Content in this reverse mortgage guide has been prepared in straight-forward terms, intended for a general audience. Certain technical details of reverse mortgage or home equity conversion mortgage (HECM) loans are presented here.
Important questions addressed in this article:
- How is the interest rate on my HECM determined?
- How do line of credit variable interest rate HECMs work?
Click on the link above to go directly to the information you need or scroll down to read this article in its entirety.
How is the interest rate on my HECM determined?
HECMs actually use two interest rates.
1. Expected interest rate. This is used to estimate how much money you can get as part of an actuarial equation.
The expected rate on adjustable-rate HECMs may be based on the lender's choice of the 10-year Constant Maturity Treasury (CMT) or the 10-year London Interbank Offered Rate (LIBOR) swap rate as an index. To this value, a margin of a few percentage points (usually 2, 3 or more) is added, and this becomes the "expected interest rate." This expected rate is used to determine the loan amount available to you and the loan's potential total costs.
For up-front calculations, there is actually a 5 percent "floor" on the expected interest rate. That is, if the 10-year CMT has a value of 1.5 percent, and the lender's margin is 3 percentage points, the expected interest rate would be 4.5 percent; however, according to Housing and Urban Development (HUD) rules, it cannot be lower than 5 percent, so 5 percent is the value the lender may use when estimating the size of your HECM. In times of more "normal" interest rates, it's likely that this expected rate could be above this threshold anyway.
2. Actual interest rate. Market conditions change over time, and the expected interest rate may not be that close to reality as the economy waxes and wanes. As such, there is also an actual interest rate applied to your loan that governs your interest costs.
Rates for adjustable or variable HECMs work much as those do on regular (forward) adjustable rate mortgages (ARMs) or Equity Lines of Credit. Several constructs are available:
The initial rate for an annually-adjustable HECM may use the 1-year CMT or 1-year LIBOR as an index.
To either of these choices, the lender adds a margin of 2 or 3 percentage points to arrive at the actual interest rate charged for the coming year.
To limit how quickly these interest rates may rise or fall in a given year, annually adjustable interest rates cannot vary by more than 2 percentage points per year, or 5 points over the life of the loan. These limits are called "periodic" and "lifetime" caps.
The initial rate on a monthly-adjustable HECM may use the 1-year CMT, 1-month CMT, or 1-month LIBOR as an index. Unlike annually-adjusting interest rate, these generally don't have periodic caps, and many have only a lifetime ceiling on how high the rate might rise. This arrangement is similar to a traditional home equity line of credit, where a cap (such as 10 percentage points over the starting rate) may be expressed -- or there may be an absolute ceiling detailed instead, where the rate can never rise above a specified amount, such as 15 percent.
How your rate is constructed (index, margin, caps) and the rate you are being charged can have an effect on how quickly any available balance may grow over time. For line-of-credit HECMs, this is called the HECM's "compounding rate;" the total "compounding rate" charged on the loan balance equals the current interest rate charged on the loan + 1.25%.
The 1.25% is the annual charge for the FHA mortgage insurance premium. This amount will be changing to a 0.5% annual fee for HECMs originated after October 2, 2017.
Example: If the 1-year Treasury is 2% and the lender's margin is 3.5%, then the compounding rate is 6.75% (2% + 3.5% + 1.25%)
Here, the unused portion of your line of credit would grow by 6.75% (in reality, this is reflected simply as an increase in your credit limit -- your borrowing capability will have grown by an annualized rate of 6.75 percent).
HUD does not specify an index or interest-rate construction to be produce the rates for a fixed-rate HECM loan; these interest rates are determined by lenders and/or their investors. For a fixed-rate HECM, the expected rate used to calculate how much money you can obtain is your loan's actual interest rate.
How do line of credit variable interest rates HECMs work?
HECM Line of credit products carry a variable interest rate, adjustable either monthly or annually. To make the program as common everywhere as possible, lenders must use either a Treasury Constant Maturity (TCM) or LIBOR rate.
- For monthly adjustables: This can be the 1-month or 1-year TCM, or the 1-month LIBOR rate.
- For annual adjustables: This can be either the 1-year TCM or the 12-month LIBOR rate.
As the value of the index isn't set by the lender, this will be a constant from place to place. However, lenders are free to set their own markups (called "margin") on top of the index value to determine the rate (the index value + the lender margin = your interest rate).
If you're considering a variable rate offer, you should ask about the margin. A lower margin means a lower interest rate and will create lower costs over time. You may wish to check with several lenders to see if one has a lower margin than another.
Like "forward" ARMs, interest rate changes are limited by interest rate limiters, or caps. For annual-adjustable HECMs, these are currently limited to changes of no more than 2 percentage points each time the interest rate is scheduled to be changed. This is called a "periodic cap." The interest rate can never increase more than 5 percentage points over the HECM's original interest rate (called the "lifetime cap"). HUD is studying whether to limit periodic changes to 1 percent per year.
Like traditional home equity lines of credit, monthly adjustable rate HECMs have no periodic cap, but instead have a lifetime ceiling to limit rate changes. This may be the HECM's starting interest rate plus 10 percentage points (more or less), and it is theoretically possible that the interest rate could jump that amount in a single month. However, that would require the governing index (LIBOR or TCM) to jump by that much… which is highly unlikely.
Reverse mortgages are complex products that should be evaluated from both a financial and personal perspective. Part 3 of this guide addresses familial considerations.
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