The initial interest rate (IIR) is the actual note rate on a HECM reverse mortgage. In other words, interest accrues onto the loan balance (assuming no monthly payments are made) at an annual rate equal to the initial interest rate.
The initial interest rate for the variable-rate HECM can change over time based on the underlying index. The initial interest rate for the fixed-rate HECM never changes for the life of the loan.
Note that the initial interest rate is not the same thing as the expected interest rate (EIR). The expected interest rate is used solely to calculate gross proceeds (called the principal limit).
Your lender will disclose both the expected interest rate and the initial interest rate on your loan documents. However, again, the initial interest rate is the actual note rate on the loan.
How interest accrues
The initial interest rate is an annual rate, but interest accrues monthly like a traditional mortgage. For example, let’s assume the initial interest rate is 5% and the loan balance is $100,000. To calculate the interest due for the current month, we need to first calculate the monthly interest rate:
5% (IIR) / 12 months = 0.41667% (monthly rate)
The monthly interest rate is then multiplied by the current loan balance to calculate the interest:
0.41667% (monthly rate) * $100,000 (balance) = $416.67 (interest due)
As you can see, the accrued interest for the current month equals $416.67. This is the same way interest is calculated for traditional “forward” mortgages. The difference, of course, is that you’re not required to make payments on the HECM balance as long as you live in the home and pay the property charges. The unpaid interest is simply tacked onto the loan balance:
$100,000 (starting balance) + $416.67 (interest due) = $100,416.67 (new balance)
The new loan balance is then used to calculate interest accruals for the following month, and so on.
How the initial interest rate compounds
Unpaid interest is considered a loan advance, so yes, interest accrues on interest over time. This means the loan balance compounds over time. This isn’t usually a big deal in the early years of the loan when the balance is relatively small. However, it can mean that interest piles up rapidly in the later years when the balance is much larger.
Some commentators might consider this a disadvantage, but it’s really just a consequence of how the program is designed and how the investors who lend the money want to be compensated. Remember, monthly payments aren’t required, so it’s possible that a lender will have to wait decades before collecting even a dollar’s worth of interest. That’s a long time to wait for a return on your investment.
Having said that, it’s also important to understand that the HECM is designed to preserve equity as well. It’s not a healthy loan program if it uses equity quickly because that would increase the risk of the loan balance growing larger than the value of the home, which could make the HECM program insolvent.
The HECM is non-recourse
Remember, you, your heirs, and your estate are not on the hook for the shortage if the home isn’t worth enough to settle the entire loan balance. A HECM reverse mortgage is a non-recourse loan. Any shortage has to be settled up by the FHA mortgage insurance fund. Obviously, FHA needs to limit the hits to the insurance fund or the whole program would go belly up.
Expert Tip
Only take out money from the reverse mortgage if you absolutely need it. It doesn’t make sense to pull out a large amount of money you don’t really need because you’ll accrue interest on a larger balance.
If there’s extra money available that you don’t need right now, go with the variable-rate HECM and leave it stored in the line of credit. The money in the line of credit is accessible at any time and you’re not accruing interest on it until you use it.
