How Does the Reverse Mortgage (HECM) Line of Credit Work?

 

One of the most powerful features of the Home Equity Conversion Mortgage is that the unused portion of the Line of Credit has a built in guaranteed growth factor. So that once the line is established, it will continue to grow regardless of the home’s value. Some have “asked how is this possible?” And the answer is really pretty simple; it was designed into the program in 1988 and has never changed.

Case Study

  • Pierce and Linda (Ages 62) have a $400,000 home
  • They have an existing Mortgage Balance of $100,000 that carries a monthly payment that they would like to get rid of
  • So they establish a HECM Reverse Mortgage
  • The PRINCIPAL LIMIT (PL) is the amount of money that is made available to them based on (1) the Age of the Youngest Borrower (2) The Value of the Home (up to $625,500) and (3) The current interest rates.
  • Pierce and Linda have $200,000 that is made available to them
  • The HECM must be a first mortgage, so $100,000 is taken out to pay off their existing mortgage and eliminate their mandatory monthly payment. Financed closing costs for this loan are $5,000.
  • So Pierce and Linda’s Initial OUTSTANDING LOAN BALANCE (OB) is $105,000

 

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So their Initial LINE OF CREDIT (LOC) of $95,000 is equal to the PRINCIPAL LIMITOUTSTANDING BALANCE

THE BASIC FORMULA
PL – OB = LOC


The First Year

  • The PRINCIPAL LIMIT of the HECM is ALWAYS Growing at the Note Rate: Interest Rate + Lender’s Margin + HUD MIP

(**Notice** This Example just shows the Lender’s Margin + HUD MIP,
because it’s the MINIMUM Growth Factor! Today’s actual growth rate is around 6.1%)

  • So you will notice below that the Principal Limit grew from $200,000 to $210,000 (or by 5%)
  • The OUTSTANDING BALANCE is also ALWAYS Growing at the Note Rate: Interest Rate + Lender’s Margin + HUD MIP
  • Notice it grew from $105,000 to $110,250 (or by 5%)
  • The difference between the Principal Limit and the Outstanding Balance = 1st Years Line of Credit of $99,750

The Subsequent Years:

  • Notice below that the Principal Limit and the Outstanding Balance are Always Growing in a HECM
  • If a voluntary mortgage payment is made, it will reduce the Outstanding Balance, but the Principal Limit will always be growing at the Note Rate
  • Notice below that Line of Credit therefore is growing as well, regardless of the underlying home’s value, the client’s income, assets or credit worthiness

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So there you have it. A very simple and powerful tool called the HECM Line of Credit. One tool capable of solving so many retirement income challenges.

Don’t Forget the Home Appreciation

Many advisors forget that the underlying asset is still appreciating. Below we show a 3% and 4% average appreciation for illustration sake; actual appreciation will naturally fluctuate. But the point is that the home itself is an appreciating asset. So in this example, one would simply need to subtract the outstanding balance from the potential future home value to determine what passes on to the estate. **Note** In certain scenarios, the home’s equity may be intentionally depleted in order to increase or preserve the overall value of the estate (which could mean preserving Equities from premature depletion, etc).

400k_home_appreciation

Too Good to Be True?

So many have questioned if this is this really true. In August of 2016, AARP Public Policy Institute made a recommendation to congressional policy makers that the HECM Line of Credit (which has functioned the same waysince 1988) was too good and the HUD should consider eliminating the growth feature of the program. I don’t know what will come of this suggestion in the future, but for now, establishing a Standby HECM Line of Credit could be a tremendous financial planning strategy.

 

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