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Reverse Mortgages Basics

You may be wondering, "Why do I want to get involved with this complicated reverse mortgage business when I could just take out a home equity loan or a new mortgage on my home?"

The problem with traditional "non-reverse" mortgage loan options is that you've got to begin paying them back soon after taking them out.

The following example illustrates the problem: Suppose that you are the proud owner of a home worth $225,000, and you have no mortgage on the home. You want to stay in the home and have no desire to sell it and move. You speak with some lenders and discover that they're willing to lend you $100,000 through a 15-year mortgage at 8 percent.

Getting $100,000 in your hands right now sounds appealing. However -- and this a big however -- you need to begin making payments of $956 per month on your traditional mortgage loan.

Now, if you invested the $100,000 that you borrowed in some high-quality bonds, you'd discover that you may get about a 7 percent return, which will bring in just $583 of monthly income, not nearly, enough to cover your monthly mortgage payments. If you invest in stocks and earn the market average return of 10 percent per year, which is by no means guaranteed, that return translates into just $833 per month -- still less than the monthly payment required on the mortgage.

Now, if you're thinking that you can simply live on the $100,000 principal to supplement the money from the investment returns, don't forget that you're going to have to keep making payments, and the longer you live in the house, the more likely you are to run out of money and begin missing loan payments. If that happens, unlike with a reverse mortgage, the lending institution may foreclose on your loan, and you can lose your property.

How it works

So what exactly is a reverse mortgage, and how does it work? Well, as the name suggests, a reverse mortgage reverses the traditional mortgage process. Think back to when you bought your first home. Unless you had generous and affluent relatives, you probably had to scrape together the money for the down payment and seemingly never-ending closing costs.

And then you were likely saddled with what seemed like a mountain of mortgage debt. Every month, thereafter, you dutifully mailed to the mortgage lender a check for the monthly mortgage payment. In the early years of your mortgage, the vast majority of those monthly mortgage payments went to pay interest on your outstanding loan balance, but a small portion of each of those payments went toward principal, in other words, reducing the loan balance. (As the years roll by, the loan balance should pay down at a faster and faster rate until, eventually, your mortgage is paid off.)

A reverse mortgage reverses this process. When you take out a reverse mortgage, the mortgage lender typically sends you a monthly check. Imagine that! You can spend the check any way your heart desires. And, because the check represents a loan, the payment to you isn't taxable.

As the reverse mortgage lender gives you more payments, you accumulate an outstanding loan balance. Unlike other loan balances you may have, such as on a credit card or a business loan, you typically don't have to pay a single penny back on your reverse mortgage loan until the home is sold (and then the loan and the accrued interest is paid back from the sale proceeds) or, with some reverse mortgage programs, when you move out of the property.