Interest rates in reverse mortgages work very similarly to the way they work in any loan. There are some differences, however, in the way the borrower pays them back and in the way they are structured that potential borrowers need to understand. It’s important to note that this article only addresses home equity conversion mortgages (HECMs), or government-backed reverse mortgages. Some reverse mortgage lenders offer proprietary mortgage loans that may have different interest rate terms than those outlined here.
What Are Interest Rates?
Interest rates are the amount lenders charge borrowers each year in exchange for lending them money. Interest rates are expressed as a percentage of the principal the borrower will owe the lender in addition to the initial loan amount. Interest is calculated based on how much principal the borrower owes at any given time.
With a traditional mortgage, interest accrues monthly, and the borrower’s monthly payment covers both accrued interest and some of the principal. As the loan principal decreases, the amount of interest charged each month also decreases. While the loan’s interest rate stays the same, the loan balance decreases as the borrower pays the principal. The loan ends within a specific timeframe over which the borrower has paid the agreed amount of interest in addition to the amount they initially borrowed.
How Interest Rates Work in a Reverse Mortgage
With a reverse mortgage, interest accrues monthly, but the amount owed goes up over time rather than down. As the borrower withdraws more money and interest compounds (or adds to itself), the amount of interest owed will also increase. Though not interest, the borrower will also see other fees, like the mortgage insurance premium (MIP), added to the reverse mortgage balance annually.
However, no matter how much the interest grows, the loan balance will only come due at the end of the loan term. Unlike a traditional mortgage, that term is not a set timeframe but dependent on the length of time the borrower remains in the home or keeps the loan in good standing.
Commonly in a reverse mortgage, the loan ends when the last borrower on the loan passes away. The borrower’s estate then works with the lender to satisfy the loan balance.
Types of Rates Applied to Reverse Mortgages
Reverse mortgage interest rates can be fixed or variable, just like rates on a traditional mortgage.
- Fixed rates. These rates are set at loan origination and remain fixed for the life of the loan.
- Variable rates. These rates fluctuate based on a rate index. Reverse mortgage variable rates are currently based on the one-year constant maturity treasury index (CMT).
Many borrowers opt for a fixed rate with a traditional mortgage because these rates offer a degree of certainty. While often higher than an opening variable rate, the borrower is guaranteed a fixed rate for the life of their loan. For traditional mortgages, fixed rates allow borrowers to know, going in, exactly how much they will pay and for how long.
However, the reverse mortgage borrower does not pay any interest until the end of the loan, and most borrowers don’t know how long the loan term will be. Thus, reverse mortgage borrowers can’t generally predict how much interest they will ultimately pay. This means that for reverse mortgages, variable and fixed rates have similar uncertainty surrounding how much interest will eventually accrue on the loan.
How Variable and Fixed Rate Reverse Mortgages Differ
The type of rate a reverse mortgage borrower chooses determines how they will be allowed to access their funds and how much will be available to them over the course of the loan.
Fixed-Rate Reverse Mortgages
Reverse mortgage borrowers on a fixed rate must take the full amount of their authorized funds in a lump sum at closing. Fixed rates on a HECM are usually higher than the initial interest rate on a variable rate HECM. But as with a forward mortgage, the borrower knows exactly how much interest will accrue each month from the outset.
For multiple reasons, fixed rates are less common than variable rates in reverse mortgages. When a borrower chooses a fixed-rate reverse mortgage, it is usually for a specific set of circumstances. Taking the full amount at a fixed interest rate may be advantageous for the borrower who intends to pay off a loan entirely after a specific length of time. This choice allows the borrower access to equity while offering the same benefit that all reverse mortgages have of removing the obligation to make required monthly mortgage payments for the term of the loan. Borrowers who want to stay in their homes for the near term but imagine downsizing down the road, or who are finding high mortgage payments difficult to keep up with may find a fixed rate reverse mortgage advantageous.
