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Because a reverse mortgage is so different than a regular mortgage, there are many new concepts for borrowers to understand. There are many unique terms and reverse mortgage terminology can be especially overwhelming and confusing because you are usually seeing it for the first time. Given the significant financial commitment involved, it is important that borrowers understand what all these terms and phrases mean.
Reverse mortgage terms indicate how much and when you receive your loan proceeds, your interest rate, closing costs, monthly servicing fee and upfront and ongoing FHA mortgage insurance fees. There are a lot of reverse mortgage fees and expenses that borrowers may not be aware of.
Knowing the terminology also enables you to understand how your loan balance and property equity are expected to change over the course of the mortgage which is a very important concept. It is impossible to know how property values are going to change in the future but learning the assumptions used for your reverse mortgage can help you evaluate the financial risks and rewards.
Learning the terminology is key to making an informed decision when deciding if a reverse mortgage is right for you. The table below summarizes the key items to focus on in evaluating a reverse mortgage. Understanding these key terms will help you better understand how a reverse mortgage works and know what questions to ask a lender.
Reverse Mortgage Key Items
The interest rate that you pay on the outstanding balance of a reverse mortgage
There are two types of interest rate for a reverse mortgage:
Fixed rate: the interest rate never changes over the life of the mortgage
Adjustable rate: the rate is subject to change, and potentially increase over the life of the mortgage
The higher the interest rate, the lower the reverse mortgage amount you qualify for and the more the reverse mortgage balance increases over time
The lower the interest rate, the higher the reverse mortgage amount you qualify for and the less the reverse mortgage balance increases over time
Maximum Claim Amount
This is the value of the property you are mortgaging up to the FHA mortgage limit
So if the property value is $1,500,000 but the FHA reverse mortgage limit is $1,089,300, then the maximum claim amount is also $1,089,300
Initial Principal Limit
This is the size of reverse mortgage mortgage you initially qualify for based on your age, reverse mortgage type, interest rate and property value
The initial principal limit is calculated using an FHA formula and is typically between 50% and 60% of the property value
If you select a fixed rate reverse mortgage, you receive a disbursement of 60% or less of the initial principal limit when the mortgage closes and no additional proceeds
If you select an adjustable rate reverse mortgage, you receive a disbursement of 60% or less of the initial principal limit when the mortgage closes and after a one year waiting period you are able to receive the remainder of the proceeds up to the initial principal limit amount
The is the amount of money you receive up-front when the mortgage closes after paying closing costs and paying off any existing mortgages on the property
You are required to pay off any existing liens or mortgages on the property with the proceeds of the reverse mortgage
Financed Closing Costs
When you get a reverse mortgage you are required to pay closing costs similar to a normal mortgage such as a lender origination fee, appraisal report fee as well as escrow and title costs
The lender, escrow and title costs are typically financed which means they are included in the loan amount and paid for with the initial proceeds from the reverse mortgage
You are typically required to pay for the cost of the appraisal report and the FHA-required reverse mortgage counseling class up-front
Beginning Mortgage Balance
Your initial loan balance on your reverse mortgage when it closes
The beginning mortgage balance typically equals closing costs plus any existing mortgage balances on the property you pay off plus the amount of money you receive
Initial Line of Credit
Depending on the type of reverse mortgage program you select and the amount of proceeds you elect to receive when the loan closes you may have access to a line a credit that allows you to draw down or pay back an amount of your choosing, up to the maximum amount of the line of credit, until the line is exhausted
Mortgage Insurance Premium
The borrower is required to pay an up-front and ongoing FHA Mortgage Insurance Premium (MIP)
The borrower does not pay for either of these fees out of pocket as the up-front MIP is included in the closing costs which are financed as part of the reverse mortgage and the ongoing annual fee is added to the mortgage balance
The upfront FHA MIP for a reverse mortgage is 2.0% of the maximum claim amount (the maximum claim amount is the value of the property you are mortgaging up to the FHA mortgage limit in your county). The ongoing annual FHA MIP for a reverse mortgage is 0.5% of the outstanding mortgage balance, calculated on a monthly basis
With a reverse mortgage, the borrower never makes a mortgage payment
Monthly Servicing Fee
This is a monthly fee charged by the lender to process and service the reverse mortgage
The servicing fee is typically included in the interest rate and the borrower does not pay the fee separately
Expected Property Appreciation Rate
