Reverse Mortgage Basics
APPENDIX: Rising Debt and Falling Equity
The purpose and operation of a reverse mortgage are different from those of a standard “forward” mortgage. The purpose of a forward mortgage is to purchase a home; the purpose of a reverse mortgage is to generate cash.
In a forward mortgage, your home equity increases over time. Your loan balance (the amount you owe) decreases as you make monthly repayments to the lender. Meanwhile the value of your home is usually increasing. Forward mortgages are “falling debt, rising equity” transactions (see Table A-1).
In a reverse mortgage, your home equity generally decreases over time. Your loan balance rises as loan advances are made to you by the lender, interest is added to the outstanding loan balance, and you make no repayments to the lender. Unless the home appreciates (grows in value) at more than a moderate rate, the loan balance starts “catching up” to the home. Reverse mortgages are typically “rising debt, falling equity” transactions (see Table A-1).
A simplified example of a reverse mortgage is presented in Table A-2. The purpose of this table is to show 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 the 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.
Figure A-1 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 A-2 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.
