Many senior borrowers have been raised on the idea that a fixed rate reverse mortgage is the “only way to go”. Still others remember back to the early 80’s when interest rates climbed as high as 18%.
Some borrowers experienced rising interest rates from adjustable-rate loans (or knew others who did) and some remember family and friends whose payments rose to a point where they could no longer afford their homes.
A fixed rate locks the rate in for the life of the loan and the borrower does not have to ever worry about a payment increase on a forward loan, but what does that mean to borrowers who make no monthly payments such as on a reverse mortgage?
Fixed rates do lock in the amount of interest that will accrue on the outstanding loan balance, but due to the rules on both the fixed rate and the adjustable-rate HUD HECM loans (or “Heck-um” as you may hear it called), the fixed rate option is not always the best choice for borrowers.
LUMP SUM PAYMENT DISADVANTAGE
Firstly, the fixed rate option requires that you take a full draw of the funds that are available to you on the HECM program.
Private reverse mortgages (often called proprietary or jumbo reverse mortgages) will sometimes have slightly different draw options, but they are subject to change and are by far the minority of the reverse mortgage loans being closed.
We will concentrate on the HECM rules and just know that if your property value exceeds the government maximum lending limit of $1,089,300, you would want to check back to see what programs and guidelines would be available to you at the time under the Jumbo options.
Taking a 100% draw works well when you need all the money from the start to pay off an existing loan or if you are using all the funds to purchase a new home with a reverse mortgage. In fact, most fixed rates today are used for purchases.
However, due to HUD limitations on initial draws, the fixed rate loans do not work well for all borrowers.
HUD LIMITS THE AMOUNT YOU CAN DRAW
Without going into all the possible scenarios, HUD limits the borrower to just 60% of your Principal Limit at closing or in the first 12 months when the borrower does not need those funds to pay off existing liens, closing costs and other “mandatory obligations”.
The only exception to this is when the 60% limitation would not allow borrowers to have any cash at all at closing or in the first year and then HUD allows borrowers up to 10% of the Principal Limit above the payment of the mandatory obligations, even if that takes them above the 60% maximum – up to the full Principal Limit.
In other words, if just paying off your existing loan and loan costs would use 59% of your available Principal Limit, HUD will allow you to pay that amount and take an additional 10% in cash at closing increasing your initial draw to 69% of the Principal Limit based on the calculator results.
This would also be true if your current loan totals 72% of your Principal Limit and you would be allowed to go to 82% of the total loan based on the calculator results with the payoff of current liens and your additional 10%.
However, the fixed rate loan is a single draw program and borrowers forfeit any money not available to them at the close of escrow, there is no secondary draw available with a fixed rate loan.
If you need all your funds as determined by the calculator just to pay off an existing loan or if you are purchasing, you do not lose any funds as all funds are available at closing and are used by the borrower.
ADJUSTABLE-RATES OFFERS GREATER FLEXIBILITY
This is in contrast to the adjustable-rate loan on which you can choose to draw any amount you wish up to and including the full amount available to you in the first 12 months at closing or any time within that 12 months, and then whatever funds were not available to you during that first 12 month period are made available to you after 12 months.
And some borrowers do choose to use the adjustable-rate loan even when using all the funds as any funds borrowed and paid back may be re-borrowed later on the adjustable rate program which is not true of the single-draw fixed rate loan.
The adjustable option works best for borrowers who do not need all their funds immediately for several reasons.
Firstly, borrowers do not accrue interest on money they do not need. You only begin to accrue interest after you borrow the funds, you do not accrue interest on un-borrowed funds available to you in the line of credit.
POWERFUL LINE OF CREDIT GROWTH RATE FEATURE
Secondly, your line of credit grows on the unused portion of the line. This is not interest earned that the lender pays you, it is more like a credit line increase.
As you are not borrowing and accruing interest, the interest you do not accrue is added to the line of credit and made available to you to borrow later if you need it. If you never borrow it, you or your heirs never have to repay it.
The adjustable rate loan has both annual and lifetime interest rate caps to prevent the rate from rising too quickly or too high. No one can tell what future rates will do, and it is very difficult to say which would be better for any given borrower.
Because the fixed rate is a full-draw only program, borrowers must take their full loan amount from the very first day and that means accruing interest on the entire balance. Borrowers who opt for the line of credit can take the money as needed and only accrue interest on the funds they borrow but today’s interest rates can increase.
We strongly recommend that borrowers discuss their situations and most probably current and future borrowing habits with their financial advisors and family members to see which strategy would work best for their goals.
SO, WHICH IS BEST FOR YOU?
So, does this mean that one program is better than the other in all circumstances? Absolutely not!
But it does mean that it pays for borrowers to understand their needs and their intended use for the loan and to choose accordingly and not so much due to a “preference” that may not accurately protect their interests.
Fixed rates have been the preference of many senior borrowers and depending on the circumstances, that might be the best option for you, but it also may be time to look at a line of credit on which you don’t have to borrow as much.
While I would agree that the fixed rates are probably best for those using all the funds to pay off existing loans or purchasing a new property, I would strongly encourage other borrowers to take a good hard look at the adjustable offerings because they work better for most other borrowers and then choose the program that is best for you.