Spending Options for a Reverse Mortgage
Originally published at Forbes
Most current HECM reverse mortgages use an adjustable interest rate, which allows the proceeds from the reverse mortgage to be taken out in any of these four ways or a combination thereof:
1. Lump-Sum Payment
Take out a large amount initially, though not necessarily the full amount available. As I’ve mentioned before, the government discourages taking out more than 60% of the available credit within the first year by charging a higher mortgage insurance premium on the eligible home value (2.5% instead of 0.5%) when this is done. Taking out more than 60% of available credit is only allowed in a few specific circumstances, such as paying down an existing mortgage or using the HECM for Purchase.
2. Tenure Payment
Works similar to an income annuity with a fixed monthly payment guaranteed to be received as long as the borrower remains in the home (which, to be clear, is not the same as dying, as the borrower may leave the home while still alive). Tenure payments allow for additional spending from the reverse mortgage even when the line of credit has been fully used. The mortgage insurance fund bears the risk that payouts and loan growth from the tenure payment option exceed the subsequent value of the home when the loan closes.
The available monthly tenure payment can be calculated using the PMT formula in Excel:
=PMT(rate, nper, pv, 0, 1)
In which rate is the expected rate plus the 1.25% mortgage insurance premium, all divided by 12 to convert into a monthly amount. This gives us the rate the loan balance is expected to grow. For example, a 5% expected rate makes this number 6.25%/12 = 0.521%.
nper is the number of months between the age of the youngest borrower (or eligible non-borrowing spouse) and age 100. For example, a new 62-year old has 456 months (38 years) until he or she turns 100.
And pv is the net principal limit from the reverse mortgage. It is found by multiplying the principal limit factor by the appraised value of the home (up to $625,500) less any upfront costs financed with the loan or any set-asides. For instance, a 62-year-old with a $500,000 home and a 52.4% principal limit who pays upfront costs from other resources will have a $262,000 net principal limit.
And so, PMT(6.25%/12, 456, 262000, 0, 1) = $1,498 for a monthly tenure payment. Annually, this adds up to $17,972 from the reverse mortgage.
3. Term Payment
A fixed monthly payment is received for a fixed amount of time. Calculating a term payment is similar to calculating a tenure payment. The only difference is that nper will be smaller, as it is the desired number of months the term payment should last. If the number of months pushed the term past age 100, a tenure payment would be used instead. As with a tenure payment, the full amount of term payments will be paid even if rising rates cause the loan balance plus new payments to exceed the principal limit.
As an example, consider an eight-year term payment, which could be used as part of a strategy to delay Social Security. The monthly term payment would be PMT(6.25%/12, 8*12, 262000, 0, 1) = $3,457, or $41,484 annually.
4. Line of Credit
Home equity does not need to be spent initially, or ever. A number of strategies involve opening a line of credit and then leaving it to grow at a variable interest rate as an available asset to cover a variety of contingencies later in retirement. Distributions can be taken from the remaining line of credit whenever desired until the line of credit has been used in its entirety.
Some of these spending options can be combined. Modified tenure and modified term are the technical names for when only a portion of the line of credit is used to create tenure or term payments, leaving part of the line of credit to grow and be used for other purposes. You can also change spending options over time, in which case updated term or tenure payments would be based on the available line of credit. Should tenure or term payments begin at a later date, the expected rate used to calculate the initial principal limit would remain the same throughout the term of the loan.