The HECM reverse mortgage is a fantastic home loan product. Though it can benefit seniors with a variety of financial goals and needs, what does the ideal reverse mortgage candidate look like? Who is the program most ideally suited for?
I’ve helped hundreds of seniors get reverse mortgages over the years. Though a reverse mortgage can benefit seniors with a variety of financial goals and needs, I think it’s best suited for candidates that fit one of three profiles:
- Owes little to nothing on the home and doesn’t need the money right now.
- Has a big mortgage balance with many years left to pay.
- Purchasing a “forever home”.
Before I dig into these profiles in more detail, let me first cover a few basics. There is a lot of misinformation circulating about reverse mortgages, so I want to lay some groundwork first. If you already know the basics, feel free to skip the next section.
How a reverse mortgage works
The reverse mortgage is probably the most misunderstood mortgage product available. Even financially savvy people often get the basics wrong.
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). If somebody you know recently got a reverse mortgage, it’s likely they got a HECM.
The HECM program was signed into law by President Reagan as part of the Housing and Community Development Act of 1987. Today, the program is overseen and regulated by the Federal Housing Administration (FHA) under the authority of the Department of Housing and Urban Development (HUD).
The HECM is designed to give homeowners aged 62 or older access to a portion of their home’s value without a mortgage payment or giving 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.
You always remain the owner of the home and you’re free to leave it to your heirs, who will inherit any equity remaining in the home.
Because the HECM is a home loan, interest accrues on the borrowed money. If no mortgage payments are made (which is the whole point, right?), interest simply accrues onto the loan balance over time.
HECM interest rates are usually pretty comparable to 30-year rates for traditional “forward” mortgages.
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.
Reverse mortgage proceeds can be received as a line of credit, lump sum, monthly term or tenure payments, or some combination of all. The HECM is highly versatile and can be tailored to your financial goals.
HECM borrowers commonly use the proceeds to eliminate existing mortgage or other debt payments, finance home improvements, or supplement retirement income and/or assets.
Non-ideal reverse mortgage candidates
Before I dig into what an ideal HECM candidate looks like, let me first address who the non-ideal candidates are. In my opinion, there are four:
- Those who lack financial discipline. I’m not trying to be harsh here, but seniors who lack financial discipline should probably avoid a reverse mortgage. Financially undisciplined seniors who get reverse mortgages often burn through the money rapidly and end up in an even worse financial situation.
- Those who want to leave the maximum amount of equity to their children. The reverse mortgage is designed to convert equity into cash. This means the loan balance increases and the equity in the home decreases. If the goal is to leave the most equity possible to your heirs, a reverse mortgage is obviously not a good fit.
- Those who plan to sell in the near future. If you plan to sell in the next few years, it’s probably better to avoid a reverse mortgage for now. You can always get a reverse mortgage when you’re permanently settled into your new home. Much of the benefit of a reverse mortgage is realized over time; it’s not meant to be a short-term loan.
- You live with children and/or disabled relatives and want them to remain in the home after you pass away. Remember, the reverse mortgage becomes due and payable in full when the last borrower or non-borrowing spouse is no longer living in the home and paying the property charges. If you have children and/or disabled relatives living with you who won’t have the means to settle the loan balance after you pass, it’s probably best to avoid a reverse mortgage.
The ideal reverse mortgage candidate
Now that we’ve covered who shouldn’t get a reverse mortgage, let’s talk about who should. Though I’m going to cover three ideal candidates, it’s important to understand that a reverse mortgage can still those who don’t necessarily fit these profiles. The HECM is highly versatile and can benefit seniors with many financial situations and goals. The three profiles I’ll cover next simply describe what an ideal candidate looks like, in my opinion.
Profile #1: Owes little to nothing on the home and doesn’t need the money right now.
In my opinion, this is the ideal reverse mortgage candidate. This candidate is financially stable, doesn’t need the money right now, and owes little to nothing on the home. The reverse mortgage is used to supplement existing retirement assets and income and provide a safety net for unexpected expenses.
For this candidate, I recommend taking proceeds in the form of a line of credit. The beauty of the line of credit is that it essentially turns a portion of the home’s value into a tax-free retirement “account” that automatically grows larger over time.
The reverse mortgage line of credit is very similar to a traditional home equity line of credit (HELOC), except that no payment is required and the money doesn’t have to be paid back as long as the program obligations are met.
The best part is that the unused credit line will automatically grow and compound larger with no limit based on an annual growth rate.
To see how the growth rate works, let’s take a look at an example. Let’s assume our candidate qualifies for an initial credit line amount of $75,000 and the annual growth rate is 5%. As you can see in the table, the line of credit will grow to over $95,000 in just five years (assuming the growth rate doesn’t change). After ten years, it will be over $122,000.
