One of the great advantages of the adjustable rate Home Equity Conversion Mortgage (HECM) is the ability to draw funds from the line of credit (LOC) when needed. For this reason, the HECM ARM is often preferred over the fixed rate option which does not allow for an open line of credit. Furthermore, those funds left in a line of credit LOC will tend to grow at the same rate as borrowed funds.
In fact, there are two factors that drive growth. The first is what I call “organic” growth where the LOC naturally increases at the same rate as the loan balance. The second is what I call “prepayment” growth. This creates one of the lesser-known advantages of the product – the flexibility to pay back funds when NOT needed. These payments are called “voluntary partial prepayments.”
Sadly, there has been widespread confusion about the application of prepayments with a reverse mortgage. Let’s be clear – when a voluntary prepayment is made by a homeowner with an adjustable rate HECM, the line of credit increases, dollar-for-dollar, at the time the payment is posted.
Where does it say that?
In addition to the HUD formulas for calculating Net Principal Limit, there are three references that serve as the basis for prepayment growth:
- HUD Handbook 4235.1 CH 5-12C
A borrower may choose to make a partial prepayment to set up or to increase a line of credit without altering existing monthly payments. By reducing the outstanding balance, the borrower increases the net principal limit. All or part of the increase in the net principal limit may be set aside for a line of credit.
- Adjustable Rate Note
A Borrower may specify whether a prepayment is to be credited to that portion of the principal balance representing monthly payments or the line of credit. If Borrower does not designate which portion of the principal balance is to be prepaid, Lender shall apply any partial prepayments to an existing line of credit or create a new line of credit.
- HUD Handbook 4330.1 CH 13-21B
Establish Or Increase A Line Of Credit. A mortgagor may choose to make a partial prepayment to set up or to increase a line of credit without altering existing monthly payments. By reducing the outstanding balance, the mortgagor increases the net principal limit. All or part of the increase in the net principal limit may be set aside for a line of credit.
But what gets paid back first?
We know that certain parts of the outstanding loan balance get paid pack first with HECM prepayments. We often call this the “servicing waterfall” or “prepayment waterfall” and is useful to the servicer, the investor, and the client for tax and accounting purposes. However, the application of prepayment should not impact the resulting LOC credit for future draws. If that were true, then repeated borrowing and prepayment could leave the borrower with no significant balance AND no LOC. Furthermore, the servicer would be out of balance with HUD’s system of record (HERMIT).
The LOC does not care what portion of the loan balance was paid back when a payment is applied. All it knows is that the Net Principal Limit has now increased. In the regulations above, HUD is clear that what increases the LOC in these cases is a reduction in the outstanding balance. It does not matter what portion of the loan balance was reduced.
Can you show me an example?
Sure. One way to explain this concept is with a simple equation:
LOC = CPL – LB
For most HECM loans, the Line of Credit at any given time equals the Current Principal Limit minus the Loan Balance. In other words, the line of credit equals what you can borrow minus what you have already borrowed. So naturally, removing $5,000 from the loan balance will increase the line of credit.
It is also important to know that HUD regulations require that ALL parts of this equation grow monthly at the same rate – 1/12th of the current interest rate and MIP rate.
So, consider a HECM ARM with no set-asides, 3.0% interest rate, 0.5% MIP rate, and a Principal Limit of $150,000. If the borrower has a loan balance of $100,000, that leaves $50,0000 in the LOC.
$50,000 = $150,000 – $100,000
After the prepayment of $5,000, and monthly accruals (1/12th of 3.5%), the next servicing statement should read the following:
$55,146 = $150,438 – $95,292
Notice that because of monthly accruals, the net increase in the line of credit (+$5,146) does not identically match the net reduction in loan balance (-$4,708). The reason for this is two-fold 1) the Current Principal Limit is also increasing, and 2) the accruals in dollars will be in proportion to the amount to which the rate is applied.
Essentially, there is a dollar-for-dollar impact at the time the payment is posted, but the loan accruals at the end of the month make it appear as though this is not the case.
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Dan Hultquist