You’ve seen the TV commercials with celebrities extolling the benefits of a reverse mortgage. It sounds good, but you need more information, right? You need a simple reverse mortgage explanation about how a reverse mortgage really works.
Well, you’re in the right place! I’ve been in the mortgage industry for a long time and have helped hundreds of seniors change their lives with a reverse mortgage. I’m happy to offer a reverse mortgage explanation that’s easy to understand.
A simple reverse mortgage explanation
A HECM reverse mortgage is an FHA-insured home loan that allows seniors 62 and older to convert a portion of their home’s value into cash. The most popular reverse mortgage in America today is the home equity conversion mortgage, or HECM (often pronounced heck-um by industry professionals).
You always remain the owner of the home and can leave it to whomever you wish after you pass away. Your heirs can keep the home by paying off or refinancing the mortgage balance. If your heirs don’t want to keep the home, they can sell it or allow the lender to sell it. You heirs will inherit any remaining equity once the reverse mortgage is paid off.
The HECM is a non-recourse loan, which means you’ll never be on the hook for more than the home is worth. If the home isn’t worth enough to pay off the entire balance, FHA will cover the shortage.
The HECM is very flexible and versatile, which means lenders can fine tune it based on your individual goals and needs. Proceeds can be received in the form of a lump sum, line of credit, term or tenure income, or some combination of all of these options.
Many HECM borrowers use the proceeds to get rid of existing mortgage payments, eliminate other debt payments, finance home improvements, or supplement existing retirement income or assets. You can use the proceeds for just about anything you like.
How lenders calculate proceeds
This part can get a bit more technical, so feel free to skip ahead if you don’t feel like delving under the hood.
HECM borrowers qualify for a percentage of their home’s value based on two main factors: age of the youngest borrower (or non-borrowing spouse) and current interest rates. Most people these days tend to qualify for around 45% to 55% of their home’s value.
To calculate proceeds, the lender first looks up a principal limit factor (PLF) in tables published by FHA. The PLF is similar to a loan-to-value. For example, if the PLF is 0.50, then you qualify for 50% of the maximum claim amount (MCA). The maximum claim amount is equal to the appraised value of the home or the current lending limit, whichever is less. The appropriate PLF is selected by the lender based on your age and the expected interest rate(EIR).
For example, let’s assume your home is free and clear and worth $300,000. Because the value of the home is less than the lending limit, the maximum claim amount is $300,000. Based on your age and the current EIR, let’s also assume the PLF is 0.50, which means the initial loan-to-value equals 50%. The total initial pool of cash available to you (called the principal limit, or PL) is 50% of $300,000, or $150,000.
Keep in mind that the principal limit is not your “walk away” cash. It is out of this pool of cash that any mortgages, closing costs, and other mandatory obligations are paid. Once the mandatory obligations are paid, the remaining money is divvied up into lump sum, line of credit, and term or tenure income based on your preferences.
Note that PLFs tend to increase with age and as interest rates fall. In other words, the HECM tends to offer more money as you age and as interest rates drop.
How interest accrues
A reverse mortgage explanation isn’t complete without going over how interest accrues. Most banks probably won’t bother to explain this to you. They usually just hand you an amortization schedule and hope you can figure it out on your own.
A HECM reverse mortgage is a home loan, so naturally, it has an interest rate like any other home loan. If you don’t make payments (the whole point, right?), the interest simply accrues onto the loan balance over time.
Lenders calculate reverse mortgage interest the same way they do for traditional mortgages. The lender first divides the annual interest rate by twelve to get the monthly rate. The monthly rate is then multiplied by the balance to get the interest due.
For example, let’s assume a traditional mortgage with a rate of 6% and a balance of $100,000. The interest due for the next payment would be $500 (6%/12 months x $100,000).
This calculation works exactly the same way for a HECM reverse mortgage. The difference is that you don’t have to pay the interest out of your pocket; it’s just added to the loan balance.
Is a reverse mortgage right for you?
Hopefully this reverse mortgage explanation was helpful! Is a reverse mortgage right for you? It could be if tapping into home equity would help you live more financially secure in retirement.
If you would like to find out how much you can get from a reverse mortgage, check out our reverse mortgage calculator.