Understanding reverse mortgage amortization
If you have taken out a loan of any kind, especially a mortgage, you are familiar with the concept of amortization. This is the process by which a loan’s principal decreases with each payment.
An amortization schedule is a table that breaks down how much of each payment goes toward reducing the loan’s principal and how much goes toward paying interest.
Amortization schedules are most commonly connected to traditional home mortgages. In a traditional mortgage, the schedule shows how the mortgage balance decreases with each payment, as well as how much of each payment is going toward principal and how much is going toward interest.
If you have a 30-year mortgage, the amortization schedule will show you what your principal balance will be after each one of your 360 monthly payments, assuming you make the minimum principal and interest payment required by the lender.
A reverse mortgage also has an amortization schedule, but it’s considered a negative amortization because the loan balance actually increases over time. That’s because you aren’t making monthly payments to make the loan balance smaller; the longer you have the reverse mortgage, the more money you’re borrowing and/or the more interest is accruing.
A reverse mortgage amortization schedule can help potential borrowers estimate how much they will eventually owe once the loan is due, which occurs when the homeowner(s) passes away or moves out of the home. At that point, the home is typically sold, and the proceeds are used to repay the loan.
A potential reverse mortgage borrower should study the amortization schedule provided by the lender before committing to the loan.
Differences between traditional and reverse mortgage amortization
In a traditional mortgage, you will pay the most amount of interest in the first years of the loan. The longer you make payments, the less the amount of interest is required with each payment.
For example, if you borrowed $300,000 on a 5-percent, 30-year mortgage, your monthly principal and interest payment would be just over $1,600.
In the first year of the loan, you would pay almost $15,000 in interest while paying down only $4,400 in principal. In year 15, your monthly payments would reduce your principal by $8,900, while accounting for $10,425 in interest. In year 30, your interest payments would only amount to a little over $500.
In a reverse mortgage, your interest obligation will compound each year and become larger, thus adding to the total amount you will repay at the end of the loan.
For example, if you took a lump sum $100,000 reverse mortgage at a fixed 5 percent interest rate, the loan would accrue $5,000 in interest the first year. That would result in you owing the lender $105,000 after the first year.
Another 5 percent interest would be tacked on to that amount during the second year, resulting in a second-year interest amount of $5,250 ($105,000 x 5%). Added to the first-year balance, your loan repayment amount would be $110,250.
In year 25 of this hypothetical example, the annual interest accrued would be $16,125, and your reverse mortgage loan repayment would total $338,635.
How to amortize for monthly payments
You can also use an amortization schedule if you plan to receive your reverse mortgage proceeds as monthly income.
For example, if you completely own a home valued at $300,000, you can borrow about $162,000, minus fees and closing costs. If you don’t receive any of the money upfronts, the reverse mortgage will pay about $785 a month as long as you live in the home.
According to a reverse mortgage amortization schedule, assuming an average annual interest rate of 3.5 percent, after ten years your reverse mortgage will have paid you a total of $94,200 while generating interest of $18,722. That means if the loan ended after ten years, you would owe $112,922.
After 20 years, the loan balance would be just over $273,000 ($188,400 in principal and $84,600 in interest). If the reverse mortgage lasted 30 years, the loan balance would be $500,250 ($282,600 in principal and $217,650 in interest).
The main thing to keep in mind with monthly income payments is that the lender will use a variable interest rate to determine the amount of interest owed at the end of the loan. That means the interest rate for your reverse mortgage will change from month-to-month or year-to-year, depending on the loan provisions.
As far as the amortization schedule, the amount of interest and total amount due will be estimates, since it is not possible to know how interest rates will fluctuate over the life of the loan.
Also keep in mind that the scenarios listed above do not include mortgage insurance premiums, which you will be charged for annually. Like interest amounts, mortgage insurance premium costs accrue over time on a reverse mortgage, and you pay it once the loan is called due and payable. The annual premium is 1.25 percent of the outstanding loan balance.