December 29, 2018 by HECM Pro
Before we dig under the hood, let me first cover some basics about what a reverse mortgage actually is. There’s a lot of misinformation floating around out there, so I want to start by setting the record straight.
Once we’ve covered a few basics, we’ll get into the nitty-gritty about how a reverse mortgage actually works.
What is a reverse mortgage?
The most common reverse mortgage product in the United States today is the home equity conversion mortgage, or HECM (often pronounced heck-um by industry insiders). The HECM is the official federally-insured reverse mortgage program overseen and regulated by the FHA. If you anybody you know recently got a reverse mortgage, it likely was a HECM.
There are other reverse mortgages out there, but we’ll focus on the HECM here.
The HECM reverse mortgage is designed to give seniors 62 years of age or older access to a large portion of their home’s value without having to make a monthly payment or give up ownership of the home. As long as at least one borrower is living in the home and paying the required property charges, no mortgage payments are required. The balance only has to be repaid when the last surviving borrower permanently leaves the home.
Reverse mortgage borrowers always retain title ownership of the home and are free to leave it to their heirs. Their heirs will inherit any equity remaining in the home.
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 off the entire balance, FHA will cover the shortage.
Reverse mortgage proceeds are commonly used to get rid of existing mortgage or other debt payments, finance home improvements, or supplement existing retirement income or assets.
Proceeds can be received in the form of a line of credit, lump sum, term/tenure payment, or some combination of these options. The HECM is very versatile and can be built around your specific financial needs and goals.
How does a reverse mortgage work?
So, how does a reverse mortgage work? Well, first of all, it works in the opposite direction of what you’re likely used to. With a traditional “forward” mortgage, you borrow a certain amount and then pay it back with each mortgage payment. You’re building equity in your home as the loan balance pays down over time.
Reverse mortgages work in the opposite direction. The amount you borrow is open-ended and you’re not required to make payments on the balance (as long as you meet program obligations). 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, interest accrues on the borrowed money. Assuming you don’t make any payments (which is the whole point), interest simply accrues onto the loan balance over time.
HECM interest rates are usually pretty comparable to 30-year rates for traditional “forward” mortgages.
How proceeds are calculated
The amount available from a HECM depends on a few different factors, including home value, 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.
A principal limit factor (PL factor) is then determined based on the age of the youngest borrower and the current expected interest rate. The PL factor is multiplied by the maximum claim amount to determine the principal limit (PL), which is the total pool of cash available. The principal limit is first allocated to existing mortgages balances, closing costs, and property taxes and insurance due. The remaining portion of the PL is then made available to the borrower in the form of term or tenure payments, lump sum, and line of credit.
Check out our reverse mortgage calculator if you’d like an estimate of how much you can get from a reverse mortgage.
How interest accrues
Reverse mortgage interest accrues on an annual basis just like a traditional forward mortgage. As an example, let’s assume we’re working with a borrower named John who wants to get rid of his existing $600/month mortgage payment. He has 26 years left on the loan and doesn’t think he’ll even live long enough to pay it off.
The transaction works just like a refinance; John simply refinances his existing mortgage into a new mortgage called a HECM that doesn’t require a mortgage payment.
Let’s assume John’s initial reverse mortgage balance is $100,000 once closing costs and his old mortgage are paid off. To keep things simple, let’s assume John has used up the entire principal limit at closing, which means no additional money can be borrowed. Let’s also assume he doesn’t make any payments toward the balance.
If the initial interest rate (the note rate) is 3%, his loan balance will accrue roughly $3,000 worth of interest over the first year of the loan. Over the second year of the loan, he’ll accrue roughly $3,100 worth of interest.
Because unpaid interest is considered a loan advance, 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 accrues rapidly in the later years if John has the reverse mortgage a long time.
Note also that it isn’t just interest that accrues – MIP does as well. MIP accrues on the loan balance at an annual rate just like interest. FHA changes the MIP rate periodically, but for purposes of this illustration, let’s assume it’s 1.25% annually (which it was at the time of publication).
For the latest MIP rates, go here.
As you can see in the table, 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 rapidly.
Some people might view this as a big negative, but it is what it is. It’s just how the program works. The HECM has to make sense for the investors lending the money too. If an investor is going to wait potentially decades before getting repaid, they want to be compensated accordingly.
In the meantime, don’t forget what John is getting out of the deal. He paid off an existing mortgage with a $600 principal and interest payment that had 26 years to go. He never planned on selling and moving, so he ultimately doesn’t care how much equity he has.
His concern was to have extra cash to spend on fun things like visiting his grandchildren. The reverse mortgage gave John an extra $7,200/year to spend on his retirement lifestyle instead of mortgage payments.
Preserving equity while giving you access to equity
The HECM reverse mortgage is designed to be conservative. The idea is to conserve equity while giving you access to equity. The HECM isn’t a healthy program if it uses up equity quickly because FHA has to cover any shortages. If FHA is covering a lot of shortages, the program isn’t financially viable.
Most reverse mortgage borrowers are able to initially access about 40% – 50% of their home’s value. If you’re older, you may be able to get more than that.
Check out next: Reverse Mortgage Myths and Misconceptions