How Do Reverse Mortgage Interest Rates Work?

Interest rates in reverse mortgages work very similarly to the way they work in any loan. There are some differences, however, that potential borrowers need to understand. It’s important to note that this article only addresses home equity conversion mortgages (HECMs), or government-backed reverse mortgages. Some reverse mortgage lenders offer proprietary mortgage loans that may have different interest rate terms than those outlined here. 

What Are Interest Rates? 

Interest rates are the amount lenders charge borrowers each year in exchange for lending them money. They are a percentage of the principal the borrower will owe the lender over the initial loan amount. Interest is calculated based on how much principal the borrower owes at any given time.  

With a traditional mortgage, interest accrues monthly. The borrower’s monthly payment covers both accrued interest and some of the principal. As the loan principal decreases, the amount of interest charged each month also decreases. While the loan’s interest rate stays the same, the loan balance decreases as the borrower pays the principal. The loan ends within a specific timeframe over which the borrower has paid the agreed amount of interest in addition to the amount they initially borrowed.   

How Interest Rates Work in a Reverse Mortgage  

With a reverse mortgage, interest accrues monthly, but the amount owed goes up over time rather than down. As the borrower withdraws more money and interest compounds (or adds to itself), the amount of interest owed also increases. Though not interest other fees, like the mortgage insurance premium (MIP), also accrue on the reverse mortgage balance annually. 

No matter how much the interest grows, the loan balance only comes due at the end of the loan term. Unlike a traditional mortgage with a set term, a reverse mortgage term depends on the time the borrower lives in the home. The term can also end if the borrower fails to keep the loan in good standing.  

Commonly in a reverse mortgage, the loan ends when the last borrower on the loan passes away. The borrower’s estate then works with the lender to satisfy the loan balance.  

Types of Rates Applied to Reverse Mortgages 

Reverse mortgages can have fixed or variable interest rates. The choice of one or the the other impacts how the borrower may receive payments and how much they can receive. This is how each type of rate works:

• Fixed rates. Set at loan origination these rates remain fixed for the life of the loan. 
• Variable rates. These rates fluctuate based on a rate index. Reverse mortgage variable rates are currently based on the one-year constant maturity treasury index (CMT). 

Many conventional mortgage borrowers opt for a fixed rate because these rates offer a degree of certainty. While often higher than opening variable rates, a fixed rate will stay the same for the life of the loan. For traditional mortgages, fixed rates allow borrowers to know exactly how much they will pay and for how long. 

The reverse mortgage borrower is not required to pay any interest until the end of the loan. Most borrowers don’t know how long the loan term will be. Thus, reverse mortgage borrowers can’t generally predict how much interest they will ultimately pay. This means there is similar uncertainty about how much interest will ultimately accrue for variable and fixed rate reverse mortgages.

How Variable and Fixed Rate Reverse Mortgages Differ 

The type of rate a reverse mortgage borrower chooses determines how they may access funds and how much will be available to them over the course of the loan. 

Fixed-Rate Reverse Mortgages 

Fixed rate everse mortgage borrowers must take the full amount of their authorized funds in a lump sum at closing. Fixed rates on a HECM are usually higher than the initial interest rate on a variable rate HECM. But as with a forward mortgage, the borrower knows exactly how much interest will accrue each month from the outset.  

For multiple reasons, fixed rates are less common than variable rates in reverse mortgages. Borrowers usually choose a fixed-rate reverse mortgage for a specific set of circumstances. Taking the full amount at a fixed interest rate may be advantageous for the borrower who intends to pay off a loan entirely after a specific length of time. This choice allows the borrower access to equity while offering the same benefit that all reverse mortgages have of removing the obligation to make required monthly mortgage payments for the term of the loan. Borrowers who want to stay in their homes for the near term but imagine downsizing down the road, or who are finding high mortgage payments difficult to keep up with may find a fixed rate reverse mortgage advantageous. 

How the 60% Utilization Rule Impacts Fixed Rate Reverse Mortgages 

It’s also worth noting that all HECMs are subject to a 60% utilization rule. This rule, set by the U.S. Department of Housing and Urban Development (HUD), limits the amount any reverse mortgage borrower can take in the first year to 60% of the principal limit. There are also mandatory obligations all reverse mortgage borrowers must fulfill as part of closing. These include paying off previous mortgages, loan closing costs, and the FHA’s upfront mortgage insurance premium.  

Because borrowers must take all fixed-rate reverse mortgage funds at closing, they will only receive the higher of: 

• 60% of the available principal minus their mandatory obligations, or 
• The amount of their mandatory obligations, plus 10% of the available principal.  

This means that in most cases, fixed-rate borrowers will have access to less equity than they would with a variable rate.  

Variable Rate Reverse Mortgages 

Although variable rates fluctuate, at the time of closing, the initial rate on a variable rate reverse mortgage is usually lower than a fixed interest rate on a HECM. Also, the variable rate on a reverse mortgage has a life cap of 5% or 10% depending on the reverse mortgage product the borrower selects. This means the rate will never exceed the percentage of the life cap over the start rate. This cap offers a degree of certainty that is not present with all variable-rate mortgages. 

Variable Rates and Loan Proceeds

Importantly, choosing the variable rate also allows borrowers to choose how and when they will receive loan proceeds. When they choose a variable rate, borrowers get options for how they will receive their funds: in a lump sum, in monthly payments, as a line of credit, or a combination of the three. For the lump-sum alternative, variable rate borrowers are still subject to the 60% utilization rule explained above. This means they will be able to take 60% of the principal limit, less any amounts needed to fulfill the mandatory obligations of the loan. The remainder of the available principal will be available to them in the 13th month of the loan and come from an established line of credit. 

Borrowers can choose to keep their available funds as a line of credit. Interest only accrues on funds withdrawn. Similarly for borrowers who take funds as monthly payments, interest only accrues on dispersed funds.  

Interest, however, will begin to accrue on any funds added to the principal in addition to cash-out funds. For instance, if the borrower has used loan proceeds to pay for their mandatory obligations, interest will accrue on that amount. Interest will also accrue on upfront and annual mortgage insurance premiums.  

Whether borrowers choose a fixed or variable rate, taking a reverse mortgage allows them to forgo mandatory monthly mortgage payments. This feature offers an improved cash flow to limited budgets. It is important for homeowners to understand they are still responsible for paying insurance, property taxes, and other home-related expenses. 

Keeping Track of Reverse Mortgage Interest  

Because interest and other fees accrue on the loan balance, some reverse mortgage borrowers fear the amount they owe will get out of control and perhaps, grow beyond the home’s value. 

There are two types interest rates associated with variable rate reverse mortgage: the expected rate and the initial rate. Understanding what these rates mean can help make projections and set expectations. 

• The expected rate. This rate is a ten-year average used to calculate how much money the borrower has access to from their home. 
• The initial rate. The initial rate is set at closing and changes over time, as outlined in the note. This is the actual note rate that accrues over time.  

Looking at monthly mortgage statements can help borrowers keep track of their principal, fees, and interest that have accrued.  

As for the fear that the interest accrual will outpace the home’s value, borrowers can find peace of mind in understanding that Home Equity Conversion Mortgages are non-recourse loans guaranteed by the federal government. This means that when the loan comes due, should the loan balance exceed the home’s value, the borrower or their heirs will not owe the lender more than the current value of the home when it is sold to repay the loan. 

If you are contemplating a reverse mortgage, you will be required to meet with a reverse mortgage counselor. This meeting is a good opportunity to discuss how interest rates on a reverse mortgage work and ask any additional questions.