April 20, 2016 by HECM Pro
The HECM reverse mortgage is a home loan program designed to give seniors 62 years of age or older access to a large portion of their home’s value without having to make a monthly payment or give up ownership of the home.
Reverse mortgage proceeds can be used to get rid of existing mortgage payments, pay off other debts, or supplement existing retirement income or assets. No monthly payment is required and the loan does not have to be paid back as long as at least one borrower is living in the home and continues to pay required property charges (property taxes, homeowner’s insurance, HOA dues, etc.).
Reverse mortgage borrowers can receive the proceeds as a term or tenure payment, line of credit, lump sum, or some combination of all. The reverse mortgage can be a powerful retirement planning tool because it’s highly customizable and can be built around your specific financial goals and needs.
How Does a HECM Reverse Mortgage Work?
So, how does a HECM reverse mortgage work? Well, it’s basically just a home loan, but it’s designed to make monthly payments completely optional. Like any other home loan, the reverse mortgage has an interest rate and interest accrues on an annual basis based on the amount owed. If you choose not to make a payment, any accrued interest is simply tacked onto the loan balance.
How Reverse Mortgage Benefits Are Calculated
The amount of money available from a HECM reverse mortgage depends on your home value, the age of the youngest borrower, prevailing interest rates, and what program (fixed-rate or variable-rate) you select. There’s no set rule for how much you receive that applies to everybody; what you may qualify for could be a completely different number than what your neighbor down the street would qualify for.
To determine how much you qualify for, the lender first establishes the maximum claim amount, which is equal to the lesser of the appraised value or the FHA loan limit. A principal limit factor (PL factor) is determined based on the age of the youngest borrower and the current expected interest rate. The PL factor is multiplied by the maximum claim amount to determine the principal limit, which is the total pool of cash available. The money in the principal limit is then allocated to existing mortgages balances, closing costs, any property taxes and insurance due, and cash back to you in the form of term or tenure payments, lump sum, or line of credit.
How Interest Accrues
Reverse mortgage interest accrues on an annual basis just like a traditional forward mortgage. For example, let’s assume a fictitious borrower named John used the reverse mortgage to pay off his existing mortgage balance with 26 years remaining and eliminate a $600/month principal and interest payment.
Assuming John’s initial loan balance is $100,000 and the initial interest rate (the note rate on the loan) is 3%, his loan will accrue $3,000 worth of interest over the first year of the loan. Again, the initial interest rate is an annual interest rate. Interest accrues on an annual basis.
Because it’s a reverse mortgage, John doesn’t have to make a monthly payment on the accrued interest if he doesn’t want to. If he chooses not to make a payment, the accrued interest just adds to the existing loan balance, which means he would end the first year with a loan balance of $103,000 ($100,000 initial principal balance + $3,000 in accrued interest). If John again chooses not to take out any money or make any payments during the second year, and his initial interest rate stays at 3%, the loan balance would be $106,090 at the end of the second year.
It’s important to note that interest accrues on the loan balance, not the original loan amount. Because unpaid interest is considered a loan advance, interest compounds on interest over time. This usually isn’t a big deal in the early years of the loan, but it can mean that interest accrues rapidly in the later years if John has the reverse mortgage for a long time.
You also need to know that it isn’t just interest that accrues – MIP does as well. MIP is charged on the loan balance over time by FHA to protect both borrower and lender in the event there’s not enough value in the home to settle the entire loan balance when the loan is due and payable. This makes the loan a non-recourse loan.
The current annual MIP rate is 1.25% and it accrues onto the loan balance just like interest. Depending on how you look at things, you could say that the total interest on John’s loan is 4.25% annually, but 1.25% of that is allocated for the MIP.
As you can see in the table, interest and MIP builds up relatively slowly in the early years of the loan. However, as the loan reaches year 20, the annual interest and MIP starts building up rapidly.
Now some people might view this as a big negative for the reverse mortgage. However, this doesn’t make it a bad loan product – it’s just how it works. The program has to make sense for the investors lending the money too. If they’re going to wait potentially decades before getting their money back along with any interest, they want to be compensated for it.
In the meantime, don’t forget what John is getting out of the deal. He paid off an existing mortgage with a $600 monthly principal and interest payment that had around 26 years to go before it was paid off. He never planned on cashing out his equity by selling and moving, so he ultimately didn’t care whether he had any equity or not. His concern was having extra cash to use for fun things, like visit his grandchildren more often.
The reverse mortgage gave John an extra $7,200 every year that he was able to spend on fun things in his retirement. That adds up to $144,000 of his retirement income over 20 years that otherwise would have gone to mortgage payments on a loan he likely will never pay off anyway.
Preserving Equity While Giving You Access to Equity
Because the reverse mortgage accrues interest and gives you access to more equity over time, it’s designed to be conservative. You have access to a portion of the value of the home initially, not all of it. Most reverse mortgage borrowers tend to be able to access around 50% to 70% of the home value at the outset of the loan. If you’re younger, you’re on the lower end of that range. If you’re older, you’re on the higher end of that range.
Understand that the reverse mortgage isn’t a healthy program if it uses up equity quickly. The FHA insurance (MIP and IMIP) make the loan a non-recourse loan, which means that if there’s not enough value in the loan to pay back the entire loan balance, the FHA insurance fund has to make up the shortage. Obviously, FHA can’t pay out too many claims or the program is financially unviable.
If you’re concerned about using up your equity quickly – don’t be. The program isn’t a safe and stable program if it does that, so it’s designed to preserve your equity at the same time it gives you access to your equity.
Check out next: Reverse Mortgage Myths and Misconceptions