You will have several loan options to choose from when getting a reverse mortgage, each of which have their pros and cons. In certain situations, there are obvious choices.
There are three options with the reverse mortgage. These options are the fixed rate, annual adjustable rate and the monthly adjustable rate.
Fixed Rate Option
This is exactly as it sounds; the interest rate is fixed for the life of the reverse mortgage. This option requires a one-time lump sum distribution. This means you get the equity you qualify for at close of escrow as a lump sum. There are no future draw options and no future payments to you. You get what you get and that’s it.
While having a fixed interest rate is nice, there are some drawbacks to this. Let me apologize now, the following information is dense and may make your head hurt.
The first drawback to having a fixed interest rate is that there is a maximum that you can receive at close of escrow. To protect borrowers and their equity, FHA limits the amount of funds you can gain access to in the first year. For the fixed rate loan, there is no future availability of funds.
The maximum you can receive is either a) 60% of your principal limit or b) your mandatory obligations
(mortgages and closing costs), plus 10% up to 100% of your principal limit. The principal limit is the total loan amount you qualify for.
Here are some examples for you to get a better understanding of how it works.
Let’s assume you can borrow $100,000 (your principal limit) and you have opted for the fixed rate.
- If the payoff of the current mortgage, plus the closing costs were $40,000, you could take out the remaining $20,000 (which totals 60% of your principal limit). There is no additional equity available at any time in the future.
- You need to consider that you are leaving $40,000 of equity on the table. You are exchanging $40,000 for the fixed rate.
- If the payoff of the current mortgage, plus the closing costs were $60,000, you would be able to get an additional 10% of the loan amount, which in this example would be $10,000. There is no additional equity available at any time in the future.
- In this example, you only get an additional $10,000 beyond paying off your current mortgage. You are leaving an extra $30,000 on the table that you will not be able to access.
- If the payoff of the current mortgage, plus the closing costs were $95,000, you would be able to get the remaining $5,000. There is no additional equity available at any time in the future.
- In this example, it is what it is. You only qualify for $100,000 initially. With the payoff and closing costs equaling $95,000, there is only the $5,000 left.
Finally, it is important to understand that this is a closed-end mortgage. What this means is that the
credit is closed upon the receipt of your initial funds. The loan is not open to future withdrawals from a line of credit and you will not receive future payments. Because it is closed, any payments made towards the loan balance will not be available for future use.
Typically, the fixed rate loan option is used when purchasing a home, or when mandatory obligations (current mortgages owed on the property, closing costs and other liens), are close to 100% of the
Adjustable Rate Option
This is just as it sounds. This loan option comes with an adjustable rate. With an adjustable rate comes many ways to gain access to utilize the equity in your home. These options include an initial draw, line of credit (LOC), tenure payments, term payments, modified tenure payments and modified term payments. The adjustable rate option has the most flexibility, allowing you to structure and utilize the loan in a variety of ways that best meets your needs.
Unlike the fixed rate option which is a closed-end mortgage, the adjustable rate option is an open-end
mortgage. This means that not only can you draw funds from it, if you make payments towards the loan balance; these funds become available for future use.
There is an initial disbursement limit. You are limited on how much of the Principal Limit (the
amount you can borrow), can be drawn in the first year. The initial disbursement limit is 60% of your principal limit, or the total of your mandatory obligations plus 10%. After one year, the remaining amount of the principal limit, plus growth, becomes available to you.
Here are some examples to get a better understanding of how it works.
Let’s assume you can borrow $100,000 (your Principal Limit) and that you opted for the adjustable rate mortgage. You would have access to $60,000, less closing costs, the first year.
- If the payoff of the current mortgage, plus the closing costs were to equal $60,000, you would be able to draw an additional $10,000. On the one-year anniversary of your loan, you would have access to the remaining $30,000, plus whatever growth of the line of credit occurred during that year.
- If the home was owned free and clear, you could request up to $60,000, less closing costs, initially. If there was no initial draw, you would have access to those funds at any time during the first year. On the one-year anniversary of your loan, you would have access to the remaining $40,000, plus whatever growth of the line of credit occurred during that year.
Initial Draw Option
The Initial Draw Option is any cash in hand that you may need or want if it is within the initial draw limits. These funds are either wired into your account after the loan has been funded, or a check can be mailed.
With this option, you will receive monthly payments for as long as you live in the home, assuming you continue to pay your taxes, insurance and maintain the home. You will receive less on a monthly basis compared to the Term Option. This is due to the risks FHA and the lender face in not knowing how long you are going to live. Living beyond your life expectancy puts FHA and the lender at a higher risk of loss, thus the smaller monthly payments. However, you are guaranteed to receive those funds regardless of the loan balance or home prices. The Tenure Option is the most conservative and safest option for receiving monthly payments.
With this option, you could also get cash to pay off debt or bills. You could also plan for the future if you know of an upcoming large expense, such as a new roof or the painting of your home. You may also just want to have some cash in savings for unexpected expenses. Keep in mind the more you pull out initially reduces the amount of monthly payments.
Modified Tenure Option
Along with receiving monthly payments for as long as you live in the home, this option would allow you to pull out cash, create a line of credit or both. Unless you have savings or other assets from which you can draw, it usually makes sense to set some of your equity aside in the line of credit. This creates a source of reserve funds for future expected or unexpected expenses.
The term option allows you to receive monthly payments for a specified term, from a few months up to 10 years. The shorter the term, the higher the payments will be, and vice versa. You are guaranteed
to receive these payments as long as you are living in the home and you pay your taxes and insurance and maintain your home. You can also draw cash from your funds through the Initial Draw. This option comes with larger monthly payments when compared to the tenure. However, once all the payments for the term have been made to you, the payments stop. This option could be riskier than the tenure option.
It is important to understand that with the Term Option once payments stop, the reverse mortgage is still active. You are not required to pay off the loan or make payments. You can continue to live in the home if you are following terms of the loan which include paying property taxes, insurance and other housing related costs.
There are plenty of situations where the Term Option may be a better choice than the Tenure Option. These situations could include things like:
- You know you will be inheriting money at some time in the very near
future and need or want the larger payments until that inheritance comes
through. This may also include gaining access to funds in a trust.
- You are trying to defer drawing as much money as possible from
retirement accounts to let them grow or recover from a downturn in the
- You have only been given a certain amount of time to live.
- You were part of a class action lawsuit and are waiting for funds to be
Modified Term Option
The same reasons for utilizing the Modified Term Option apply to the Modified Tenure Option. It typically makes much more sense to set some of the equity aside in a line of credit for future unexpected expenses
than to receive the larger monthly payment.
As with the Modified Tenure, the more money you set aside for the line of credit, the smaller your monthly payments will be.
Line of Credit Option
The line of credit is by far the most popular choice in the various equity payout options of the reverse mortgage. In fact, it is such an excellent option that I am going to dedicate the next chapter to this option.
What’s Owed in The Future With a Reverse Mortgage?
Regardless of which of the options you choose, your loan balance only increases as you receive funds, plus interest and mortgage insurance that has accrued based on current loan balance.
Let’s assume you chose to go with the tenure option and receive monthly payments for as long as you live in the home. Let’s also assume you owned your home free and clear and that you would receive $500 a
If you passed away one year after receiving the reverse mortgage, the loan balance would be the sum of the 12 months of payments you received, $6000, plus your closing costs, accrued interest and accrued mortgage insurance. Whoever is inheriting your home could sell it and net the difference between what you owe and the sales price.
A Word of Caution
Do not get hung up on whether
the loan is a fixed rate or an adjustable rate. You need to focus on which of these options is going to best meet your needs now and in the future.