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.


How does an annuity work? What determines your monthly payment?

Good Evening FPO Readers,

An annuity is a financial instrument which can be purchased with a lump sum payment.  In return, the annuity pays a monthly payment to the annuity holder for the remaining life of the annuity.  The payment can be either at a fixed or variable rate and the remaining life can be defined multiple ways, but is most commonly based on the remaining physical life of the annuity holder; and their spouse in the case of a joint annuity.  Since the life of the annuity is tied to your own lifespan, an annuity is more properly classified as an insurance product as opposed to an investment product.  Even though an annuity wraps together both an investing and an insurance element it is possible to break the two apart for analysis.

The below explanation is for a standard, fixed rate annuity.  There are various types of annuities, but the underlying principles described below remain the same.

Think of an annuity as a combination of a long term bond and a reverse cash flow life insurance policy at 0% interest.  What is a reverse cash flow life insurance policy you ask?  It is the same as a normal life insurance policy, but the order of payments switch.  The lump sum is paid up front by you and the monthly payments are paid afterwards to you for the rest of your life.  The opposite of your life insurance policy, right?

The bond element is mostly straightforward.  In the case of a $100K annuity, the bond element would consist of a $100k bond that pays the current market rate for long term, low risk bonds, which is about 1.75% presently.  In this case, the annual simple interest payment would be $1750.

The reverse cash flow life insurance is based on the age of the annuity holder at the time of annuity issue.  The $100k lump sum is exchanged for monthly payments for the rest of your life.  If you live a long time, you come out ahead, otherwise the issuer of the annuity comes out ahead.  The rate of the insurance component is based on market rates, but for a 65 year old man expect a yearly payment of about $4500.

The total annuity payment is $6250 per year or about $521/month.

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