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Understanding reverse mortgages

Reverse mortgage: it can help you to use some of the equity built up in your home

Readers, this is a current update on a previous article I wrote for Moneywise in The Royal Gazette more than nine years ago.

A few weeks ago, readers of The Royal Gazette read an incredibly sad story: “After the tragic loss of my daughter, I’m out of money, I cannot find a job, I am behind in my mortgage payments and am in serious danger of losing my home. Readers responded with sympathy and suggestions, among them obtaining a reverse mortgage from a local bank or lending institution.”

Let’s understand what a reverse mortgage is — compared to a regular mortgage. Since — to the best of my knowledge (I’m not perfect though) — there is no reverse mortgage product currently offered in Bermuda, so we will look to other countries, primarily the United States, to platform off their more than 50 years of mortgage finance experience. I may use bank and lending institution nomenclature interchangeably.

Conventional mortgage summary

• You purchase the home in your name.

• Generally, a down payment is required from you, usually the amount the bank won’t lend to you (say 25 per cent of purchase price).

• The bank loans the difference in appraised value from the down payment. We assume this value is 75 per cent of purchase price.

• You pay the bank your monthly mortgage payments, thus, the mortgage principal balance decreases over the life of the loan, say 20 years.

• The bank keeps your deed until the entire mortgage principal balance (and interest) is paid in full down to zero.

• You receive the deed — you own the home outright.

• Your home is unencumbered (no debt). Therefore, you have 100 per cent equity value (whatever the appraisal value is at any point in time).

Reverse mortgage summary

In 1961, the US saw the first reverse mortgage product in Portland, Maine designed by a Nelson Haynes of Deering Savings & Loan (now an inactive bank) to help a widow stay in her home. http://www.russcares.com/reverse-mortgage-history.html

Fifty years on, reverse mortgages (more than 70,000 new issues each year) are part of mainstream US finance activity, while the government regulations have been updated for better consumer and lender protection.

See Wikipedia for a summary of US, Canada, and Australia reverse mortgages. https://en.wikipedia.org/wiki/Reverse_mortgage

The UK also appears to offer them. See Credit Explained. http://creditexplained.org.uk/credit-explained/mortgages/reverse-mortgages/

• You own the property, free and clear (unencumbered) and you are over 62.

• It may have a remaining mortgage balance attached.

• The bank appraises your property to determine its value (collateral for the mortgage).

• The bank pays you a lump sum (or monthly payments) based upon a percentage of appraised value formula.

• Your reverse mortgage balance owed back to the bank increases over time.

• At the end of the agreed reverse mortgage term, or the end of your life, the reverse mortgage is due.

• Your estate or your relatives must pay the reverse mortgage in full back to the bank.

• If the resources are inadequate, the bank forecloses and the family property is sold.

The basic premises of a reverse mortgage

Unequivocally, there are four premises (yes, this is also a play on words) that have to happen in order for a reverse mortgage to take place. Naturally, in between these four data points, there are significant legal and financial conditions that also come into play.

1. Equity in the home at the beginning. Is there sufficient unencumbered equity in your home to write a reverse mortgage?

2. Equity in the home at the end. Will there be sufficient real property value at the end of the contract for the lending institution (bank) to recoup the amount of the reverse mortgage?

3. Is there a financial institution willing to offer a reverse mortgage on your home? This is a very long-tailed product profit wait.

4. How long do you plan on living going forward — in your home — and on this earth?

The process

What value can be taken from the existing home under a reverse mortgage contract?

George Homeowner is 78 years young, his wife Rochelle is 75. While they used to be able to get by on their Social Insurance benefits and interest on savings, now inflation, and health costs are whittling their principal down at an alarming rate.

George is adamant that they will not, ever, be a financial burden to their children, but is increasingly anxious about their future. Their home, estimated to be worth about $600,000 is debt-free, but they are not eligible for a bank loan because neither they, nor their children, have the extra income to cover loan payments.

They could sell the home, but where would they live then? A reverse mortgage may be a good way to get the funds they need to balance their budget.

We illustrate reverse-mortgage amount this hypothetical composite couple (and two other anonymous homeowners) might receive.

Readers keep in mind that percentage of value amounts loaned, at a minimum, depend upon age of applicant, any outstanding mortgages, and current interest rates in capital markets, i.e. anywhere from 45 per cent to 66 per cent — the top percentage of appraised home value according to US HUD and FHA guidelines. http://oureverydaylife.com/percent-value-can-borrow-reverse-mortgage-41748.html

Composite Case 1: Individuals (A) own a home appraised at today’s value of $600,000. They owe $150,000 on the home mortgage.

The bank is willing to write a reverse-mortgage contract for 50 per cent of the appraised current value, plus interest. Total amount of the reverse mortgage plus interest and fees is $300,000. The existing mortgage will be paid off, leaving $150,000 clear.

Composite Case 2: Individuals (B) own a home appraised at today’s value of $600,000. They owe $350,000 on the home mortgage.

They may not be eligible as the 50 per cent amount would not even reduce the outstanding mortgage.

Composite Case 3: George and Rochelle own a home appraised at today’s value of $600,000. They are debt free, the home is completely unencumbered. They are eligible, after meeting all conditions, for a $300,000 reverse-mortgage to be paid out in monthly instalments for their remaining years.

There are many terms and restrictions in the reverse mortgage contracts between the bank and the homeowner, along with advantages and disadvantages for the homeowner and the lending institution.

We discuss these in the final part next week.

Martha Harris Myron CPA CFP JSM: Masters of Law, International Tax and Financial Services, Pondstraddler* Life™ Financial Perspectives for Bermuda Islanders with Multinational Families and International Connections on the Great Atlantic Pond. Contact: martha@pondstraddler.com