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reverse mortgage interest explained

Understanding reverse mortgage interest

Paying interest on a regular loan is a fairly straightforward concept; a borrower is charged a rate of interest based on the outstanding principal balance. When a payment is made, a portion goes to pay down the principal and the rest covers the interest due.

Paying interest on a reverse mortgage is a little more complicated. That’s because borrowers don’t pay interest as they go along. Instead, all accrued interest is paid at the time the loan is repaid, which typically occurs at the death of the homeowner or when he or she moves out of the home.

Plus, most reverse mortgages use an adjustable rate that changes over time. So if a reverse mortgage lasts ten years before it’s repaid, the lender will collect interest based on a multitude of rates.

The basics of fixed rate HECM reverse mortgage loans
To help borrowers, reverse mortgage regulations began allowing fixed rate loans in 2007. A fixed interest rate loan remains constant through the life of the loan.

This appeals to many potential borrowers. But it’s important to understand that choosing between a fixed rate and a variable rate loan for a reverse mortgage is not the same as it is for a standard mortgage. Changes in the interest rate do not affect monthly benefits because borrowers are not making monthly payments.

The main downside to a fixed interest rate is that reverse mortgage borrowers can only receive the proceeds in a lump sum. No other payment options are available with a fixed rate loan.

In addition, reverse mortgage rules state that borrowers can only claim 60 percent of the loan’s principal amount in the first year unless they are using it to pay off the existing mortgage balance. So a borrower may forfeit 40 percent of the loaned amount just to get a fixed interest rate. A reverse mortgage loan can be refinanced into another reverse mortgage loan down the line to capture more of the home’s equity if home values increae.

Therefore, experts typically advise that borrowers use a fixed rate reverse mortgage only in circumstances where a large lump sum is needed, such as paying off the existing mortgage or other debt, or making major repairs to the home.

One advantage to a fixed-rate loan is knowing that the interest rate won’t change, even if market rates rise above the fixed rate down the road. Since the interest accrual is known, borrowers can know about how much of the home’s equity they may pass on to their estate.

The basics of variable rate loans
Variable, or adjustable, interest rate reverse mortgages are a little more complex. But they also offer more payment options than a fixed rate loan. Borrowers can choose between monthly payments, line of credit, a lump sum or a combination.

In addition, interest on a variable rate loan is only charged on withdrawn funds. So if you use a reverse mortgage primarily as a line of credit, you will only be charged interest on the funds you use.

In general, variable rates are best for borrowers who plan to use their reverse mortgage funds for monthly retirement income or as a line of credit.

As the name implies, variable rate loans will fluctuate over the life of the mortgage. The rate is determined using two components: an index and a margin.

HECMs typically use the London Interbank Offered Rate (LIBOR) Index to determine variable loan rates. This index reflects the rate at which banks borrow money from other banks. The U.S. Treasury Index is also commonly used.

Reverse mortgage lenders will then set a margin above the index percentage to determine the variable loan rate. Once the margin is set, it cannot change for the life of the loan.

For example, a lender may set its margin at 2 percent. If the LIBOR Index is 2.5 percent, the variable loan rate charged during that period will be 4.5 percent (2 + 2.5). If the LIBOR Index rises to 5 percent, the reverse mortgage interest rate will also rise, to 7 percent.

Borrowers can choose whether their variable rate loan changes monthly or annually. Annual variable loans protect borrowers against frequent and steep market rate changes while monthly variable loans typically offer lower initial rates.

Don’t forget about mortgage insurance
In addition to the loan interest rate, reverse mortgages that are insured by the Federal Housing Administration have an additional mortgage insurance premium. The current premium amount is 1.25 percent of the loan balance. Therefore, if the interest rate is 3 percent, you will actually be paying 4.25 percent because of the insurance requirement.

It’s important for prospective reverse mortgage customers to shop around for the best rates, and to ask about margins if a variable rate is used. A lower rate will result in fewer interest charges over the loan’s life, which will increase the amount of equity left once the loan is repaid. Lower rates also provide a higher principal lending limit, which means more available funds.