A HECM doesn’t require a monthly payment (as long as program obligations are met, such as paying property charges). Any unpaid interest simply accrues onto the loan balance over time at an annual rate equal to the initial interest rate.
How the index influences the initial interest rate
To calculate the fully-indexed initial interest rate, the index is added to a margin set by the lender. For example, if the index is 0.50% and the margin is 2.50%, the fully-indexed initial interest rate is calculated as follows:
0.50% (index) + 2.50% (margin) = 3.00% (fully-indexed initial interest rate)
If the index increases, the initial interest rate will increase as well. This means interest will accrue onto the loan balance faster. If the index decreases, the initial interest rate will also decrease. This means interest will accrue at a slower rate onto the loan balance.
The margin is set by the lender during the origination process and never changes throughout the life of the loan.
The most commonly used indices for the variable-rate HECM are the 1-Month LIBOR and the 1-Year LIBOR. 1/1/2021 UPDATE: In 2021, the reverse mortgage industry will be transitioning to the CMT index instead of the LIBOR.
There is no index for the fixed-rate HECM because the initial interest rate is fixed for the life of the loan.
The impact to proceeds
The index and margin are used to set the expected interest rate, which is used (along with age and home value) to calculate the principal limit. The principal limit is the total pool of cash available from a reverse mortgage before mandatory obligations are paid.
The expected interest rate has a significant impact on the amount of proceeds available. If the expected interest rate increases, proceeds will typically decrease. If the expected interest rate decreases, then proceeds will typically increase. Expected interest rate and principal limit have an inverse relationship.
The expected interest rate is calculated by adding together the margin and the index. Because the index is a component of the expected interest rate, the index impacts the amount of money available from a reverse mortgage.
Note that the expected interest rate is used only to calculate proceeds. It’s not the actual note rate on the loan, though it can sometimes equal the note rate. The initial interest rate is the actual note rate at which interest accrues on an annual basis.
The initial and expected rates for a variable-rate HECM are commonly different numbers. For the fixed-rate HECM, however, the initial and expected rates are typically the same.
The impact to line of credit growth
The variable-rate HECM offers multiple payout options, including lump sum, term/tenure income, and line of credit. The fixed-rate HECM offers just lump sum. The versatility of the variable-rate HECM is a big reason why it is more popular than the fixed-rate HECM.
The HECM line of credit comes with an annual growth rate, which gives you access to more equity over time automatically. The growth rate is calculated by adding the initial interest rate to the annual MIP rate. For example, if the initial interest rate is 4.50% and the MIP rate is 0.50%, the growth rate is calculated as follows:
4.50% (initial interest rate) + 0.50% (MIP) = 5.00% (growth rate)
Because the growth rate is determined in part by the initial interest rate, it is also impacted by the index. An increase in the index will increase the growth rate on your line of credit. A decrease in the index value will decrease the growth rate. The movements in the index have a significant impact on how fast (or slow) the line of credit grows.
The lender doesn’t have control over the index, but it does have control over the margin. You may be able to negotiate for a lower margin, which lowers the initial interest rate and reduces interest costs over the life of the loan. However, again, note that the growth rate on the line of credit is tied directly to the initial interest rate. A lower initial interest rate will also reduce the growth accrued on the line of credit.