Reverse Mortgage Interest Rate Choices
For most of the life of the HECM Reverse Mortgage, the only choice was an adjustable rate. It wasn't long ago that another choice became available. The fixed rate - long a favored choice for regular mortgages - became available for reverse mortgages. At about the same time, a different index was offered for adjustable rate reverse mortgages. In addition to the Treasury index, a LIBOR index was added. At the time of this writing, while still allowed, I'm not aware of any lenders using the Treasury index. Everyone is using the LIBOR index.
Reverse Mortgage Adjustable Rate
For someone with a regular mortgage, an adjustable rate can be scary. If the rates go up, the payments go up. If the rates go up too much and the payments become more than the borrower can afford, they might find themselves unable to make the payments and could lose their home.
A reverse mortgage is different in that no monthly payments are made so the potential of losing your home because you can't make the payments is not there. Yes, if interest rates rise, you could be accruing more interest on your mortgage. But interest rates can also go down with lower interest accruing on your mortgage. I've seen both happen. I've also seen them go down, then up, then down again.
The adjustable rate is made up of two parts. The base is the index. Some constant financial instrument that the lender can't manipulate and one that is available to the public to watch is chosen.
The most prevalent for the HECM Reverse Mortgage is the LIBOR index. LIBOR stands for London Inter-Bank Offer Rate. This is the rate banks charge one another for loans between themselves.
Added to the index will be the margin. For the longest time, the margin was 1.50%. A while back, it moved down to 1%. It has since moved to something in the range of 2-3% at this writing. The margin can differ from lender to lender with one lender willing to charge 2% and another charging 3%. This is VERY important to the borrower. Not only does the rate (index plus margin) affect how much interest accumulates over time but also HOW MUCH MONEY THE BORROWER RECEIVES.
Annual or Monthly Adjustable?
The rate is capped at 10 percentage points above the start rate for the monthly adjustable choice and 5 percentage points above the start rate for the annual adjustable rate. In very round figures (at this writing) the annual index is about one percentage point higher than the monthly. (You could think of this like the difference between a savings account and a one year CD - but there is a lot more behind it.) As an example, that means the most a 4% monthly adjustable can go up is 10 more percentage points to 14%. However, the most the annual adjustable rate of 5% can go up is 5 percentage points to 10%.
How do you choose? In my opinion, it would be based on your personality (conservative or not) and what you think interest rates will do over time. If you think interest rates might sky rocket and you would lose sleep over that possibility, then you might be willing to pay more initially and choose the annual rate that starts about a percent higher but couldn't be higher later by more than 5 percentage points. I find most of my clients make this choice.
For myself, I don't think interest rates will skyrocket. I think the Fed has a better handle on rates than it did in the late 70's and early 80's. I don't think the index plus margin will exceed 10% (the max in my example of the annual) so I would choose the monthly to generally have a one percent lower interest rate.
Your thought process might be different if you start off with a very small loan balance and are getting the Reverse Mortgage mainly for the growing Line of Credit (LOC). In that case, you hope interest rates skyrocket, helping your LOC grow to larger and larger balances. Under that scenario you would choose the monthly adjustable that would allow rates to go up to 14% in my example.
Reverse Mortgage Fixed Rate
A fixed rate has become available in the relatively recent past. Like regular mortgages, they may be slightly different from lender to lender. All that I have seen have some significant differences from the adjustable rate reverse mortgage
The most notable difference is that all of the available money most be taken up front as a lump sum distribution. This compares to the adjustable rate that allows for funds not needed now to be placed in a Line of Credit with interest not charged until used.
In late 2013, new rules limited this upfront amount to 60% of the Principal Limit (the amount available) or 10% above mandatory obligations. A typical mandatory obligation is usually a mortgage. If the amount available was $300,000 and the mortgage was $200,000, the borrower could have the mortgage paid off as part of the process, closing costs covered and take cash back of $30,000 ($10% of $300,000). That is actually closer to 80%. Someone with no mortgage could take about $180,000 or the allowed 60%.
Also, like regular mortgages, the interest rate is higher for a fixed rate than for an adjustable rate. This difference is frequently 2-3% more for the fixed rate than the adjustable rate. If the adjustable rate were 3%, the fixed rate would frequently be in the 5% neighborhood.
The less money the borrower wishes to take up front compared to how much is required is what can take this from being a possible choice to a poor choice. As an example, if a borrower wanted to take $50,000 up front and the fixed rate choice had $250,000 available, that borrower would have to take all $250,000 up front.
Using the examples from the two paragraphs above, the borrower would be charged $12,500 in a year for $250,000 for a fixed rate in the 5% range. For an adjustable rate of 3% on $50,000, the amount of interest charged in one year would be $1,500. At the maximum capped rate of 13%, the interest charged in one year would be $6,500. Even though the borrower may draw from the line of credit over time and the balance would grow bigger, the fixed rate wouldn't appear to be the best choice.
What if the borrower had a $250,000 existing mortgage that was being paid off with the $250,000 available in a fixed rate mortgage. This is a closer call. While interest rates are below the 5% used in the example, the borrower would be paying more than necessary. While interest rates were above 5%, the borrower would be saving money. As an example, while rates were still 3%, the annual interest would be $7,500 vs. the $12,500 of the fixed rate. When the adjustable rate grew to approach the 5% example, the savings would be less with the adjustable. At the maximum capped rate of 13%, the annual interest would be $32,500. While we all remember the late '70's and early '80s when interest rates grew into double digits, that hasn't happened for some time and may never happen again. While difficult to predict the future from the past, reverse mortgage monthly adjustable rates haven't been over 8% for the past 15 years.
However, if you have a large mortgage to pay off that is close to the amount available in a fixed rate reverse mortgage, it is worth looking closer to the pros and cons as they apply to your specific situation.
New Fixed Rate Versions beginning in 2013
Late in 2013, a couple lenders created a new variation of the HECM (FHA version) Reverse Mortgage.
Until then, you had a choice of a fixed rate that required you to take all that was you were allowed (60% of the amount available or the mandatory obligations - think mortgage and some other things plus 10%). Or you could choose the adjustable rate that offered choices of cash up front, monthly payments, a line of credit or a combination of any two or three.
See 2014 Updates for more on this.