Understanding the Costs of a Reverse Mortgage
Article by R. Joseph Ritter, Jr. CFP® EA
Television commercials and other advertisements make the reverse mortgage seem as though it does not cost you anything and that all you have to do is collect the money paid by the bank. The reason these advertisements are set up like this is because there is no requirement for you to pay the initial expenses up front. It does not mean the reverse mortgage is free.
To illustrate the costs associated with a reverse mortgage, let’s take a look at George who owns a home worth $250,000, age 70 years old with a life expectancy of 20 years (to age 90), and plans to remain in his home for as long as he can (he is planning on all 20 years). George is a widower with two adult children who are financially independent. He expects to receive 60% of his home’s value in the reverse mortgage, or a total of $150,000, which he has elected to be paid in monthly installments over the next 20 years. George was told about a new product from HUD called the HECM Saver, but because he would have received less money, he decided not to use the HECM Saver.
At closing on the reverse mortgage, George is told that he does not need to bring any money, although he does see some paperwork that lists several amounts of money. He is not real sure what this paperwork means.
On the paperwork are the following itemized charges:
- $2,500 – origination fee. There are origination fees for writing the mortgage. Although some lenders may reduce or waive the fee, HUD allows lenders to charge $2,000 on the first $200,000 of the value of George’s home, and up to 1% on the excess value. The origination fee can be financed (added to the amount to be paid back later) or paid in cash up front. Financing the closing costs is a major selling point in reverse mortgages, but this tends to hide the true costs of the reverse mortgage.
- $3,750 – initial mortgage insurance premium. Unlike traditional mortgages, all federally insured reverse mortgages (which is the vast majority) are required to have mortgage insurance, and the premiums are paid by the homeowner. An initial mortgage insurance premium is due at closing in the amount of 2.5% of the mortgage amount. The amount of the initial mortgage insurance premium is substantially less with an HECM Saver, however, this is not the only difference. The HECM Saver also pays you less, and that is the primary reason that the initial mortgage premium is less. There are certainly tradeoffs to consider between the standard reverse mortgage and the HECM Saver.
- $6,000 – There are typically closing costs involved with a reverse mortgage similar in nature to the costs associated with a traditional mortgage. These costs include recording fees, title search and insurance, documentary stamp taxes, appraisal fee, and survey fee, among others. These costs can easily be 2% to 4% of the mortgage amount.
- $12,250 – Total costs financed at the closing on George’s reverse mortgage. He does not realize that his reverse mortgage has these costs up front, but because he is told he does not need to pay anything a closing, he does not question the amount.
George is anxious to receive his first check but is unaware that there are costs associated with each payment he receives. The closing costs are only part of the expenses of a reverse mortgage.
- Monthly service fees – Each month the reverse mortgage is active and outstanding, the bank can charge as much as $35 to maintain the account. The fee is financed into the overall balance that will eventually become due, so it is another expense that is somewhat hidden. If George stayed in his home for 20 years as he plans, the total monthly service fees would be $8,400 over the life of the reverse mortgage.
- Mortgage insurance premium – The initial mortgage insurance premium is only an upfront payment. The premiums do not stop there. Each month the reverse mortgage is active and outstanding, the bank is required to pay FHA mortgage insurance premiums. The annual premium is 1.25% of the mortgage and is to be paid monthly. The monthly premium on George’s reverse mortgage is $156.25. Although the bank is required to pay this amount to FHA, the bank charges it to George’s reverse mortgage and finances the expense each month, so when his reverse mortgage becomes due, he will be paying for all the premiums. The total premiums over 20 years would be $37,500.
- Interest – The bank is not willing to do all this for free. They charge interest on all the money that George borrows and finances in the reverse mortgage. Each monthly check he receives is charged interest, from the date of the check until the reverse mortgage is paid in full. All amounts George finances, including the closing costs, monthly service fees and mortgage insurance premiums, are also charged interest from the day they are paid until the reverse mortgage is paid in full.
George’s reverse mortgage has a monthly adjustable interest rate (only lump sum reverse mortgages have fixed interest rates). This means the interest rate can (and probably will) change from month to month, either up or down. The common interest rate index used by banks in reverse mortgages is the LIBOR (London Interbank Offered Rate) 10 year swap rate which tends to be a more volatile index. The bank then adds a margin rate to the LIBOR rate. As of January 28, 2014, the LIBOR 10 year swap rate is 2.885%. The bank’s margin will vary from lender to lender, however, if we are conservative and use 1% as our margin (known as HECM-100), the initial interest rate is 3.885%. You can only count on this rate when the reverse mortgage begins, however, because it is subject to change from month to month. The variability and unpredictability of the interest rates over a long period of time is one reason why reverse mortgages commonly only allow homeowners to tap 60% of their equity. The longer the period of time the reverse mortgage is anticipated to be outstanding the less equity you can borrow because the bank needs the extra cushion to ensure the interest is paid.
The amount of interest that will be due on George’s reverse mortgage is unpredictable because the rate will adjust from month to month. However, if we used 4% over 20 years, an estimate of the interest would be $145,049.13.
