How a Home Equity Conversion Mortgage (HECM) Works

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A home equity conversion mortgage is a unique home loan product that offers seniors the ability to tap into home equity without giving up ownership of the home or taking on a mortgage payment.

What if you could tap into your home’s equity without giving up ownership of your home or taking on a mortgage payment? How would that change your retirement? Would you be able to have more fun and feel more financially secure? This is exactly what a home equity conversion mortgage is designed to do!

The home equity conversion mortgage, or HECM (often pronounced heck-um by industry professionals), is the most popular reverse mortgage program in the United States today. If you know somebody who got a reverse mortgage, it’s likely they got a HECM.

The HECM is a very legitimate mortgage program; it was created and signed into law by President Ronald Reagan as part of the Housing and Community Development Act of 1987. Today, the program is insured and regulated by the Federal Housing Administration (FHA) and the Department of Housing and Urban Development (HUD).

Over 50,000 HECM reverse mortgages are written every year in America today. This number will likely grow as our population ages and continues to be unprepared for retirement.

So, what is a HECM? How does it work? Who should (and shouldn’t) get a HECM? Read on! We’ll answer these questions and more.

Home equity conversion mortgage basics

The first and most important thing to understand about a HECM is this: it’s simply a home loan. However, it’s a unique home loan designed specifically to give you access to home equity without selling or taking on a mortgage payment.

The minimum qualifying age is 62. However, if you’re married, only one spouse needs to be at least 62. The younger spouse can qualify as an eligible non-borrowing spouse

No mortgage payments are required as long as at least one borrower or non-borrowing spouse is permanently living in the home, maintaining it, and paying the required property charges. Required property charges include property taxes, homeowner’s insurance, HOA dues, special assessments, and ground rents (where applicable).

You always retain title ownership of the home and you’re free to leave it to your heirs. Your heirs can keep the home by paying off or refinancing the loan balance. If your heirs don’t want the home, they can choose to sell it. Once the home is sold, the loan balance is paid off and the remaining equity goes to your heirs.

If your heirs don’t want to keep the home or mess with selling it, the lender will sell it to pay back the loan balance. Once the home is sold, the loan balance is paid off and any remaining equity goes to your heirs.

A HECM is best suited for seniors who don’t plan to move, but there is no prepayment penalty or limitation on selling. You always remain the owner of the home, so you’re free to sell at any time. Selling works just like it would for a traditional “forward” mortgage: you list the house, sell it, and pay off the loan balance through the proceeds of the sale. Any remaining equity goes to you.

The HECM is a non recourse loan, 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 pay back the entire loan balance, FHA will cover the shortage. You’ll never leave a big debt for your heirs to clean up, even if your home isn’t worth enough to pay off the entire balance.

HECM proceeds are not subject to income taxes and have no impact on Social Security retirement or Medicare benefits. Proceeds can potentially impact Medicaid and Social Security disability benefits, however. If you receive these benefits, be sure to research how a reverse mortgage could affect them.

How proceeds can be received

The HECM is highly versatile and can be structured based on your financial goals and needs. Seniors commonly use HECM proceeds to:

Proceeds can be received in the form of a lump sum, term or tenure income, line of credit, or some combination of all of these options.

  • Lump sum – A one-time payout at closing. This is a good option if you plan to make a large purchase or need a large sum of cash right away.
  • Term – A set monthly income for a certain amount or time period.
  • Tenure – A monthly income guaranteed for life, regardless of how long you live or if you use all the equity in your home.
  • Line of credit – A revolving line of credit that will automatically grow and compound larger.

You also also change any of these payout options years in the future with a simple phone call to your lender.

Common Misconceptions

There are a lot of misconceptions and misinformation floating around about the HECM. The following are a few of the most common ones:

Misconception #1: “I’m giving up ownership of my home.” Not at all. A reverse mortgage is fundamentally just a home loan. However, it’s designed to give you access to your home equity without having to sell or take on a monthly payment. You always retain title ownership of the home.

Misconception #2: “The reverse mortgage will use up all of my equity.” Yes, a reverse mortgage is designed to convert equity into cash over time. However, it’s also designed to preserve equity. Remember, the HECM is non recourse, which means FHA makes up the shortage if your home isn’t worth enough to pay off the entire loan balance. Obviously, FHA can’t be making up lots of shortages or the program isn’t financially viable.

Misconception #3: “I’ll be passing on a big debt to my heirs.” The reverse mortgage is a non recourse loan, which means that you’ll never pass a big debt onto your heirs. If there isn’t enough value in the home to pay off the entire balance, you and your heirs are not responsible for covering the shortage. Again, FHA covers the shortage.

Misconception #4: “Reverse mortgage interest rates are sky high.” Not at all. In fact, HECM reverse mortgage rates are often comparable to traditional mortgage rates.

How a home equity conversion mortgage works

A HECM works opposite to a traditional “forward” mortgage. With a traditional mortgage, you borrow a certain amount and pay it back in installments over time. Your loan balance decreases and your equity increases.

A reverse mortgage works in the opposite direction. You borrow over time and the loan is paid back in one lump sum when you permanently leave the home. Remember, the HECM is designed to convert equity into cash, which means your loan balance increases and your equity decreases.

Like any other home loan, interest accrues on the borrowed money. HECM interest rates are usually comparable to traditional 30-year fixed mortgage rates.

HECM interest rates are annual rates, but the interest accrues monthly like a traditional forward mortgage. The difference, of course, is that you don’t need to make a mortgage payment. If you choose not to make a mortgage payment (the whole point, right?), the accrued interest is simply added to the loan balance.

