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 just need a simple reverse mortgage explanation that covers how it 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 enables 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 your home, which means you can leave it to your heirs. Your heirs can keep the home by paying off or refinancing the mortgage balance. If your heirs don’t want the home, they can either sell it or let the lender to sell it. Any remaining equity goes into your estate once the reverse mortgage is paid off.
The HECM is a non-recourse loan, which means you (or your estate) will never be on the hook for more than the home is worth. FHA will cover the shortage if your home isn’t worth enough to pay off the entire balance.
The HECM is very flexible and versatile, which means your lender can tailor it to your individual goals and needs. You can take the proceeds as a lump sum, line of credit, term or tenure income, or some combination of these options.
Many HECM borrowers use the proceeds to get rid of existing mortgage or 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
HECM borrowers qualify for a percentage of their home’s value based on two factors: the 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 reverse mortgage proceeds, your 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 home value is less than the lending limit, the maximum claim amount equals $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. Existing mortgage balances, closing costs, and other mandatory obligations are paid out of the principal limit. The remaining money after mandatory obligations are paid is what you’ll have available for allocation to lump sum, line of credit, and term/tenure.
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. Next, the lender multiplies the monthly rate 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 the same way for a HECM reverse mortgage. The difference is that you don’t have to pay the interest out of your pocket. Again, no mortgage payments required, right? The unpaid interest simply accrues onto 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.