Break Down These Words To Understand The Concept

The U.S. Department of Housing and Urban Authority (HUD site) administers the a federal program that allows homeowners to use their home as equity for income. Basically the homeowner gives up some or all of the home in order to get monthly income. The mixture of the words annuity and mortgage is a bit confusing to some people. The key to understanding is to break down the two. Let us start with the "mortgage" part.

Regular Mortgages In Brief

Regular, "forward" mortgages are easy to understand for most people by virtue of their familiarity. It goes something like the following: a lending company has the requisite capital to buy a house outright for you. You obtain the house, but now owe some amount (say $200,000) to the lending company. You must pay back the lending company but cannot do so in one go. Instead you set up a mortgage, in effect a contract, that specifies the time period (usually 30 years) over which you make monthly or bi-monthly payments (the periodic mortgage payment) to the lending company at some interest rate.

Compare Regular Mortgage To The Reverse Kind

A reverse mortgage annuity is so-named because the lending company will confer you more money under a second contract, which are actually loans. During this time, the loans accumulate interest so that the outstanding loan amount increases gradually over time. The key advantage is that you do not have to pay back the loan! But then how does the lending company make money? When you move out or pass away, the lending company recoups its loan amount by taking possession of your home.

If You Own A Home You Can Get A Reverse Mortgage

You must own full equity of a home, and that you should be willing to part with it in return for a series of payments. The total value of the payments will be less than the value of the house because the payments are treated as loans. For example, the very first payment from the lending company to you will accrue interest over the life time of the contract. The second payment will accrue slightly less interest, etc. The sum of interest plus principal is in theory recovered by the lending company through the acquisition of your house. Of course, the lending company will have to use its actuarial tables to calculate the correct interest to charge so that over the population of its customers it is able to make money.

Differences From Pensions And Traditional Annuities

A reverse annuity mortgage bears resemblance to regular annuities and pensions. In a regular annuity you pay into the fund and receive an income stream from the fund. In the reverse annuity mortgage, you pay into your fund by giving up your home but the big difference is that the loan company hasn't taken your home yet so is unable to use the equity to generate the income directly. This means you're stuck with the rising interest on the loan. Remember that any contract that confers a series of payments over time is called an annuity. Another fact to note is that you must own a home, and that you are willing to part with the home.

Estimating Your Income

To estimate the monthly payments you will receive, you need to know three things, the valuation on your home, the prevailing interest rate, and the term length you want for receiving the payments. The prevailing interest rate is the hardest to guess, and in fact changes over time. Your best bet is to look at U.S. long term federal bond rates or ask the company for information. But most likely the financial company won't be able to give a straightforward answer because their calculations will be more complicated, taking into account interest rate fluctuations. The following calculation assumes that you will deplete all equity in your home through the reverse mortgage. Note also that your total payout will be less than the value of your home not only because of the interest on loans (which is calculated in our little calculator below) but also due to transaction costs (which we don't include).

Benefits Of The Reverse Mortgage Annuity

Usually, if you are a senior and want to convert your home into equity, you have the option of selling your home and then downgrading to a less expensive living arrangement. This converts part of your home into income that you can reinvest or use slowly in retirement. The first big drawback is that you have to move out and give up your comfortable life in the current home. The second big drawback is transaction costs involved in selling the home, and then buying or renting a new one. This is why people like to take part in a reverse mortgage: they get to keep their home for as long as they live, and use it as equity for living and other expenses. Finally, let us point out that when interest rates are very low, it is an excellent time to take out loans because you repay less than under conditions of high interest rates and this is true for a reverse mortgage.

Disadvantages Of The Reverse Mortgage Annuity

There are a few disadvantages that homeowners should be aware of. Money received from loan means less money for your heirs, family members and children. You are in effect giving up the house to retain a finite income stream. Setting up your account will also cost you in transaction fees which might be on the order of $10,000 taken from the equity in your home; after all, the loan company needs to make a profit from your contract. Plus during this time when you're living in the home, you're responsible for taxes and repairs. If you stop paying your taxes on the property, the loan company might consider this a breach of contract and cancel the loan in which case you'll be responsible for paying off the principal and interest. Furthermore, will you have enough money from the income to cover incidental expenses? Incidental expenses include the renovation and repairs on the home, and health emergency costs.

Watch Out For Financial Scams Or Conflicts Of Interest

The same company issuing the debt is interested in getting you to complete the transaction in order to make money from the fees, which we mentioned already are on the order of $10,000 to $15,000 for a medium-sized home. This company, if unscrupulous, might take the opportunity to "cross-sell". That is, they'll try to get you to buy their annuities, investment schemes, pension funds etc set up by their own or subsidiary companies. In principle there is nothing wrong with investing your income, in practice this is a conflict of interest when the same company is lending and selling! To get unbiased advice, look for a fee-only or fee-based financial consultant who do not have such conflicts of interest. Fee-based consultants make money directly from you paying them for advice, not from commissions on selling financial products.

Finding A Lender

For information, look at the federal government website which administers the HUD Reverse Mortgage program. They have a webpage that gives general information like we do, and also specifics on whether you qualify for this type of federal loan. Check their site on HUD Reverse Mortgage. You can find a list of approved lenders on this page of approved HECM lenders.

Useful Resources For Interested People

• FTC information on reverse mortgages
• Washington State fact sheet for reverse mortgage
• Editorialized information from AARP on reverse mortgages