The requirements to become an eligible HECM (Home Equity Conversion Mortgage) borrower include age (at least 62), equity in your home (any existing mortgage can be paid off with loan proceeds), financial resources to cover tax, insurance, and maintenance expenses, no other federal debt, competency, and the receipt of a counseling certificate from an FHA-approved counselor for attending a personal counseling session on home equity options.
HUD provides a list of approved counselors on their website. The property must serve as your primary residence and also must meet FHA property standards and flood requirements and pass an FHA appraisal to be eligible. You must maintain the home to meet FHA health and safety standards and there may be a requirement for some home improvements as a condition for initiating a reverse mortgage. Up to $625,500 of a home’s value can be applied to a reverse mortgage.
It is important to remember that your obligations to pay property taxes, homeowner’s insurance, and home maintenance are required for any type of mortgage. This is not a unique situation for reverse mortgages. This is important to protect the lender by keeping up the value of the collateral for the loan.
The Initial Principal Limit: Measuring Available Credit
Reverse mortgages use their own jargon, and it is important to understand the meaning of three key terms: (1) principal limit factors (PLF), (2) the expected rate, and (3) the effective rate. The alliterative nature of the last two terms can be jarring, but understanding the issue is manageable.
The principal limit represents the credit capacity available with a HECM reverse mortgage. We need to understand how to calculate the initial principal limit when the reverse mortgage is opened, as well as how to understand the way that the principal limit grows over time. The initial principal limit is calculated with the expected rate, while principal limit growth is calculated with the effective rate.
PLF factors are published by HUD, and the version in use today became effective in August 2014. Factors are updated over time to manage the risk to the insurance fund. Because HECMs are non-recourse loans, the principal limit that can be borrowed must be less than the home’s value, so that there is less potential for the loan balance to ever grow to be worth more than the value of the home.
The idea for reverse mortgages is that the value of the home is eventually used to repay the loan balance. The loan balance can exceed the home’s value in practice, but this should not happen too frequently if the program is to remain sustainable. In cases where the loan balance exceeds the home’s appraised value, the insurance fund makes up the difference to protect both the borrower and lender, and this is an important reason why insurance premiums are paid.
The important factors for determining how much credit is available through the HECM include the appraised home value, homeowner age (or, for couples, the age of the younger spouse, and one spouse must be at least 62), a lender’s margin, and the 10-year LIBOR swap rate. Together, the lender’s margin and the 10-year swap rate sum to the “expected rate.”
Expected rate = 10-year LIBOR Swap Rate + Lender’s Margin
The Principal Limit Factor (PLF) determines the borrowing amount as a percentage of the appraised home value, up to the FHA mortgage limit of $625,500. The expected rate is meant to estimate the compounding series of shorter-term interest rates over the next 10 years, which provides an estimate for the future path of effective rates. The expected rate is used with the age of the younger spouse to determine the principal limit factor (PLF), or the percentage of the home’s appraisal value that may be borrowed. If the home’s appraisal value exceeds $625,500, this serves as a maximum to which the PLF is applied.
Figure 1 provides a visual for how these PLFs vary by age and effective rates. The percentage of home value increases when the age of the youngest borrower or non-borrowing spouse is higher and when the expected rate is lower. The PLF is based on a present value calculation: more can be provided initially when the time horizon is shorter and when the discount rate is less.
The current low-interest rate environment does tend to provide an advantage when opening a reverse mortgage, as the PLF is a higher amount than otherwise. Also, note that interest rates are much more important than age for determining the PLF. For example, with an expected rate of 5%, the PLF is 50% when the youngest borrow is 58. However, should the rate rise to 6.5%, the youngest borrower would have to be 81 before the PLF exceeds 50%. If the expected rate is 6%, the PLF reaches 50% at age 76.
Because the expected rate is so important, a future increase in interest rates would quickly counteract any benefits from an increasing age in determining the PLF for a new reverse mortgage contract.
Figure 1: Principal Limit Factors: The Percentage of Home Value Initially Available
Figure 2 provides a similar perspective, but with age and expected rates swapped on the horizontal axis. Again, we observe lower principal limit factors when expected rates are higher, and increasing ages do support higher principal limit factors across the range of expected rates.
Figure 2: Principal Limit Factors: The Percentage of Home Value Initially Available
The PLF is the percentage of the home’s value. If it then grows at the “expected rate” thereafter, it will grow to equal the appreciated home’s value when the loan becomes due (either upon death or leaving the home), using a projected growth rate for home prices similar to the projected overall price inflation rate. This calculation assumes the entire principal limit is borrowed when the loan originates, which generally is no longer possible. For example, with the current table from August 2014, the PLF is 52.4% when the youngest borrower is 62 and the expected rate is 5%.
The government’s specific assumptions are not provided publicly, but if we assume a 2% growth rate for home appreciation and a remaining life expectancy of 22.3 years, then we can replicate the actual value for the PLF. Alternatively, a home appreciation rate of 2.95% combined with a life expectancy to 100 (38 years) also makes the calculation work.
The government might use a different combination of values for these two variables, but the below formula shows the basic idea for how the PLF is calculated:
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