Growth of principal limit is a key feature of a reverse mortgage, but few people really understand how it works. I’m going to get a little technical here, but hang with me. If you grasp what I’m about to cover, you’ll have a better understanding of the reverse mortgage than many industry professionals. Growth of principal limit really is the key machinery that makes a reverse mortgage work.
Before we dig into the nuts and bolts, let me first cover a few basics about what a reverse mortgage is. There is a lot of misinformation floating around out there. I want to make sure you have the basics right before we dig into the more advanced topic of growth of principal limit.
Reverse mortgage 101
The most popular reverse mortgage in the United States today is the federally-insured home equity conversion mortgage, or HECM. If anybody you know recently got a reverse mortgage, chances are it was a HECM.
The HECM is a unique mortgage program designed to give seniors 62 or older access to a portion of their home’s value without a mortgage payment or giving up ownership of the home. No monthly payments are required as long as at least one borrower is living in the home and paying the required property charges.
You always remain the owner of the home and you’re free to leave it to your heirs, who will inherit any equity remaining in the home.
The HECM reverse mortgage is non-recourse, which means the most that will ever have to be repaid is the value of the home. If the home isn’t worth enough to settle the entire balance, FHA will cover the shortage out of its mutual mortgage insurance fund.
HECM borrowers commonly use the proceeds to get rid of existing mortgage or other debt payments, finance home improvements, and supplement existing retirement income or assets.
Proceeds can be received in the form of term or tenure payments, line of credit, lump sum, or some combination of all of these options.
The opposite of what you’re used to
A reverse mortgage works in the opposite direction of what you’re likely used to. With a traditional “forward” mortgage, you borrow a large amount and then pay it back with interest over time. Your balance starts high and gradually pay it off over time, which increases your equity position in the home.
Reverse mortgages work in the opposite direction. You start with a low loan balance (and a lot of home equity) and gradually convert equity into cash over time. Your loan balance grows over time. Remember, “HECM” stands for home equity conversion mortgage. The idea is to convert home equity into cash that can be used for other purposes. Instead of paying down the balance, your balance grows as you extract equity out of your home.
Like any other home loan, the HECM has an interest rate, which is usually pretty comparable to traditional mortgage rates. Assuming you don’t make any mortgage payments (which is the whole point), interest simply accrues onto the loan balance over time.
FHA also assesses MIP, which accrues like interest. MIP helps make the HECM non-recourse because it goes into the FHA mutual mortgage insurance fund to cover shortages when homes aren’t worth enough to settle entire loan balances.
Assuming the borrower doesn’t make any payments (which is the point, right?), both interest and MIP accrue onto the loan balance over time.
How proceeds are calculated
The total amount of money available through the reverse mortgage is called the principal limit, or PL. The PL is the initial portion of the value of the home the lender is allowed to lend under the FHA guidelines. It is basically the bag of money available to supplement income, retirement assets, or pay off existing mortgages, credit card debt, closing costs, etc.
The PL is calculated based on home value, age of the youngest borrower (or non-borrowing spouse), and the expected interest rate (EIR).
The HECM is built on an annuity-like structure, so age plays an important role in the size of the initial PL. Older borrowers have a shorter remaining life expectancy, so they tend to qualify for more than younger borrowers.
PLs tend to be larger when interest rates are low versus when rates are high. This is a big reason why HECMs have been particularly attractive in recent years. The combination of low rates and high home values has been fantastic for seniors taking advantage of the HECM.
Most borrowers these days tend to initially qualify for somewhere between 45% to 55% of the value of the home, depending on age.
Striking a balance
Because the HECM is a non-recourse loan, FHA is on the hook for any shortage if the home isn’t worth enough to settle the entire loan balance. Obviously, FHA has strike a delicate balance between giving seniors access to home equity while preserving the mutual mortgage insurance fund.
This is why the HECM offers less to younger borrowers and more to older borrowers. Younger borrowers have a much longer life expectancy, which means interest could be accruing on the loan balance for much longer than older borrowers. If younger borrowers got the same amount as older borrowers, there would be a much higher risk that the HECM would be upside down and FHA would settling part of the loan balance.
This is also why the HECM tends to offer more when rates are low. If rates are low, then less interest accrues on the loan balance, which means that lenders can safely offer more money than if rates are high. If rates are high, then you can’t lend as much money without risking the loan being upside down at some point. Obviously, more interest accrues onto the loan balance when the interest rate is higher, right?
Growth of principal limit
Now that we’ve covered some basics, let’s start tying it all together. As I mentioned, the principal limit, or PL, is the initial pool of cash available through the reverse mortgage. The term also refers to the total amount of money borrowed or available to borrow once the reverse mortgage is already in place.
