So, how does a reverse mortgage work? First of all, a reverse mortgage works in the opposite direction of what you’re accustomed to. When you take out a traditional “forward” mortgage, you borrow a large amount upfront and pay it back 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 upfront and more over time. The loan balance is paid back all at once when the loan becomes due and payable (usually after the last borrower is no longer living permanently in the home).
Interest accrues on the borrowed money just like it does for any other home loan. Assuming you don’t make mortgage payments (the whole point, right?), interest 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 several factors, including the value of your home, age of the youngest borrower (or non-borrowing spouse), current interest rates, and the particular loan product you select (fixed-rate or variable-rate). There’s no set amount that applies to every scenario.
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.
A 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). The principal limit is the total amount of money offered by the reverse mortgage.
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 the principal limit as follows:
$400,000 (maximum claim amount) * 0.50 (PL factor) = $200,000 (principal limit)
As you can see, the principal limit is $200,000. This is the total amount of money 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 based on age and current interest rates, they vary from one scenario to the next. Older borrowers tend to get higher PL factors and younger borrowers tend to get lower PL factors. This means that older borrowers tend to qualify for more and younger borrowers tend to qualify for less.
PL factors also tend to be higher when rates are low, which means you’ll likely qualify for more when rates are lower rather than higher.
If you’d like an estimate of how much you can get from a reverse mortgage, feel free to check out this reverse mortgage calculator.
How interest accrues
HECM interest is calculated the same way as for 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
If you don’t make a mortgage payment, then the outstanding interest is simply added to the loan balance. This means that the 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 want to wait that long to pay it off.
Let’s assume John’s initial reverse mortgage balance is $100,000 once closing costs and his old mortgage are paid off. 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 will accrue more rapidly in the later years of the loan.
MIP accrues onto the loan balance over time as well. MIP is used by FHA to insure the reverse mortgage, which makes the loan non-recourse. MIP accrues based on 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. 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 negative, but 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 is 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.