So, what is a HECM loan, exactly? How does it work? Glad you asked! I’m an experienced industry professional and I will be happy to fill you in. There is a lot of misinformation out there about the HECM, so I want to make sure you have accurate information.
What is a HECM loan?
So, what is a HECM loan? The acronym HECM stands for home equity conversion mortgage. The FHA-insured home equity conversion mortgage is the most popular reverse mortgage program in the United States today. If you somebody who got a reverse mortgage, chances are it was a HECM.
The HECM is a unique mortgage program that enables seniors 62 or older to convert a portion of their home’s value into cash. No monthly payments are required as long as at least one borrower (or non-borrowing spouse) is living in the home and paying the required property charges.
You always remain the owner of the home and you can leave it to your heirs. Your 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 settle the entire balance, FHA will cover the shortage out of the mutual mortgage insurance fund.
The HECM is very versatile and can be tailored to your individual financial needs and goals. 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.
A potential retirement game changer
Though not perfect for everybody, the HECM can be a game changer for many seniors. Proceeds are commonly used to:
- Eliminate existing mortgage payments
- Eliminate other debts, such as credit cards and auto loans
- Finance home improvements
- Supplement retirement income
- Pay off medical bills
- Increase liquid retirement assets
- Set up a rainy day or emergency fund
- Take a vacation
According to 2010 US census data, the typical American’s net worth at age 65 is $194,226. Around 25% of that is in the form of liquid retirement assets like savings, retirement accounts, etc. The other 75% is in the form of home equity.
Normally, there are only two ways to get into your home’s equity:
- Sell the house. If your goal is to relocate, then obviously selling is the right move. However, if you wish to stay in the home, selling to get at your equity makes zero sense.
- Cash out refinance or HELOC. The problem here is the mortgage payment, which could last twenty or thirty years. If the last thing you need is another payment, then a traditional mortgage or HELOC doesn’t make sense (not to mention HELOCs can be risky).
The reverse mortgage is designed to solve both of these problems. No other program allows you to tap into your home’s equity without giving up ownership of the home or taking on a mortgage payment.
The HECM reverse mortgage is a fantastic program, but there are a few potential negatives you should be aware of: 1) the fees, and 2) how interest compounds in the later years of the loan.
If there’s anything negative about the reverse mortgage, I would say it’s the fees. The costs to get into a reverse mortgage can be stiff – sometimes 3% to 5% of the home’s value. A big driver of the cost is the initial mortgage insurance premium (IMIP).
IMIP is charged by FHA and goes into the mutual mortgage insurance fund to protect and insure the reverse mortgage. The IMIP enables FHA to cover the shortage if the value of the home isn’t worth enough to settle the entire mortgage balance.
Regardless of what the fees add up to, note that the vast majority typically do not need to be paid out of pocket. They’re usually rolled into the starting loan balance and settled up when the entire loan is paid back in the future.
Note also that lenders sometimes have leeway to cover fees. If interest rate conditions are favorable and you’re starting off with a large mortgage balance (such as when you’re paying off an existing mortgage), lenders sometimes have leeway to cover all or part of the fees.
The HECM is a mortgage, so naturally, interest accrues on the borrowed money. HECM interest rates are usually comparable to traditional 30-year mortgage rates.
Accrued interest for a HECM is calculated exactly the same way interest is calculated on a traditional mortgage. For example, if you have a 6% 30-year fixed mortgage and the balance is exactly $100,000, the current monthly interest due is $500 (6%/12 months * $100,000 principal balance).
Interest is calculated this way for both reverse and traditional mortgages. The difference with the reverse mortgage is that you don’t have to actually pay the interest due out of your pocket. Again, no mortgage payments are required as long as at least one borrower is living in the home and paying the required property charges. Any interest not paid is added to the loan balance over time. This means the principal balance on which interest is calculated is growing, which means that interest is accruing on interest.
Note that this isn’t some dirty secret the banks try to hide from you. Reverse mortgage lenders disclose this on amortization schedules that they provide to you.
In the early years of the loan, this isn’t a big deal because the balance is relatively small. But if you have the loan a lot of years and the balance grows substantially, it could mean that interest piles up rapidly in the later years of the loan.
Having said that, don’t forget that the reverse mortgage is a non-recourse loan. If for some reason the loan balance grows larger than the value of the home, FHA will cover the shortage. You won’t leave a big mess for your heirs to clean up.
What would a HECM mean for your lifestyle?
What is a HECM loan . . . to you? What would it mean for your lifestyle? Regardless of the fees and interest (they are what they are), how would it transform your retirement lifestyle to get rid of a mortgage payment or other bills? What would it mean for your peace of mind to know you have reserves in case of a financial emergency?
If you have a lot of equity in your home, tapping into it with a HECM could substantially improve your retirement lifestyle and financial security.