This is the expected annual rate of property value increase used to project what your property will be worth in the future
Your future projected property value minus your future projected reverse mortgage balance equals your equity
The equity in your property is the value of your property minus the amount of any mortgages you have on the property, so it is basically the financial value of your ownership of the property
A higher expected appreciation means that the property value will increase more in the future
If the expected appreciation rate is higher than the reverse mortgage interest rate then the value of the property grows faster than the the loan balance and the borrower is building equity in the property
If the expected appreciation rate is lower than the reverse mortgage interest rate then the value of the property grows slower than the the loan balance and the borrower is losing equity in the property
Borrowers should be aware of lenders that use a high expected appreciation rate (4% or higher)
Borrowers should use a more conservative appreciation rate (3% or lower) or contact a real estate agent to understand the expected property appreciation rate in your area
The example below shows how the expected property appreciation rate impacts your projected future equity with a reverse mortgage
Life Expectancy Set Aside
If the borrower does not demonstrates sufficient income to pay for property tax and homeowners insurance or has poor credit, the lender sets aside a certain portion of the reverse mortgage proceeds to pay for these expenses
The amount of the Life Expectancy Set Aside is based on the borrower's age and expected property tax and insurance costs. The younger the borrower and higher the costs, the higher the set aside
Life Expectancy Set Aside can be tens of thousands of dollars and take up a significant portion of a borrower's reverse mortgage proceeds
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Example: How the Property Appreciation Rate Impacts Your Equity with a Reverse Mortgage
One of the most important inputs for a reverse mortgage is the expected property appreciation rate, or how much the value of your property is projected to increase in the future. With a reverse mortgage, your future home owners equity changes depending on the expected property appreciation rate -- the lower the rate, the lower your equity. The example below the table demonstrates how your future home owner equity changes based on the expected property appreciation rate. Be sure to ask the lender what property appreciation rate they are using when they show you how your reverse mortgage and equity project in the future.
The example below demonstrates how the expected appreciation rate for your property impacts the equity in your home with a reverse mortgage. In this example, we assume that our property has an initial value of approximately $286,000 and look at how different rates of property appreciation impact our equity, or the value of the property minus the mortgage balance. The initial reverse mortgage balance in this example is $100,000 so the owner’s equity in the property is $186,000 ($286,000 (property value) - $100,000 (mortgage balance) = $186,000 (equity)).
The blue line in the chart shows how the principal balance for a reverse mortgage with an initial balance of $100,000 and an interest rate of 5.1% grows over time. At the end of year 30, the principal balance for the reverse mortgage is approximately $660,000.
The green line in the chart shows how the owner’s equity in the property changes over time using a 4.0% annual property appreciation rate. At the end of year 30, assuming the property value increases 4.0% every year, the value of the owner’s equity in the property is approximately $270,000.
The red line in the chart shows how the owner’s equity in the property changes over time using a lower, 2.0% annual property appreciation rate. At the end of year 30, assuming the property value increases 2.0% every year, the value of the owner’s equity in the property is approximately negative $140,000. Although you can never owe more on your reverse mortgage than value of your property, you can lose all of your equity which means that your ownership stake in the property is worth nothing.
This example demonstrates the importance of the property appreciation rate in assessing what your property equity could be worth in the future with a reverse mortgage. It should raise a red flag if a lender uses a high property appreciation rate (4% or above) to try to convince you to do a reverse mortgage. Use a more conservative appreciate rate (3% or lower) or contact a real estate professional to discuss what property appreciation rate you should use to evaluate if a reverse mortgage is right for you.
This example shows a reverse mortgage after 30 years but there is no set term for a reverse mortgage. A reverse mortgage lasts as long as the owner lives in the property or until the mortgage is paid off.
“CFPB Report Finds Confusion in Reverse Mortgage Market.” CFPB. Consumer Financial Protection Bureau, June 28 2012. Web.
About the author
Harry Jensen, Mortgage Expert
Harry is the co-founder of FREEandCLEAR. He is a mortgage expert with over 45 years of industry experience. Over his career, Harry has closed thousands of loans for satisfied borrowers and now offers his advice and insights on FREEandCLEAR. Harry is a licensed mortgage professional (NMLS #236752). More about Harry