The federally insured reverse mortgage, known as a Home Equity Conversion Mortgage (HECM), is a unique and powerful financial planning product. It is structured so that the maximum borrowing power increases as the borrower ages, regardless of the underlying value of the property. However, that feature and the functions that make it happen are often misunderstood.
Consider a homeowner who qualifies for $200,000 in principal and uses ALL of it, presumably to access cash, pay off a traditional mortgage, and pay closing costs. Assuming a 5% compounding rate (including interest and mortgage insurance) and no payments, the borrower would owe $210,000 after the first year.1 Essentially, the homeowner “borrowed” $10,000 in interest they did not wish to pay.
But what happens when the borrower doesn’t use all their principal? Most HECMs are adjustable-rate loans where the unused principal can be left in a growing line of credit. Some will even have a set-aside for specific purposes, like repairs or property charges. Those items grow at the same rate as the loan balance, giving the homeowner more borrowing power as they age.
The following critical questions naturally arise:
- How does the line of credit (and set-aside) grow?
- What happens when I draw from my line of credit?
- Does my line of credit grow when I make a prepayment?
- What happens when property charges are paid from my set-aside?
- What happens to the set-aside and line of credit when the loan matures?
Fortunately, all these questions can be answered by understanding the following simple formula:
Principal Limit = Line of Credit + Loan Balance + Set-Asides
The Current Principal Limit of a HECM loan is shown on the borrower’s servicing statement, and it represents the total borrowing power at a given time. Here is the formula explained: The borrower’s maximum borrowing capacity at any time equals the sum of money they CAN borrow plus money they HAVE borrowed plus required reserves.
This formula will explain quite a bit and can answer many critical questions, like the following:
1. How does the line of credit (and set-aside) grow?
The HECM product was created so that borrowing power increases with age. To do this, all portions of the reverse mortgage formula grow at the same rate: the current interest rate plus 0.50%.2
Assuming 5% growth, no draws, no prepayments, and no set-aside disbursements, the HECM loan would perform like this:
- Principal Limit = Line of Credit + Loan Balance + Set-Asides
- At closing: $200,000 = $100,000 + $50,000 + $50,000
- After 1 year: $210,000 = $105,000 + $52,500 + $52,500
Notice the HECM loan and the reverse mortgage formula stay in balance after loan accruals and growth.
2. What happens when I draw from my line of credit?
When draws are taken from the line of credit, the line of credit is reduced by the amount of the draw, and the loan balance increases. The loan is still in balance, and nothing else is impacted by the draw.
3. Does my line of credit grow when I make a prepayment?
Yes. A voluntary prepayment is the opposite of a draw. The loan balance is reduced by the amount of the prepayment, and the line of credit grows dollar-for-dollar. The loan is still in balance, and nothing else is impacted by the draw.
4. What happens when property charges are paid from my set-aside?
When property charges like property taxes are paid through a Life Expectancy Set-Aside (LESA), the set-aside is reduced by the amount of the payment, and the loan balance increases. The loan is still in balance, and nothing else is impacted by the draw.
5. What happens to the set-asides and line of credit at loan maturity?
Remember, the line of credit and the set-aside represent money you have not borrowed. They are both forms of credit. Therefore, when the loan matures, that credit is not extended to the estate. The HECM has no additional borrowing capacity other than the loan balance, which continues to grow. At this point, the line of credit and the set-aside go away, and the current principal limit equals the loan balance as shown here: Principal Limit = Loan Balance.
This formula can be verified on the servicing statement and holds true with few exceptions.3 Write it down. If you are a reverse mortgage professional, memorize it. This formula can answer many critical questions that arise.
For more information on reverse mortgage guidelines, please consider purchasing the books Understanding Reverse, and Navigating Reverse, and subscribe to this blog.
Dan Hultquist
1. Technically, the loan balance would accrue slightly more than described because HECM loans compound monthly at 1/12th of the interest rate and MIP rate.
2. Some HECM loans originated between 2013 and 2017 had an MIP rate of 1.25% rather than the 0.50% rate offered today.
3. If this formula does not hold true when reviewing the monthly servicing statement, these are possible explanations: a) Within the first year of the loan there may be initial disbursement limits; b) The borrower has had a TENURE payment for more than 5 years AND lives past age 100; or c) The loan is an older HECM where the servicing fee set-aside grew at a different rate.