For example, let’s assume we have a borrower named Sam who has had a reverse mortgage for a few years. Let’s assume he has a current principal balance of $100,000 and an available line of credit for $100,000. In other words, he’s borrowed $100,000 so far, but he still has another $100,000 available in his HECM line of credit if he needs it. If we total the two numbers, we arrive at a current principal limit of $200,000.
Again, the term principal limit refers to two different, but similar things:
- The initial pool of cash available when the reverse mortgage is initiated.
- The total of the principal balance and money available at any time after the reverse mortgage is initiated.
Now, Sam may currently have a PL of $200,000, but that’s not what he started with. His PL was lower when the reverse mortgage was originally initiated because the principal limit grows over time.
Why does the principal limit grow? For two main reasons:
- Make more equity available over time.
- Cover interest deferrals.
How the principal limit growth rate is calculated
As I mentioned, the HECM needs to achieve two goals: 1) Make more equity available to the homeowner, and 2) Cover accrued interest and MIP. And, it needs to do this without risking a hit to FHA’s mutual mortgage insurance fund.
How the principal limit growth rate is calculated is very simple: add the initial interest rate (IIR) and the MIP together. For example, if the initial interest rate is 4.50% and the MIP rate is 0.50%, then the total interest and MIP accruing onto the loan balance annually is 5.00%. The principal limit grows by the exact same total rate.
For example, if the principal limit starts at $100,000, then it would be $105,116 one year later based on a 5% growth rate.
Now that we know this, let’s take a look at how this works in the real world. We’ll use our reverse mortgage calculator to generate the figures.
Scenario #1: 100% utilization
Let’s assume we have a borrower named Anne who is 70-years old. Her home is worth $300,000 and she has an existing mortgage balance of $128,500. Her goal is to get rid of her mortgage payment and free up cash flow so she can afford to fix up her home. If we run her scenario through the reverse mortgage calculator, we get an initial principal limit of $143,700, which is enough to cover her mortgage balance, closing costs, and leave her with $3,400 in extra cash at closing.
Anne decides to take the $3,400 at closing, so she’s utilized 100% of the reverse mortgage proceeds. There is no more money available to her in the reverse mortgage.
Anne’s reverse mortgage initial interest rate is 4.71% and the MIP rate is 0.50%, for a total interest rate of 5.21%. Interest and MIP will accrue at a rate of 5.21% annually against the loan balance.
As I mentioned earlier, the principal limit growth rate is equal to the total of the initial interest rate and MIP, so the principal limit growth rate is also 5.21%. As we can see, the principal limit grows at exactly the same rate that interest and MIP accrue onto the loan balance.
Scenario #2: Partial utilization
Now, what if Anne only owed $63,000 on her mortgage instead of $128,500? Well, she still qualifies for the same principal limit of $143,700, but she’s got a lot more money left over once the mortgage is paid off. Instead of taking funds at closing, she instead opts to leave the remaining funds on a line of credit.
According to the calculator, once the closing costs and her old mortgage are paid off, she has a starting principal balance of $74,800 and $68,900 available on her line of credit. As you can see, both numbers add up to the starting principal limit of $143,700.
Remember, the HECM is designed to not only account for deferred interest, but also give the homeowner access to more cash over time. Even though Anne hasn’t borrowed all the money she has available, her principal limit still grows over time. It grows to cover interest on the loan balance and to give access to more money through the line of credit.
Assuming the same total interest rate of 5.21%, interest and MIP are accruing at an annual rate of 5.21% on the loan balance. Because the entire principal limit is growing, that means the available line of credit is also growing at a rate of 5.21%. That means Anne is automatically getting access to more money over time on her line of credit. How cool is that?
If Anne leaves the line of credit untouched for 1 year (and doesn’t make any mortgage payments), this is what her reverse mortgage would look like:
- Principal balance: $78,792
- Available line of credit: $72,577
If we add these two numbers together, we get a total principal limit after one year of $151,369. Again, this is based on an annual principal limit growth rate of 5.21% (note that the rate is an annual rate, but it compounds monthly like any other mortgage).
Anne’s principal balance has grown $3,992 in on year, but she’s also gained access to another $3,677 on her line of credit.
In short, growth of principal limit increases the size of the pie. It increases the proportion of the value of the home that is borrowed or available to be borrowed. That enables the HECM to give access to more equity while accounting for the interest accruing onto the loan balance.
If you’re reading this sentence, then you’ve stuck with me this far. Congratulations! 🙂 This topic is pretty “in the weeds”, but it’s worth digging into if you really want a deep understanding of how the reverse mortgage works. If you’ve grasped everything I’ve covered, then you’re better informed and have a stronger understanding of the HECM program than many industry professionals.
Have a great week!
Updated 7/14/2022 to fix a calculation error. Thank you to the reader who pointed that out!