Originally published at Forbes
A mortgage’s effective rate is applied not just to the loan balance, but also to the overall principal limit, which grows throughout the duration of the loan. How the effective rate is applied may sound technical, but it is an overwhelmingly important point to understand in order to grasp the value of opening a line of credit as early as possible.
Typically speaking, the principal limit, loan balance, and remaining line of credit all grow at the same rate. There have been rare past cases in which a reverse mortgage included a servicing set-aside that grew at a high enough expected rate that the set-aside balance grew even as expenses were paid, but that is not to be expected. As such, a consistent growth rate will be true for all new loans today, since any new set-asides will also grow at the same effective rate.
The loan balance and line of credit and any set-aside add up to equal the principal limit. Interest and insurance premiums are charged on the loan balance, but not on set-asides or the line of credit. Set-asides are not part of the loan balance until actually used, but they limit access to the line of credit. Though interest and insurance premiums are not levied on set-asides or the line of credit, both of these components also grow as if interest and premiums had been charged.
When funds are borrowed, the line of credit decreases and the loan balance increases. Conversely, voluntary repayments increase the amount of the line of credit, which will then continue to grow at the effective rate, allowing for access to more line of credit later.
The following equation shows this relationship, and this relationship always holds for recent reverse mortgages because each of the four variables in the equation grows at the same effective rate:
Principal Limit = Loan Balance + Available Line of Credit + Set-Asides
Likewise, Figure 3 below expresses the same concept. The overall principal limit consists of the loan balance, remaining line of credit, and any set asides. Again, all of these factors grow at the same effective rate, which will increase the size of the overall pie over time. If no further spending or repayment happens over time, then the proportions of each of these components of the principal limit will remain the same, since they all grow at the same rate.
Figure 3: Components of the Principal Limit
The next important point is that interest and insurance premiums are charged on the loan balance, but not on set-asides or the line of credit. To be clear, set-asides are not part of the loan balance until actually used, but they limit access to the line of credit. Though interest and insurance premiums are not levied on set-asides or the line of credit, both of these components also grow as if these costs had been charged, as they are components in the effective rate.
The ability to have an unused line of credit grow is a valuable consideration for opening a reverse mortgage sooner rather than later. It is also a detail that creates a great deal of confusion for those first learning about reverse mortgages, perhaps because it seems this feature is almost too good to be true.
I speculate that the motivation for the government’s design of the HECM reverse mortgage program is based on an underlying assumption that borrowers would spend from their line of credit sooner rather than later. Implicitly, the growth in the principal limit would then reflect growth of the loan balance moreso than the growth of the line of credit. In other words, designers assumed the loan balance would be a large percentage of the principal limit.
The line of credit happens to grow at the same rate as the loan balance, and if left unused, the line of credit could grow to be quite large. There was probably not much expectation that individuals would open lines of credit and then leave them alone for long periods of time. However, as will be discussed, the brunt of the research on this matter since 2012 suggests that this sort of delayed gradual use of the line of credit can be extremely helpful in prolonging the longevity of an investment portfolio.
If this discussion is too abstract, a simple example may help to illuminate the blunt usefulness of this concept. Consider two different individuals who each open a reverse mortgage with a principal limit of $100,000. To simplify, we assume that ten years later the principal limit for both borrowers has grown to $200,000.
Person A takes out the entire $100,000 initially from the reverse mortgage (100% of the principal limit is the loan balance). For Person A, the $200,000 principal limit after 10 years reflects a $200,000 loan balance (the loan balance is still the same 100% of the principal limit), which consists of the initial $100,000 they received plus another $100,000 divided between accumulated interest payments and insurance premiums.
However, Person B opens a reverse mortgage but does not use any of the credit, so that the $200,000 principal limit at the end of 10 years fully reflects the value of the line of credit. The principal limit was still 100% in the line of credit. This value was calculated with an implicit assumption that interest and insurance payments have been accruing, even though they haven’t.
Person B can then take out the full $200,000 after 10 years, and have the same loan balance as Person A, but Person B has received $200,000 rather than $100,000. At this point, Person B has bypassed the accumulation of the interest and insurance, to the detriment of the lender and the mortgage insurance fund.
One other question that will arise is: Would the line of credit ultimately be larger when it is opened early on, rather than waiting until later to open it? We can further explore this question with a more realistic type of example. Figure 4 below provides an illustration about the impact of opening the reverse mortgage at different points of time using a few basic assumptions.
To still keep matters relatively simple, I assume that the one-month LIBOR rate stays permanently at 0.4% and the 10-year LIBOR swap rate remains permanently at 2.1%. The lender’s margin is assumed to be 4%, and home inflation is 2%.
For a 62-year old with a home worth $250,000 today, the figure charts three values over time until the individual is 90. The home value grows by 2% annually, and it is worth $435,256 by age 90. The principal limit for a reverse mortgage opened at 62 is $98,750 (based on a principal limit factor (PLF) of 39.5% for the 6% expected rate used in this calculation, rounded down to the nearest 0.125%). The effective rate that the principal limit grows is 5.65%, and the principal limit is worth $460,133 by age 90.
At 90, the principal limit has actually exceeded the value of the home. As a side note, if this principal limit were reflected as a loan balance instead of a line credit, the loan is non-recourse and the amount due by the borrower cannot exceed the home’s value – this is a guarantee supported by the insurance premiums.
Finally, Figure 4 also shows the available principal limit if the reverse mortgage is not opened until each subsequent age, rather than at age 62. By delaying the start of the reverse mortgage and assuming the expected rate of 6% remains, the principal limit grows because the principal limit factor is higher at advanced ages, and because this factor is applied to a higher home value.
Nonetheless, even at age 90, the available principal limit for a new reverse mortgage is only $286,046, which is based on a PLF of 64.8% applied to a higher home value. The overwhelming message from this example is that opening the line of credit early allows for a much greater availability of future credit relative to what could be obtained by waiting to open the reverse mortgage later in retirement.
Figure 4: Comparing Principal Limits Based on When the Reverse Mortgage Opens
This example assumes that interest rates remain low, but if interest rates were to increase in the future, the value of opening the line of credit today would be even greater. With lower rates today, the available PLF is currently higher. Then, higher future interest rates would cause the effective rate to be higher, so that the principal limit grows more quickly. Rising rates would also increase to the expected rate used to calculate principal limits on new reverse mortgages in the future. This would reduce the principal limit on newly issued future loans.
Only extreme growth in home prices could possibly allow more credit to be obtained by delaying the start of a reverse mortgage, but higher home price growth would surely be caused by higher inflation which would also increase interest rates and reduce the future PLF. It seems to be a relative certainty that more credit will be available in the future by starting the reverse mortgage as soon as possible rather than by waiting to open it later.
All of this may sound too good to be true, and it probably is, to some extent. Perhaps this is a reason why it is difficult to grasp the concept of line of credit growth throughout retirement. I’ve already noted that unused lines of credit work for borrowers to the detriment of the lenders and the government insurance fund. Such use of a reverse mortgage does still exist today and would be contractually protected for those who initiate reverse mortgages under the current rules. But at some point in the future, I would expect to see new limitations about line of credit growth, especially as more people start to follow the findings of recent research on this matter.
Line of credit growth may be viewed a bit like an unintended loophole that is strengthened by our low interest rate environment. The rules will probably be changed someday for newly issued loans. Until then, research points to this growth as a valuable way reverse mortgages can contribute to a retirement income plan.