How the 60% Utilization Rule Impacts Fixed Rate Reverse Mortgages
It’s also worth noting that all HECMs are subject to a 60% utilization rule. This rule, set by the U.S. Department of Housing and Urban Development (HUD), limits the amount any reverse mortgage borrower can take in the first year to 60% of the principal limit. There are also mandatory obligations that all reverse mortgage borrowers must fulfill as part of closing, such as paying off previous mortgages, loan closing costs the borrower elects to finance, and FHA’s upfront mortgage insurance premium.
Because the fixed-rate reverse mortgage requires that all funds that will ever be taken on the mortgage must be taken at loan closing, borrowers who choose this interest rate structure will only receive the higher of:
- 60% of the available principal minus their mandatory obligations, or
- The amount of their mandatory obligations, plus 10% of the available principal.
This means that in most cases, fixed-rate borrowers will have access to less equity than they would with a variable rate.
Variable Rate Reverse Mortgages
Although variable rates fluctuate, at the time of closing, the initial rate on a variable rate reverse mortgage is usually lower than a fixed interest rate on a HECM. Also, the variable rate on a reverse mortgage has a life cap of 5% or 10% depending on the reverse mortgage product the borrower selects. This means the rate will never exceed the percentage of the life cap over the start rate. This cap offers a degree of certainty that is not present with all variable-rate mortgages.
Importantly, choosing the variable rate also allows borrowers to choose how and when they will receive loan proceeds. When they choose a variable rate, borrowers get options for how they will receive their funds: in a lump sum, in monthly payments, as a line of credit, or a combination of the three. For the lump-sum alternative, variable rate borrowers are still subject to the 60% utilization rule explained above. This means they will be able to take 60% of the principal limit, less any amounts needed to fulfill the mandatory obligations of the loan. The remainder of the available principal will be available to them in the 13th month of the loan and come from an established line of credit.
Borrowers can choose to keep their available funds as a line of credit, and interest will only be charged on funds withdrawn. Borrowers who take funds as monthly payments will not be charged interest until funds have been disbursed.
Interest, however, will begin to accrue on any funds added to the principal in addition to cash-out funds. For instance, if the borrower has used loan proceeds to pay for their mandatory obligations, interest will accrue on that amount. Interest will also accrue on upfront and annual mortgage insurance premiums.
The variable rate may make sense for reverse mortgage borrowers who do not have an immediate need for an influx of cash or have long-term plans for how they would like to use their equity over time.
Whether borrowers choose a fixed or variable rate, taking a reverse mortgage allows them to forgo mandatory monthly mortgage payments. This feature offers an improved cash flow to limited budgets. It is important for homeowners to understand that they will still be required to pay insurance, property taxes, maintenance, and any other home-related expenses.
Keeping Track of Reverse Mortgage Interest
Because interest and other fees are accruing without being paid down, a common fear of reverse mortgage borrowers is that the amount they owe will get out of control and perhaps, grow beyond the home’s value.
Two interest rates are associated with a variable rate reverse mortgage: the expected rate and the initial rate. Understanding what these rates mean can help make projections and set expectations.
- The expected rate. This rate is a ten-year average used to calculate how much money the borrower has access to from their home.
- The initial rate. The initial rate is set at closing and changes over time, as outlined in the note. This is the actual note rate that accrues over time.
Looking at monthly mortgage statements can help borrowers keep track of their principal, fees, and interest that have accrued.
As for the fear that the interest accrual will outpace the home’s value, borrowers can find peace of mind in understanding that Home Equity Conversion Mortgages are non-recourse loans guaranteed by the federal government. This means that when the loan comes due, should the loan balance exceed the home’s value, the borrower or their heirs will not owe the lender more than the current value of the home when it is sold to repay the loan.
If you are contemplating a reverse mortgage, you will be required to meet with a reverse mortgage counselor who can further explain how interest rates on a reverse mortgage work and clear up any additional questions you might have.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.