Reverse Mortgages: Ongoing Credit and Costs

Reverse Mortgages: Ongoing Credit and Costs

Faculty Member Wade Pfau Landscape Photo
January 2, 2019

The ongoing costs for a reverse mortgage relate to the interest accruing on any outstanding loan balance, as well as any servicing fees. Servicing fees can be up to $35 per month, though they are generally now incorporated into a higher margin rate rather than charged directly to the borrower. Interest on the loan balance grows at the effective rate:

Effective Rate = One-month LIBOR rate + lender’s margin + annual mortgage-insurance premium (0.5 percent)

In October 2017, the one-month LIBOR rate was about 1.25 percent, and the ten-year LIBOR swap rate was about 2.25 percent. If we assume a 2.75 percent lender’s margin, that gives us an expected rate of 5 percent and an effective rate of 4.5 percent:

Expected Rate = 2.25 percent + 2.75 percent = 5 percent (for initial principal limit)

Effective Rate: = 1.25 percent + 2.75 percent + 0.5 percent = 4. 5 percent (for principal-limit growth)

Once determined through the Principal Limit Factor, the initial line of credit grows automatically at a variable rate equal to the lender’s margin, a 0.5 percent mortgage-insurance premium (MIP), and subsequent values of one-month or one-year LIBOR or Treasury rates. These short-term rates are the only variable part for future growth, as the lender’s margin and MIP are fixed at the beginning. Though the variable rate can be a one-month or one-year LIBOR or Treasury rate, in subsequent descriptions I will refer to the one-month LIBOR case. The effective rate is adjusted monthly.

The lender’s margin rate and ongoing mortgage-insurance premium are set contractually at the onset of the loan and cannot change. The margin rate charged on the loan balance is the primary way that the lender—or any buyer on the secondary market—earns revenue, especially lenders who have forgone the origination and servicing fees. Estimates for reasonable margin rates are generally between 1.75 percent and 4.5 percent, with higher numbers typically being associated with lower origination and/or servicing costs.

Meanwhile, the ongoing mortgage-insurance premium helps ensure that the government can meet the obligations for the guarantees it supports through the HECM program to both the lenders and borrowers. I noted that the government guarantees two things: that the borrower will be able to access the fully entitled line of credit regardless of any financial difficulties on the part of the lender, and that the insurance fund will make the lender whole whenever payment falls due and the loan balance exceeds 95 percent of the appraised value of the home. The government fund also bears the risk with the tenure- and term-payment options as distributions are guaranteed to continue when the borrower remains in the home, even if the principal limit has been fully tapped.

The insurance premiums protect homeowners from not having to pay back more than the value of the home in cases where the loan balance exceeds this value. The lender is protected as well, as the FHA pays the difference in such cases. While this could potentially leave taxpayers on the hook if the mortgage-insurance premiums are not sufficient to cover these cases, the government attempts to stay on top of this matter. Mortgage-insurance premiums and principal limit factors have been adjusted over time to help keep the system in balance.

I have previously felt that if the option to open a line of credit and leave it unused for many years grew in popularity, further changes might be needed to keep the mortgage insurance fund sustainable. One intended purpose for the new October 2017 rules was to accomplish this by reducing the likelihood that the principal limit grows larger than the value of the home.

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