As an example, let’s assume a borrower named John wants to get rid of an existing $600/month mortgage payment. He has 26 years left on the loan and doesn’t think he’ll live long enough to pay it off. He wants to free up cash on a monthly basis so he can do more fun things with his grandchildren.

Let’s also assume John’s initial reverse mortgage balance is $100,000 after his existing mortgage and the closing costs are paid off. To keep things simple, let’s also assume John has used up the entire principal limit at closing to pay off his existing mortgage. No additional money is available and he doesn’t make any payments toward the loan balance in the future.

If the initial interest rate (the actual note rate on the loan) is 5%, John’s loan balance will accrue roughly $5,116 worth of interest in the first year. In the second year, he’ll accrue roughly $5,378 worth of interest. Unpaid interest is considered a loan advance, so yes, interest compounds on interest over time. This isn’t a big deal in the early years of the loan, but it can mean that interest piles up more rapidly in the later years.

MIP also accrues onto the loan balance over time. MIP is used by FHA to fund the mutual mortgage insurance fund, which makes it possible for the HECM to be a non recourse loan. FHA periodically changes the MIP rate, but as of this writing, it’s an annual rate of 0.50%. For the latest MIP rates, go here.

Home Equity Conversion Mortgage Interest and MIP Accruals

The table shows how interest and MIP accrue over time onto the loan balance. As you can see, interest and MIP build up relatively slowly in the early years of the loan. However, as the loan reaches year 20, you can see that interest and MIP start accruing relatively rapidly.

Some people might see this as a negative, but it’s just how the program works. The HECM has to make sense for the investors lending the money, too. Investors have to wait potentially decades to get repaid, so the program needs to be worth their while.

In the meantime, don’t forget what John is getting out of this. He eliminated a $600 mortgage payment he otherwise would have been stuck with for another 26 years. This gains him an extra $7,200 per year to spend on fun things like travel and visiting his grandchildren.

How proceeds are calculated

How much you qualify for depends on your home value, the age of the youngest borrower (or non-borrowing spouse), current interest rates, and the program you select (fixed-rate or variable-rate). There’s no set amount that applies to everybody because everybody’s situation and qualifications are different.

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.

principal limit factor (PL factor) is then determined based on the age of the youngest borrower (or non borrowing spouse) and the current expected interest rate (EIR). The PL factor is multiplied by the maximum claim amount to determine the principal limit (PL), which is the total gross pool of cash available. Mandatory obligations such as existing mortgages, closing costs, set-asides, property taxes and insurance due, etc., are paid out of the proceeds first. Once the mandatory obligations are settled, the remaining portion of the principal can be allocated to you in the form of term or tenure payments, lump sum, line of credit, or some combination of these options.

Put simply, you qualify for a certain portion of the value of your home based on your age and the expected interest rate (which is based on prevailing interest rates). Older borrowers tend to qualify for more than younger borrowers. The HECM also tends to offer more money as rates decrease and less money as rates increase.

Check out our reverse mortgage calculator if you’d like an estimate of how much you can get from a home equity conversion mortgage.

Closing costs

Closing costs cover the services necessary to complete your reverse mortgage and generally fall into three categories:

  • IMIP – A one-time fee charged at closing by FHA to insure the loan in the event there’s not enough value in the home in the future to settle the entire loan balance. IMIP (along with MIP) is used to fund the FHA mutual mortgage insurance fund, which is what makes the reverse mortgage non recourse.
  • Origination fee – This is charged by lenders to cover their overhead and help pad their bottom line. Lenders are often willing to negotiate this fee, particularly if you’re borrowing a pretty sizable initial loan amount.
  • Third party costs – These are fees charged to cover third party services necessary for the completion of the loan. Common third party costs include title insurance, appraisal, government recording, credit report, etc. Lenders are not allowed to mark-up third party costs; they can only pass along the bona fide cost they were charged by the service provider.

If you’re refinancing with a HECM, it’s a good bet that most (or all) fees can be rolled into the new loan amount. At most, you may need to pay for the appraisal and counseling out of pocket, but the rest of the closing costs can be rolled into the loan.

If you’re purchasing with a HECM, you’ll likely need to cover all closing costs out of pocket along with your down payment.

Who should (and shouldn’t) get a HECM

The HECM reverse mortgage is a great financial solution for the right candidate. You may be a good candidate for a reverse mortgage if you:

  • Have substantial equity in your home,
  • Aren’t concerned about leaving equity to your heirs.
  • Don’t plan to move anytime soon.
  • Could live a more enjoyable and financially secure retirement by tapping into your home’s equity.

On the other hand, you may want to avoid a reverse mortgage if:

  • You plan to move in the near future. There is no prepayment penalty or limitation on selling, but a reverse mortgage is best for seniors who want to stay in their homes. Much of the benefit comes over time. A reverse mortgage is not a short-term solution.
  • You desire to pass the maximum equity possible to your heirs. A reverse mortgage is designed to convert equity into cash. If your goal is to leave the most equity possible to your heirs, a reverse mortgage is obviously not a good fit.
  • You live with children and/or disabled relatives and want them to remain in the home after you die. Remember, the loan balance becomes due and payable when the last borrower or non-borrowing spouse no longer lives in the home and pays the required property charges. If you have children and/or disabled relatives living with you who won’t have the means to settle the loan balance after you die, it’s probably best to avoid a reverse mortgage.
  • You know you’ll need your equity in the future. If you know you’ll need your equity in the future to move into another home or into a nursing or senior-living facility, a reverse mortgage probably doesn’t make sense. The reverse mortgage will gradually reduce your equity over time, leaving you with less equity available for other purposes in the future.

How much can you get from a HECM?

If you’d like to find out how much you can get from a home equity conversion mortgage, be sure to check out our HECM calculators.

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