How Does a Reverse Mortgage Work?

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Updated 9/8/2020.

So, how does a reverse mortgage work? With this article, I want to dig under the hood and show you the nuts and bolts of a reverse mortgage. I can almost guarantee most lenders will not explain what I am about to go over. I think you’ll find this information valuable if you want to be a savvier reverse mortgage shopper and really understand what you’re signing up for. 

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 of how a reverse mortgage actually works. If you’re already familiar with the basics, feel free to skip this next section. 

What is a reverse mortgage?

The most common reverse mortgage in the United States 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 somebody you know recently got a reverse mortgage, it likely was a HECM.

The HECM is designed to give seniors 62 or older access to a portion of their home’s value without a monthly payment or giving up ownership of the home. As long as at least one borrower (or non-borrowing spouse) is living in the home and paying the required property charges, no mortgage payments are required. The loan only has to be repaid when the last borrower or non-borrowing spouse permanently leaves the home.

You always remain the owner of the home and you’re free to leave it to your heirs. Your heirs will inherit any equity remaining in the home whether they choose to keep it, sell it, or let the lender sell it.

The HECM is a non-recourse loan, which means the most that will 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.

The HECM is highly versatile; proceeds can be received in the form of a line of credit, lump sum, term/tenure income, or some combination of these options.

Borrowers commonly use the proceeds to get rid of existing mortgage payments, pay off other debts, finance home improvements, or supplement existing retirement income or assets.

How does a reverse mortgage work?

So, how does a reverse mortgage work? We’ve covered the basic features, but how does it work under the hood? Glad you asked! 🙂

First of all, a reverse mortgage works opposite of what you’re used to. With a traditional “forward” mortgage, you borrow a large amount and pay it back in installments over time. Your loan balance decreases and your equity increases over time (assuming home values don’t fall, of course). 

Reverse mortgages work in the opposite direction. You borrow a relatively small amount at the outset and more over time. The amount you borrow is open-ended and you’re not required to make payments on the balance (as long as you meet your 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 payments (which is the point, right?), interest simply accrues onto the loan balance over time. HECM interest rates are typically comparable to traditional 30-year fixed mortgage rates.

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.

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. The PL factor is multiplied by the maximum claim amount to determine the principal limit (PL), which is essentially the total pool of cash available.

For example, let’s assume the home value is $400,000 and the PL factor is 0.50. Because the home value is less than the lending limit, we calculate based on the home value as follows:

$400,000 (maximum claim amount) * 0.50 (PL factor) = $200,000 (principal limit)

In this case, the principal limit is $200,000. This is the total pool of cash available to pay off existing mortgages balances, closing costs, and other mandatory obligations. The remaining portion of the principal limit once mandatory obligations are paid can then be allocated to term or tenure income, lump sum, and line of credit.

Because PL factors are related to age and rates, they vary from one scenario to the next. Older borrowers tend to get higher PL factors, which means they qualify for a larger percentage of their home’s value than younger borrowers. PL factors also tend to increase as interest rates fall. Borrowers qualify for more when rates are low versus when rates are high. However, most borrowers in my experience (who tend to be between 65 and 75) usually qualify for around half their home’s value. 

If you’d like an estimate of how much you can get from a reverse mortgage, feel free to check out our reverse mortgage calculator

How interest accrues

HECM interest is calculated exactly the same way as a traditional “forward” mortgage. You take the annual interest rate, divide it by 12, and multiply it by the outstanding loan balance. For example, if the loan balance is $100,000 and the annual interest rate is 4%, then the interest due for the current month is calculated as follows:

$100,000 (loan balance) * 0.33% (monthly interest rate) = $333.33

No mortgage payments are required, so the outstanding interest is simply added to the loan balance. Thus, the new starting loan balance for the following month would be $100,333.33. 

To see how interest accrues over time, let’s check out 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 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 later. 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.

How interest accrues on a HECM reverse mortgage.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 has no plans to sell, so he doesn’t care how much equity he has. His goal was to get extra cash to spend on his grandchildren. By getting rid of the mortgage payment, John has an extra $7,200/year to spend on his retirement lifestyle that otherwise would have gone to mortgage payments.

Check out next: Reverse Mortgage Myths and Misconceptions

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