A Rising Debt "Loan "
By: Source: AARP.org Date Posted: 2006-04-17 16:17:43.866137-04:00
The purpose of a reverse mortgage is different from that of a traditional "forward" mortgage. The purpose of a forward mortgage is to purchase a home; the purpose of a reverse mortgage is to get cash from your home.
In a forward mortgage, your loan balance (the amount you owe) gets smaller with each monthly repayments to the lender. Meanwhile the value of your home usually increases. So your home equity grows larger over time as your debt decreases. So forward mortgages are "falling debt, rising equity" loans.
In a reverse mortgage, your loan balance (debt) rises each time you get money from the lender, as interest is added to the outstanding loan balance, and you make no repayments to the lender. Unless the home's value grows very fast, the loan balance starts "catching up" to it. So reverse mortgages are typically "rising debt, falling equity" loans. Table 1 compares a forward mortgage to a reverse mortgage on a step-by-step basis.
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A Simplified Reverse Mortgage
Table 2 shows the "rising debt, falling equity" characteristics of reverse mortgages in general. To simplify the example, the table does not include all the closing costs and fees that are generally charged by a mortgage company or bank. It also does not include the costs of selling a home, which typically reduce the amount of equity remaining at the end of the loan.
In this simplified example, you can see that the $1,000 monthly loan advances in column A are added to the monthly interest at 0.5% in column B to equal the loan balance (amount owed) in column C. Over time, the loan balance grows larger. You can also see that the loan balance is subtracted from the home's value (assumed to be growing at 4% per year) in column D to produce the amount of remaining home equity in column D-C.
Table 2: Simplified* Reverse Mortgage Example
Assumptions: Monthly Loan Advance.........$1,000
Monthly Interest Rate...….....0.5%
Original Home Value......…...$200,000
Appreciation Rate.........…….4% per year
| A | B | C | D | (D - C) | |
| End of Year | Principal Advances | Interest @ 0.5%/mo. | Loan Balance | Home Value | Home Equity |
| 1 | $12,000 | $397 | $12,397 | $208,000 | $195,602 |
| 2 | 24,000 | 1,559 | 25,559 | 216,320 | 190,760 |
| 3 | 36,000 | 3,532 | 39,532 | 224,872 | 185,339 |
| 4 | 48,000 | 6,368 | 54,368 | 233,971 | 179,602 |
| 5 | 60,000 | 10,118 | 70,118 | 243,330 | 173,211 |
| 6 | 72,000 | 14,840 | 86,840 | 253,063 | 166,222 |
| 7 | 84,000 | 20,594 | 104,594 | 263,186 | 158,591 |
| 8 | 96,000 | 27,442 | 123,442 | 273,713 | 150,270 |
| 9 | 108,000 | 35,453 | 143,453 | 284,662 | 141,208 |
| 10 | 120,000 | 44,698 | 164,698 | 296,048 | 131,349 |
* Illustrative example only; does not include loan closing costs and fees, or home selling costs.
Picturing the Difference
Figure A below shows how the loan balance on a forward mortgage declines over time while the home's value is rising. Since home equity equals home value minus debt (the top line minus the bottom line in the figure), home equity is everything between the two lines, which increases over time.
Figure B shows how the loan balance on a reverse mortgage rises over time (the figure assumes a monthly loan advance). Since home equity equals home value minus debt (the top line minus the bottom line in the figure), home equity is everything between the two lines, which decreases over time.
For more information, see the Debt Limit section at http://www.aarp.org/money/revmort/revmort_basics/a2003-03-21-revmortfactsheet.html.
AARP does not endorse any reverse mortgage lender or product.
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