Choosing Costs for a Reverse Mortgage
Originally published at Forbes
The discussion of reverse mortgage costs has several moving parts. Which type of cost combination to choose depends on how you plan to use the line of credit during retirement. Let me reveal the punchline for the following discussion: Those seeking to spend the credit quickly will benefit more from a cost package with higher upfront costs and a lower lender’s margin rate. Meanwhile, those seeking to open a line of credit that may go unused for many years could find better opportunities with a package of costs that trades lower upfront costs for a higher lender’s margin rate.
To summarize the cost discussion, costs determined by the lender include:
- Origination fees
- Other closing costs
- Servicing Fees
- Margin Rate
Along with the upfront mortgage insurance premium, which the lender does not control (though some lenders may provide a credit to cover it), the upfront costs include the origination fees and other typical closing costs. The maximum that can be charged for origination fees is set by the government and relates to the home’s value, as described before. Lenders have discretion to charge less than this amount, though the larger lenders with national advertising campaigns may be more likely to include the full amount of the allowed origination fee. Smaller lenders with smaller marketing budgets may compete more on price, which can include a lower origination fee, or even credits to offset other fees.
For other closing costs, these fees vary and relate to the typical costs for opening a mortgage (e.g., titling and appraisal charges) as well as payment for the mandatory counseling session. Some lenders may also provide credits to cover these costs as well. As for servicing fees, lenders are allowed to charge up to $35 per month, but recently it is common to not charge an explicit servicing fee, and instead include the servicing fees as part of the lender’s margin rate.
The final cost to consider is the lender’s margin rate. This is not an upfront cost but an ongoing cost charged to the outstanding loan balance. The choice of lender’s margin is important because it affects both the initial PLF and the subsequent growth rate of the principal limit. The following table provides an indication for how the lender’s margin affects the initial principal limit. The lender’s margin is part of the expected rate, and a higher lender’s margin implies a higher expected rate, which in turn implies a lower principal limit factor. For example, a sixty-two-year-old with a $400,000 home could see his initial principal limit fall from $190,000 to $145,600 by choosing a 4% lender’s margin instead of a 3% lender’s margin.
Table: Initial Line of Credit Based on Home Value and PLF (Before Upfront Fees & Set Asides)
|10-Year Libor Swap rate: 2.375%|
|Lender’s Margin: 3%|
|Expected Rate = 5.375%|
|10-Year Libor Swap rate: 2.375%|
|Lender’s Margin: 4%|
|Expected Rate = 6.375%|
The lender’s margin is also included as a variable to determine the effective rate—the rate at which the principal limit grows. Remember that the effective rate also defines the rate of growth for both the outstanding loan balance and the remaining line of credit. Those with a small loan balance would like a high lender’s margin because it will allow their line of credit to grow more quickly, while those with a large loan balance—everything else being the same—would prefer a lower lender’s margin so the loan balance does not grow as quickly.
As I mentioned in my last post, these four ingredients can be combined into different packages by the lender. Which version is best depends on how the reverse mortgage is to be used. When funds will be extracted earlier, it may be worthwhile to pay higher upfront fees coupled with a lower margin rate. However, for the standby line of credit, which may never be tapped, it is beneficial to lean toward a higher margin rate combined with a package for reduced origination and servicing fees. Some lenders may even offer credits to cover most of the upfront fees. Keep in mind, though, that while a higher lender’s margin will allow the line of credit to grow more quickly, the initial line of credit value will be smaller because the PLF will be smaller. These are tradeoffs to consider.