Money can be borrowed in so many ways nowadays and it becomes easier by the second. Not only banks but other financial offices and even the government are allowed to lend you money. The procedures are also simplified and you can get approval within minutes. In the past you would be required to have a guarantor in order to apply for a loan but this isn’t the case anymore. There is just one social group which generally struggles to receive loans due to their high risk profile. That group is the senior citizens of our society. Very rarely banks will loan elder people huge sums because, well…it is uncertain how the debt will be paid back in case anything bad related to health happens. We cannot say that this is age discrimination because all the private financial institutions are free to decide who gets a loan and who doesn’t.
There is one financial mechanism which targets seniors and it grew pretty popular over the last few years. It is called reverse mortgage. In our piece we will analyse this product and will try to see exactly how reverse mortgages work. In short it allows you to borrow money and secure your loan with the equity of your home. You are allowed to monetise just a percentage of your home value and then you have to pay it back with compounding interest. However, there are no monthly payments to be made as this is what you might typically expect from a regular loan. A reverse mortgage is paid back when the estate is sold or when the last remaining borrower passes. The final crucial component of a reverse mortgage is the fact that you retain ownership of your property.
The way a reverse mortgage works, it allows you to get an immediate cash injection in the form of a lump sum or a steady income stream. It can definitely have a positive impact on your current finances as you will definitely feel a sudden improvement. Many older couples do it so that they can renovate their home or maybe buy a new car. Others go on vacations because they simply want to enjoy life to the fullest. Another group of users allocates this money to medical care or simply looks to improve their own pension fund. All of this is great because receiving money for your equity and still getting to keep your home just sounds fantastic. It does, however, provide you with a short term financial enrichment and might have a negative impact on your long-term plans for retirement or leaving behind some heritage.
We advise you to always seek professional help because realtors will definitely help you understand better how reverse mortgages work along with the risks of which you should be made aware. Our advice is to never sign the dotted line before you get the full picture and projections on your future financial state. Ask all the questions because when it comes to reverse mortgages, not only your own future needs to be taken in account but also the one of your heirs and family. Get all the details of how a reverse mortgage works by asking for costs to be calculated. See the potential impact of the interest rates and definitely ask about the effect of this transaction on your home equity. And finally get all the contact information possible especially the one related to external resolution of disputes. Things can sometimes go wrong with such long-term commitments and you need to be prepared for anything.
Here’s another angle to how reverse mortgages work. We have all deposited money in banks enjoying a compounding interest. If we do not withdraw anything for years, then the interest rates are in our favour and the bank pays as more money after a certain period of time. Well, in this case the bank deposits its money with you. The only difference is that the interest is much higher and as it is capitalised monthly, your debt grows as the interest compounds. So the longer you hold their money, the more they will want to get back when it is all set and done. A $60,000 loan with a compounding interest rate of 10% means that you will owe almost $300,000 in 15 years. That sounds scary, doesn’t it? Well, it is because the lender realises your home equity grows in time while money becomes devalued. In other words, when we explain how reverse mortgages work, we say that money “races” with inflation while the property “races” with the rates of appreciation. The bottom line is that the interest rates will likely defeat the growth of your home value and you will end up giving up more home value than expected.
This is another reason why lenders do not have a problem increasing your loan as some years go by. At the age of 60 you can borrow $40,000, for example, and then 5 years later you might be able to borrow $10,000 more. The bank or whoever lends you the money has no problem with that exactly because of interest rates and inflation.
So does that mean that you might end up owing more money than the actual value of your home when it is finally time to repay your debt? Theoretically yes, but most countries in the world have something called “negative equity protection”. This provision was put in place specifically to regulate how reverse mortgages work. It states that you cannot be held accountable for any debt which surpasses the size of the earnings from the sale of your property. The lender can “only” ask for 100% of the proceeds when you sell your home even though you might owe them a larger number than that.
If you feel like the situation might come out of hand, then you can still make voluntary payments whenever you wish in order to diminish the effect of the reverse mortgage over your financial status.