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Comparing Reverse and
Forward Mortgages
You can see how a reverse mortgage
works by comparing it to a “forward” mortgage – the kind you use to
buy a home. Both types of mortgages create debt against your home.
And both affect how much equity or ownership value you have in your
home. But they do so in opposite ways.
Falling Debt, Rising Equity
When you purchased your home, you probably made a small down payment
and borrowed the rest of the money you needed to buy it. Then you
paid back your traditional “forward” mortgage loan every month over
many years. During that time:
As you made each repayment, the
amount you owed (your debt or “loan balance”) grew smaller. But your
ownership value (your “equity”) grew larger. If you eventually made
a final mortgage payment, you then owed nothing, and your home
equity equaled the value of your home. In short, your forward
mortgage was a “falling debt, rising equity” type of deal.
Rising Debt, Falling Equity
Reverse mortgages have a different purpose than forward mortgages
do. With a forward mortgage, you use your income to repay debt, and
this builds up equity in your home. But with a reverse mortgage, you
are taking the equity out in cash. So with a reverse mortgage:
It’s just the opposite, or reverse,
of a forward mortgage. With a reverse mortgage, the lender sends you
cash, and you make no repayments. So the amount you owe (your debt)
gets larger as you get more and more cash and more interest is added
to your loan balance. As your dept grows, your equity shrinks,
unless your home’s value is growing at a high rate.
When a reverse mortgage becomes due and payable, you may owe a lot
of money and your equity may be very small. If you have the loan for
a long time, or if your home’s value decreases, there may not be any
equity left at the end of the loan.
In short, a reverse mortgage is a “rising debt, falling equity” type
of deal. But that is exactly what informed reverse mortgage
borrowers want: to “spend down” their home equity while they live in
their homes, without having to make monthly loan repayments. There’s
more about this important concept in an article called “A ‘Rising
Debt” Loan” in the Basics section of this site.
Exception
Reverse mortgages don’t always have rising debt and falling equity.
If a home’s value grows rapidly, your equity could increase over
time. Or, if you only get one loan advance and no interest is
charged on it, your debt would never change. So your equity would
grow as your home’s value increases. But most home values don’t grow
at consistently high rates, and interest is charged on most
mortgages. So the majority of reverse mortgages end up being “rising
debt, falling equity” loans.
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