“There are significant advantages in making payments toward HECM loan balances that are not well known. Many homeowners are too intrigued by the fact that HECMs don’t REQUIRE a payment. Unfortunately, they miss a great opportunity to maximize some advantages of a HECM.”
– Understanding Reverse
Why would homeowners voluntarily make payments? The reverse mortgage, or Home Equity Conversion Mortgage (HECM) doesn’t require monthly principal and interest payments through the life of the loan. In fact, isn’t that a common selling point of the product?
Part of the confusion is that many older homeowners think obtaining a reverse mortgage means giving up their equity (and the home) to the bank. Why make payments, when you don’t own the home? But that’s not the way the HECM product works. The homeowner continues to own the home through the life of the loan, and reducing the loan balance will increase their equity position.
So, the decision to make periodic payments depends on the motives of the homeowner and his or her ability to make payments. According to HUD Handbook 4235.1, a borrower may “choose to make a partial prepayment because his or her financial circumstances have improved and he or she wishes to preserve more of the equity in the property.” A homeowner may also use payments to increase future monthly payouts, or to “set up or to increase a line of credit.”
That last phrase, “increase a line of credit” explains the movement toward using HECMs for financial planning purposes. Yes, the line of credit (LOC) will actually grow with each payment and be secured for later use. The available LOC will also grow naturally at the current interest rate plus 1.25%. This will give the homeowner even more accessible funds in retirement, regardless of future home value.
Keep in mind, the Fixed Rate HECM does NOT offer a Line of Credit. Prepayments will reduce the loan balance and increase homeowner equity, but that is the extent of the impact. However, when homeowners make payments toward Adjustable Rate HECM loan balances,
- the homeowner’s loan balance DECREASES,
- the homeowner’s equity position INCREASES, and
- the homeowner’s Line of Credit (LOC) INCREASES.
When a servicer receives a payment, FHA requires certain items to be paid back first. Known as a “prepayment waterfall”, this is important for accounting and tax purposes. However, the LOC doesn’t care whether the payment was applied to accrued mortgage insurance, interest, or principal. It just knows the loan balance went down.
Be aware that borrowers cannot pay more than their loan balance to gain a larger LOC. In fact, paying it off completely will close the HECM. This would be unfortunate for those wanting to use it later in retirement.
The ability to make payments to reduce loan balances and secure a larger LOC for the future is a prudent financial planning strategy and should be great news for every older homeowner.