Because the growth rate applies to the available line of credit, growth compounds on growth. This means the available credit can really pile up over time.
The growth rate will also keep up with prevailing interest rates. If interest rates rise in the future, the growth rate will as well. This means the line of credit will grow even faster.
There is no limit on how much the line of credit can grow, so it’s possible it could outgrow the value of the home. And remember, the HECM is a non-recourse loan, which means the most that will ever have to be repaid is the value of the home. FHA will cover any shortage if the home isn’t worth enough to settle the entire balance.
Profile #2: Big mortgage balance and many years left before it’s paid off.
Many seniors have refinanced in recent years to take advantage of low interest rates and reduce monthly payments. The problem, however, is that they’ve reset the clock on their mortgage payoff. Most seniors looking for a lower payment usually opt for a 30-year loan, which means many have mortgages that won’t pay off until sometime in the 2040s.
This begs a few important questions: what’s the point of paying on a mortgage you may never pay off anyway? If you have no plans to sell your home, why not get rid of the mortgage payment and improve your monthly cash flow?
The senior who doesn’t plan to sell, has a lot of years left on the mortgage, and doesn’t care about leaving equity to heirs is an ideal candidate for a reverse mortgage. Why not refinance the existing mortgage with a HECM and get rid of the mortgage payment? That frees up cash that can be used for more important things.
To see how this works, let’s look at an example. Let’s assume we’re working with a 72-year old borrower named David who has 26 years left on his 30-year fixed mortgage. David knows he’ll likely never live long enough to pay off the entire mortgage balance, so he wants to use the HECM to get rid of his $700/month principal and interest payment.
Let’s also assume that David qualifies for a reverse mortgage principal limit of about $160,000, which is just enough to cover his existing mortgage balance, closing costs, and leave him with a few hundred dollars in incidental cash.
The interest rate on the new reverse mortgage is 5.32%. When the annual mortgage insurance of 0.50% is added, the total interest rate adds up to 5.82%. Again, this is a reverse mortgage, so no monthly payments are required. Any unpaid interest simply accrues onto the loan balance over time.
Let’s fast forward ten years and see how things are going for David. Assuming rates haven’t changed and David hasn’t made any payments on the balance (the whole point, right?), the HECM balance will have grown to nearly $288,000. That means David has added almost $136,000 to his loan balance. This might initially sound bad, but don’t forget that David hasn’t made a single mortgage payment for ten whole years. He’s kept a whopping $84,000 in his pocket that otherwise would have gone to his mortgage lender.
Instead of throwing $84K at a mortgage he’ll likely never pay off, David’s has instead been spending more on grandchildren, home upgrades, cruises, etc. Yes, he’s added a lot of dollars to his loan balance, but he’s not worried about it because he has no plans to sell. It doesn’t matter how much equity he has, because he’ll never sell and cash it out. It’s more important to maximize monthly cash flow so he can maximize his lifestyle. Getting rid of a $703 mortgage payment was like getting a $703 income increase. For David, that’s a huge game changer!
Profile #3: Purchasing a “forever home”.
The HECM for purchase is one of the best kept secrets in the mortgage lending industry. The HECM enables seniors to finance the purchase of a home without a mortgage payment. Sound crazy? Read on! I will explain.
Most people know the reverse mortgage as a tool to tap into the equity of a home you already own. However, relatively few people know you can also use a HECM to buy a home.
How it works is very simple: the bank finances a certain dollar amount and you bring in the rest as your down payment. Again, no mortgage 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.
The portion the bank finances is the principal limit, which is determined based on age and expected interest rate. The principal limit is calculated exactly the same way as a “regular” HECM: the lender determines the correct principal limit factor based on the expected interest rate and the age of the youngest borrower or non borrowing spouse. The principal limit factor is then multiplied by the maximum claim amount to get the principal limit. The cash to close is the difference between the principal limit and the purchase price, plus closing costs.
In short, you qualify for a certain portion of the purchase price based on home value, age, and prevailing rates. The difference between what you qualify for (the principal limit) and the purchase price, plus closing costs, is your cash to close.
As with a “regular” HECM, principal limits are higher for older borrowers, which means the cash to close tends to be lower for older borrowers. Principal limits are also higher when interest rates are low, which means the cash to close is lower when rates are lower.
Most HECM borrowers tend to qualify for between 45% to 55% of the purchase price of the home. That means the typical borrower will need a down payment of 45% to 55%, depending on age and current interest rates. The rest is financed by the bank with no mortgage payments.
If you’d like to get a HECM for purchase down payment estimate, check out our HECM for purchase calculator.
A fantastic home loan solution
The HECM isn’t the perfect solution for every senior. However, it’s a fantastic financial solution for the right candidate. If you fit one of these three profiles, a reverse mortgage could be a game changer for you.