How does a reverse mortgage work? What determines the payment amount?

A reverse mortgage is a financial product using your existing primary residence as collateral.  The borrower must be at least 62 years of age in the U.S.  There are various ways the cash flows can be worked in a reverse mortgage.  The product is similar to the annuity.  One type of a reverse mortgage is where you “sell” your house today for monthly payments of a certain amount and remain in the house until your death.  The part of remaining in your house is what is different than an annuity.  In the case of an annuity, you won’t have access to the funds used to purchase the annuity once it’s purchased.  In addition, a reverse mortgage is not considered a sale, by standard sales definitions.

The key part of a reverse mortgage is staying the fact that the borrower will be staying in the house as their primary residence.  It is part of the terms and conditions.  Moving, selling the house, or dying all bring the loan due.  A reverse mortgage is also heavily loaded with fees.  Origination costs of 2%, upfront insurance of 2%, and your effective rate of borrowing are all higher than other products using your house as collateral.  The good news, is that there is a way to emulate the reverse mortgage using other financial products.

A reverse mortgage can be approximated by taking a “cash out refinance” on your house and using the proceeds to buy an annuity.  Using our previous example of an annuity of $100k paying $6250 a year:

  1. The homeowner has a house worth $100k and is completely paid off
  2. The homeowner takes out a $100k cash out refinance (or home equity loan) with interest only payments
  3. The $100k is used to purchase the example annuity
  4. The homeowner receives $6250 a year from the annuity, but must pay the cost of the cash out refinance
  5. The interest only payments at 3% would be $3600 a year
  6. Your net income from an arrangement equivalent to a reverse mortgage is $2650 a year or about $221/month.

There is one small concern on the above arrangement.  Interest only mortgages are not particularly common.  It is more likely that this arrangement would be worked with a 30 year mortgage instead, and the extra amount in house payment would start to build equity back into the house.

This arrangement can also be worked between a variable home equity line of credit and a variable annuity.

 

About Steve @ FPO
Hello FPO readers, I have been writing on financial topics for about 12 years now, but I have only recently reignited the fire of publishing online. I have to say, its good to be back. I am an electrical engineer by trade who enjoys all topics engineering and financial. I started Financial Place Online (FPO) to create a value added financial news and education website that would provide a refreshing daily financial read. Financial Place Online websites are built around the principles of consumer empowerment, leveling the playing field, zero spam tolerance, and none of those annoying sidebar or banner ads. For us, it's all about enjoying a good read.

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