April 26, 2017 by HECM Pro
You’ve seen the TV ads or heard of friends who’ve gotten one, but you’ve never actually had the reverse mortgage explained to you. Well, you’re in the right place! This article is written by an experienced industry professional who will give you the straight deal on what a reverse mortgage is and how it works.
The Reverse Mortgage Explained
The most common reverse mortgage product today is the HECM (often pronounced heck-um by industry insiders), which stands for Home Equity Conversion Mortgage. The HECM program was signed into law by President Ronald Reagan as part of the Housing and Community Development Act of 1987. Today, the program is overseen and regulated by the Federal Housing Administration (FHA) under the authority of the Department of Housing and Urban Development (HUD).
The HECM is a unique mortgage product designed specifically to give seniors easy access to their home’s equity without a monthly payment or giving up ownership of the home. The following are some notable features of a HECM:
- No monthly payments are required and the loan does not need to be repaid as long as at least one borrower is living in the home.
- You remain the owner of the home and are free to will it to your heirs.
- Loan proceeds can be taken as a lump sum payout, credit line, monthly term or tenure payment, or some combination of all three.
- Loan proceeds are not subject to income taxes and do not impact Social Security or Medicare benefits.
- The HECM is a non-recourse loan, meaning you, your estate, or your heirs will never have to repay any more than the value of the home regardless of how much you borrow.
- The HECM program was created by the federal government and is insured and regulated by FHA.
Your obligations under the HECM program are simply to pay your real estate taxes, homeowners insurance, and live in the home as your primary residence. As long as you do these things, no monthly mortgage payment is required and the loan does not have to be repaid.
How Does the HECM Reverse Mortgage Work?
If you’ve never had the reverse mortgage explained to you, the idea of getting one is probably a little scary. Perfectly understandable! It’s important to have the reverse mortgage explained by somebody who knows what they’re talking about so you can make an informed decision about whether it’s right for you.
So, how does a HECM reverse mortgage work? Well, it’s simply a type of home loan, but it’s one designed to make monthly payments optional. Like any other home loan, it 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.
To see how this works, let’s assume a fictitious borrower named John used the reverse mortgage to pay off an existing mortgage that has a $600/month principal and interest payment and 26 years remaining.
Assuming John’s starting reverse mortgage balance is $100,000 and the initial interest rate (the note rate on the reverse mortgage) 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). Don’t forget that he’s also saved $7,200 worth of mortgage payments that he no longer has to make.
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 even a penny of 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 on a monthly basis that he could spend on fun things, like improving his home or visiting 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.
Still With Me?
Now that we’ve had the inner workings of the reverse mortgage explained, let’s cover some other important considerations when deciding if a reverse mortgage is right for you.