It may sound really strange, but as it follows from the title, it is the opposite of a mortgage, so instead of spending money each month — you receive them! What a miracle you may think, but how does a reverse mortgage work exactly? You can not just be paid for nothing.
Do not worry, today we will tell you everything we know about a reverse mortgage, how it works, what you need to receive it, advantages and disadvantages, and much more. So, let’s start!
What a Reverse Mortgage Is
Let’s start from scratch, from the definition of the reverse mortgage. With a regular mortgage, you borrow a large amount of money to buy a house, which you then pay off in small payments (monthly, two times per month, or weekly).
With a reverse mortgage, you receive small amounts, usually in monthly installments, and then (after the sale of the house for example) you pay back a large amount of debt accumulated by receiving these periodic payments and interest on them.
As it follows from the above, a reverse mortgage is a special mortgage in which you receive money instead of spending it. This program was developed for Canadian elders or retirees, who experienced a grave lack of money after they left their work and stopped receiving the salary.
Historically, if you would recommend a reverse mortgage to an older person he or she would just roll their eyes on you and wonder about your financial literacy. However, time passes, and programs are changing, that is why it is not that shameful to have a reverse mortgage as a retiree because its main difference from other supporting programs is that you do not have to have a regular income for this one.
How Does a Reverse Mortgage Work?
And now let’s go to the main section of this article which is dedicated to the explanation of how does a reverse mortgage works. You will see a collocation ‘home equity’ several times so let`s firstly revise what it is. Home equity is what is left when you subtract the unpaid mortgage balance from the overall value of the home. Using a reverse mortgage you monetize a part of your home.
But why would I need this knowledge? We were talking about how does a reverse mortgage work! Stay calm, you need it throughout the article. Basically, a reverse mortgage can be called a loan secured by real estate, with the difference that it is paid monthly and not the full amount in cash right away. With a reverse mortgage, your unpaid mortgage balance increases. However, this may be partially offset if your home appreciates over the same time period.
Let’s look at the example. Seniors, each 65 years old, live only on the minimum pension in their home, worth $ 1,000,000. They enter into a loan agreement with a bank (but these are not the banks whose branches you see on the street), according to which they receive a sum at the conclusion of the agreement of $ 25,000, and then $ 1,000 every month for 14.5 years (175 payments). The second important fact: these payments do not reduce the pensions they receive (in particular, GIS and GAINS), since they are not income from the point of view of the tax agency.
Further calculations are made on the assumption that the value of their home grows by 3% per year, and the interest on the loan grows by 0.25% every 5 years when the loan is renewed. In five years, the value of their house will be $ 1,159,274, the accumulated equity in the house will remain $ 1,060,711, and in fifteen years the value of their house will already be $ 1,557,967, the accumulated money (equity) in the house will remain $ 1,237,858.
That is, their condition or equity (that is, the amount of money accumulated in the house) does not decrease with an increase in debt, but even increases. In addition, when the price of the house rises, the loan agreement can be renegotiated for a larger amount.
Alternatives
There are two tablets, red and blue, HELOC and RRSP. Which one will you choose? It is just a joke. Let’s talk about reverse mortgage alternatives if something goes wrong with it no matter the cause. We can think of 2 alternatives:
- HELOC
- RRSP
What are they? A home equity line of credit (HELOC) differs from a home equity loan in that, instead of a single amount of money distributed to the homeowner, a line of credit is created from which they can borrow. If a home equity loan has a start and an end with fixed payments in between, HELOC offers more flexibility in the amount you borrow and in turn how much you will be in monthly payments. You can borrow funds from HELOC on an ongoing basis and your payments reflect the amount of money you borrowed.
RRSP (Registered Retirement Saving Plan) on the other hand is an individual retirement program that is opened in addition to two government programs: CPP (Canada Pension Plan) and OAS (Old Age Security). RRSP is the most popular personal savings method for retirement, especially if you are not participating in an employer’s retirement plan. So it is not quite an alternative but a helpful thing too.
Reverse mortgage pros and cons
There are several pros and cons when it comes to reverse mortgages since it is a loan available when the buyer is elderly. Prices vary, so it is hard to compare them when you can not find enough information on the web.
Pros:
- No taxes
- You stay in your own home and gain money for that
- Access considerable funds
- Do not require regular payments to be made on the loan
Cons:
- Slightly higher mortgage rates and associated fees with a reverse mortgage
- If the owner(s) pass away during the loan, beneficiaries must pay off the loan and any interest owing
- The interest amount increases with every payment. If you miss a single payment, the interest rate will increase and you may need to pay a lot of money for late fees
Reverse mortgage conditions
Now that we have talked about how does a reverse mortgage work, let’s talk more about its conditions. To apply for a reverse mortgage you need to be a Canadian, of course, who owns a house and who is aged 55 or older. You must pay your existing debts (like HELOC) and you can do it with a reverse mortgage for example and the house you own must be your only place to live (and you live there for more than 6 months).
When should I repay a reverse mortgage? You can return this loan at any time if the opportunity arises. But the obligation to repay the loan arises when the house is sold. That is, as soon as the house is sold, the mortgage loan is returned to the bank. This usually happens when owners move to a nursing home, if their health has deteriorated so much that they need constant supervision, or after they have passed away.
Other cases are when:
- Property taxes or condo fees stop being paid
- The last borrower no longer resides in the property (for a period of at least 6 months)
Conclusion
A reverse mortgage is a good opportunity to receive a pension increase without increasing taxes or reducing social programs GIS and GAINS (in Ontario). So if you or your parents or your relatives are thinking about where to get money, you can tell them about this brilliant opportunity. However, one should be aware of all the other conditions which the bank will set you in the contract and do not make hasty decisions.