Reverse Mortgage Interest and How it Works
Before taking out a reverse mortgage loan, it’s best to understand exactly how the loan works – particularly when it comes to interest. Since interest is essentially the extra cost the bank charges for a loan, the more interest you build, the more money you’re going to owe.
How does the interest work in a reverse mortgage?
Unlike conventional mortgage loans, where the borrower pays down the principal and interest through monthly payments, reverse mortgage loans work in the opposite way. The bank either makes regular payments to the borrower or lends the money in a lump sum. No matter how the borrower chooses to receive the money, every month, the balance and interest will increase, as long as the interest goes unpaid. This is one of the reasons reverse mortgages are considered a more expensive form of financing, as the borrower usually ends up paying interest on interest.
The process of a loan amount increasing over time is also known as reverse amortization. Conventional mortgages, 30 year fixed rate mortgages for example, are amortized over a period of time with the borrower agreeing to make regular payments to bring the balance down. With reverse mortgages, both the principal balance and interest can grow, depending on the structure of the bank’s payments and whether or not the borrower decides to make payments toward the balance.
If the borrower opts to receive monthly payments, and does not make any payments toward the loan, then both the principal and interest will increase – and at a fairly rapid rate. If the borrower chooses a lump sum payment and opts not to pay anything toward the mortgage, then the principal balance will remain the same, but the interest will compound.
All of this may sound very confusing, which is why it is important for potential borrowers to discuss their reverse mortgage options fully with a licensed mortgage professional.
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Can the borrower make prepayments?
Although borrowers are not required to make principal or interest payments on their reverse mortgage loans, prepayment penalties are not assessed. This means you can make payments toward your reverse mortgage as you see fit and you won’t be penalized for it.
A wise strategy for reverse mortgage borrowers could be to make payments toward the interest as regularly as possible. This can help prevent your overall balance from escalating while still being able to enjoy having extra cash. Of course, this strategy makes the most sense for those who opt for a lump sum payment instead of equal monthly installments. Another benefit to making interest payments is that the borrower can receive a tax deduction, just as they would for the interest paid in a conventional mortgage.
How does reverse mortgage interest increase?
Although your interest rate on a reverse mortgage won’t necessarily change, your interest expense will likely increase. This is due to the fact that your principal balance will increase (if you choose to receive regular payments instead of a lump sum). In other words, as you receive a check every month, your outstanding debt increases – so the amount you pay in interest increases as well.
How can I avoid paying more in interest?
The best way to avoid paying more in interest on a reverse mortgage may be to opt for a lump sum (where the principal loan balance does not increase) or choose to make payments toward your loan whenever possible. Talk to your loan consultant to find out which type of reverse mortgage plan will work best for you.