A Rising Debt "Loan"

A Rising Debt "Loan"
Source: AARP Foundation Reverse Mortgage Education Project | November 2008

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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.

Table 1: Comparing "Forward" & Reverse Mortgages

"Forward" Mortgage Reverse Mortgage
Purpose of loan to purchase a home to get cash from your home
Before closing, borrower has… no equity in the home a lot of equity in the home
At closing, borrower… owes a lot, and owes very little,
has little equity and has a lot of equity
During the loan, borrower… makes monthly payments to the lender receives payments from the lender
loan balance goes down loan balance rises
equity grows equity declines
At end of loan, borrower… owes nothing owes substantial amount
has substantial equity has much less, little, or no equity
Type of Loan Falling Debt, Rising Equity Rising Debt, Falling Equity



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%
/month
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



* llustrative example only; does not include loan closing costs, mortgage insurance premiums, fees, or home selling costs. For complete cost example, see Federally-Insured