How a reverse mortgage line of credit works
A reverse mortgage is a type of home equity loan that allows certain homeowners to convert their home equity into cash. It differs from a traditional home equity loan in that the home owner does not make monthly payments to repay the loan. Instead, a reverse mortgage loan is repaid, with interest, when the property is sold, refinanced, or when the homeowner moves out of the house.
The most common reverse mortgages are Home Equity Conversion Mortgages (HECMs). These are federally insured loans backed by the U.S. Department of Housing and Urban Development (HUD).
HECMs offer several payment options, including a line of credit that allows you to draw down the loan proceeds at any time, in amounts you choose, until you have used up the line of credit.
Why a line of credit
HECMs can also be paid in a single lump sum, which is ideal for seniors who have a major expense to pay right away. Another payment option is a series of monthly payments, most often used by borrowers who need a regular supplement to their retirement income.
A line of credit, on the other hand, is ideal for borrowers who:
- May have a short-term or temporary financial need
- Anticipate having a financial need down the road
- Want quick access to cash if and when a need arises
They can be used for a variety of needs such as paying to replace a broken appliance, taking a vacation, buying a new car, or paying a large medical bill.
The initial amount a homeowner can borrow will depend on the age of the youngest borrower, current interest rates and the property’s appraised value, up to a cap of $625,500.
The interest rate owed on an HECM line of credit is adjustable, which means it will vary over time. However, because it’s a line of credit, you will only owe interest on the amount you use when it’s time to repay the loan.
A line of credit increases
In addition, the amount of credit available to the borrower — the initial amount of credit minus any used funds — increases each month. After the first month, the principal limit increases monthly at a rate equal to 1/12 of the mortgage interest rate in effect at that time, plus 1/12 of the monthly mortgage insurance premium rate. This growth is essentially a further extension of credit based on the previous month’s credit line balance and the current interest rate.
In some cases, the line of credit can grow as much as 5 percent annually. That means if you started with a line of credit of $200,000, in a year that credit line would be $210,000, assuming you did not withdraw any of the available funds.
Because of this feature, many seniors with enough equity in their homes will take out a reverse mortgage line of credit as soon as they’re eligible at age 62, with the idea of only using the funds when a need arises and letting the line of credit grow.
Another strategy is to limit oneself to the growth in the credit line amount each year, leaving the original credit line in tact. This is similar to the strategy of owning bonds or CDs and using the annual interest payments as income while maintaining the original principal.
An HECM line of credit differs from a traditional home equity loan in that the home owner does not make monthly payments to repay the loan. Instead, a reverse mortgage loan is repaid, with interest, when the property is sold, refinanced, or when the homeowner moves out of the house. Reverse mortgages are set up so that you never own more than the home’s value at the time the loan is repaid.
When the home is sold or no longer used as a primary residence, the cash, interest, and other finance charges must be repaid. All proceeds beyond the amount owed belong to your spouse or estate. This means any remaining equity can be transferred to heirs. No debt is passed along to the estate or heirs.
How does an HECM line of credit “growth feature” work?
One of the payment options a federally insured Home Equity Conversion Mortgage (HECM) offers is a line of credit. When you opt for a line of credit, you only pay back the funds, with interest, that you withdraw, not necessarily on the entire credit line.
A homeowner who takes out an HECM line of credit is not required to make monthly repayments. Instead, the loan proceeds are due when the home is sold or no longer used as a primary residence.
The structure of an HECM line of credit makes it an intriguing option for seniors who may not need money right away, but could benefit from reverse mortgage funds down the road. Specially, the line of credit offers a growth feature that increases the amount of money available on the credit line the longer you wait to access those funds.
According to the U.S. Department of Housing and Urban Development, the unused portion of an HECM line of credit grows at the same rate at which the principal limit and the loan balance grow. Therefore, the amount of funds available to the borrower from a line of credit grows larger each month for as long as any funds remain.
This is a feature primarily found on the federally insured HECM. Proprietary reverse mortgages offered by private lenders that are not federally insured often have a lower credit line of growth rate or none at all, which will affect the amount of cash available to the borrower over the life of the loan.
The growth formula
HECMs use a variable interest rate formula to determine the amount of interest that accrues over the life of the reverse mortgage. Lenders 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.
Once the initial line of credit is determined — based on the value of the home and the age of the borrower — it grows automatically at a similar variable rate. The growth rate is equal to the lender’s margin, plus the 1.25 percent mortgage insurance premium assessed on the loan plus subsequent values of one-month LIBOR rates.
So if the lender’s margin was 2 percent and the LIBOR index value was 1.5 percent, the lender would add the 1.25 percent MIP to create a credit line growth rate of 4.75 percent (2% + 1.5% + 1.25%).
In some cases, the line of credit can grow as much as 5 percent annually. That means if you started with a line of credit of $200,000, in a year that credit line would be $210,000, assuming you did not withdraw any of the available funds.
Because of this feature, many seniors with enough equity in their homes will take out a reverse mortgage line of credit as soon as they’re eligible at age 62, with the idea of only using the funds when a need arises and letting the line of credit grow.
A hypothetical example
Say you are 62 and owe nothing on your home currently valued at $300,000. Based on your age and current rates, you can establish an HECM line of credit totaling about $148,000.
Now, assume you decide you don’t need a line of credit right away and wait ten years. Also assume that your home increased in value by around 2 percent annually, which means it would be worth about $370,000. If rates didn’t change, based on your age, your line of credit would be worth about $208,000.
But what if you decided instead to take out the line of credit immediately at age 62 even though you didn’t “need it.” Based on the current rates, the growth rate on the line of credit is projected to be about 4.5 percent annually. So in 10 years, the $148,000 credit line would grow to almost $230,000, provided you did not access the funds. You would essentially have $22,000 more that you could borrow, and it wouldn’t have cost you any more to establish in early than waiting.
A word of caution: Don’t confuse an extension of credit with earning interest on a savings account. It’s not necessarily about having more to spend; the benefit of a the HECM line of credit growth is that it enables you to borrow more against your home the longer any the unused loan balance remains. But if you take advantage, it also means you’re borrowing more money and will, therefore, have more to repay once the loan becomes due, such as when you pass away or move out of the home.