Navigating the complex world of reverse-mortgage rates
How reverse mortgage interest rates are determined
- HECMs with adjustable rates are pegged to a benchmark rate.
- Lender profit, mortgage insurance and rate adjustments all influence interest costs.
- Rates can change based on the index being used, but changes follow strict rules.
If you’re a homeowner who’s at least 62 years old, you may be considering a reverse mortgage for a variety of reasons, including maximizing your retirement savings. This type of loan is common and a relatively safe way to borrow against your home equity, but there are associated costs to consider, particularly interest rates.
First, it’s important to realize that interest on a reverse mortgage is only paid on the funds you receive. In other words, if you take out a $100,000 loan in monthly installments of $1,000, you’ll only pay interest on each $1,000 increment. In addition, with a reverse mortgage, the loan and interest repayment is deferred until the loan matures and generally recouped by the lender through a sale of the home.
If you’re looking into a reverse mortgage, it is important to understand upfront how the interest rate is calculated, which may wind up sparing you a lot of future headaches.
How are reverse mortgage rates calculated?
About 90 percent of all reverse mortgages are Home Equity Conversion Mortgages, or HECMs. These are federally insured, non-recourse loans, which means you will never be required to pay back more than 95 percent of the home’s value, regardless of the ending balance on the loan. It pays to compare lenders, however, because different lenders may offer different rates.
Unless you need to tap a large amount of equity through a jumbo reverse-mortgage loan from a private lender, the chances are you’ll pursue an HECM. The Federal Housing Administration capped the HECM claim limit at $679,650 as of January 2018. Proprietary loans have different caps and may have different interest calculation methods than HECMs.
If your HECM has a fixed interest rate, your lender will determine the rate based on market dynamics because the federal government does not require the use of a specific rate index.
But if it’s an adjustable-rate mortgage (ARM), the rate will be linked to either on the Constant Maturity Treasury (CMT) rates from the U.S. Department of the Treasury, or to an international benchmark rate known as LIBOR. Beyond that, there are a few other factors that determine a variable-rate loan’s cost, including the interest rate:
- Margin: This is the lender’s profit above the benchmark rate, also referred to as the interest rate spread. Although the margin will stay the same over the life of the loan, the underlying benchmark rate can change, which can push up your interest rate. Margins can often be negotiated with a lender.
- MIP Margin: All HECMs include an upfront and annual mortgage insurance premium (MIP). As of October 2017, the upfront MIP is 2 percent of the base loan amount while the margin applied to cover the annual MIP premium is 0.5 percent.
- Interest rate caps: Lenders are limited in the interest they can charge and must be clear on how often the rate can adjust, regardless of what the underlying benchmark rate is. But there are multiple types of caps. Your loan may have one cap on interest following the expiration of a fixed-rate period, another for subsequent adjustment periods and a third cap over the duration of the loan. These rate caps vary depending on the allowed frequency of the rate-adjustment period.
Initial interest rate vs. expected interest rate
Obtaining the best loan with the lowest interest rate is obviously the No. 1 goal for any homeowner. Interest charges eat into equity, and if you’re borrowing the maximum amount of equity, there may not be anything left when repayment is due. But, again, HECMs have built-in security: You’ll never owe more than what your home is worth because the loan is federally insured.
When you review loan documents for a reverse mortgage, there may be some unfamiliar acronyms. There’s the initial interest rate (IIR), which refers to the beginning rate period. If the loan uses LIBOR as its index, for example, the IIR will factor in the one-month or one-year LIBOR rate, as well as the lender’s margin and insurance premiums.
The expected interest rate (EIR) is essentially a lender’s prediction of average interest over the life of the loan. EIRs and IRRs on fixed-rate mortgages are the same because the rate doesn’t change. Lenders use EIRs for adjustable-rate loans as a way to determine principal limits, service-fee reserves and monthly disbursement amounts. The FHA is less likely to insure a loan if interest accrues too quickly and could exceed the value of a home. That’s because the FHA is ultimately responsible for making up any shortfalls when repayment is due.