimated closing costs. Keep this in mind when you’re shopping for a reverse mortgages – it’s not just the interest rate that matters, it’s the total amount of money involved.
If this sounds a lot like a home equity loan – it is, but with one fundamental difference…you don’t have to start making payments immediately after getting the loan. This works more like a balloon loan. All of the money will be due at some point in the future, usually from the sale of the home.
Finally, these loans are only for retirees (you have to be at least 62 to take one). Ideally, you’ll be in a position during retirement where you don’t need to take one of these (if you wanted to know more, here’s a comprehensive guide to reverse mortgages). If you haven’t started saving for retirement, start now! Even if you can only afford to invest a small amount of money each month, get in the game if you can. If you end up having to rely on a reverse mortgage, the option is there, but it’s a worst case scenario. Thanks for reading.
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