For many Americans, their home is their biggest asset, and for some it’s the asset they’ve invested in the most throughout their lives. In fact, U.S. homeowners have an average of 70% of their net worth tied up in their home equity.1 Perhaps this rings true for you, too!
As retirement approaches, many seniors find themselves with significant home equity but a lack of liquid assets to cover ongoing and unexpected expenses. In such cases, a reverse mortgage loan can provide a supplement to income by allowing older homeowners to tap into their home equity without needing to make monthly mortgage payments – all while they continue to live in the home they love. They must of course continue to pay their property taxes and insurance and maintain the home.
With so much equity built up, it’s no wonder 1.3 million Americans have already made a reverse mortgage loan part of their retirement plan.2 Could this retirement solution be the right move for you?
What You Need to Know
Before applying for a reverse mortgage, it is essential to understand two key factors that affect the lending amount of the loan: the principal limit factor and expected interest rate.
While it is always important to do our own research, it is equally important to work with a reputable lender to ensure that you are getting the best possible terms on your loan. How can you know if you are getting the best possible terms? A good first step is understanding the key elements and how they impact your loan, like the principal limit factor and expected interest rate. Let’s look at what these two terms really mean and how they impact reverse mortgage loans!
What is a Reverse Mortgage Principal Limit Factor?
Principal limit factors, or PL factors, are percentage values published in tables by the Federal Housing Administration (FHA) for purposes of calculating the amount of money that a reverse mortgage borrower can receive – this total amount is called the principal limit.3 Generally, PL factors increase with age which means that older borrowers qualify for more money than younger borrowers. PL factors also tend to increase as the expected interest rate decreases. This means when rates are low, reverse mortgage borrowers will typically receive more money.
The principal limit – or total amount of money received from a reverse mortgage – is calculated using several different elements including the PL factor, the expected interest rate, the value of the home, the age of the youngest borrower or eligible non-borrowing spouse, and maximum claim amount.4 The maximum claim amount is either the value of the home or the reverse mortgage lending limit, whichever is less.5 The lending limit is set by the U.S. Department of Housing and Urban Development (HUD) and, for the calendar year of 2023, is at an all-time high of $1,089,300.6
The principal limit is important to consider when deciding whether a reverse mortgage is the right option for you. Understanding the PL factor and expected interest rate can give you a better understanding of how your principal limit is calculated and greater insight into how reverse mortgage loans work. Let’s look at how the expected interest rate comes into play when calculating the principal limit!
What is the Expected Interest Rate?
The expected interest rate (EIR) is another important factor to consider when applying for a reverse mortgage loan. The EIR is used to estimate the future interest rate that will be charged on the loan and is derived from the initial interest rate on the loan. It is akin to a ten-year projection of that initial rate. On adjustable-rate reverse mortgage loans, a 10-year average based on the interest rate of the US Treasury securities is projected to determine the EIR. This projection considers that some years rates may be higher and other years they may be lower. Because it is simply a projection, the EIR is an entirely hypothetical number with regard to adjustable-rate loans and is used for calculation purposes only. For fixed rate reverse mortgages, the EIR is identical to the initial interest rate because there is no variability (the rate is fixed) and therefore no need to take a hypothesized 10-year average.
While the EIR is an important factor, it is only important when calculating the principal limit – it is not the actual interest rate.7 When deciding whether a reverse mortgage is the right option for you, the EIR is a critical element to consider. Not only does it affect the amount of money you can borrow, the EIR also affects the overall cost of the loan.
How Do the PL Factor and EIR Affect the Cost of a Reverse Mortgage?
The PL factor and EIR both have a significant impact on the principal limit. The higher the principal limit, the more money you can borrow, and potentially more interest and fees you will pay over the life of the loan. Alternatively, the higher the EIR, the less money you can receive.7
It is important to understand that a reverse mortgage is a loan, and like any loan, it comes with costs and fees. These costs may include origination fees, appraisal fees, and closing costs. In addition, borrowers are required to pay mortgage insurance premiums (MIP) that protect the lender in the event that the loan balance exceeds the value of the home.8 The good news is, because of MIP, with a reverse mortgage you’ll never owe more than the home is worth when the loan becomes due and the home is sold!
The PL factor and EIR also impact the amount of equity that will be available to the borrower or their heirs when the loan is repaid. The higher the loan balance, the less equity will be available to the borrower or their heirs when the loan is paid off. It is important to consider the impact of the loan on your future financial situation, including your ability to leave your home to your heirs.
Let’s look at a simplified example to better understand how the PL factor and EIR are used to calculate a reverse mortgage principal limit!9
- Maximum Claim Amount: $850,000
- Age: 75
- EIR: 6.00%
- PL Factor: 0.4819
- Principal Limit = (PL Factor 0.481 * Maximum Claim Amount $850,000)
- Principal Limit = $408,850
How to Determine if a Reverse Mortgage is Right for You
Before deciding whether a reverse mortgage is right for you, it is important to consider your current and future financial goals. A reverse mortgage may be a good option if you:
- Could use additional cashflow each month to cover expenses.
- Have a plan for how you will use the loan proceeds.
- Do not plan to move or sell your home in the near future.
- Could benefit from eliminating your monthly mortgage payments. (Though you must meet your loan obligations, keeping current with property taxes, insurance, and maintenance.)
- Understand the costs and fees associated with the loan.
- Have heirs who understand how the loan may impact them.
If one or more of these statements sound applicable to you, a reverse mortgage might be the right financial tool for your retirement! So, how do you know if you might qualify for a reverse mortgage? While there are a number of different considerations, three basic requirements for revere mortgage eligibility are as follows:
- You must be at least 62 years old for FHA-insured Home Equity Conversion (HECM) reverse mortgage loans. For propriety reveres mortgage loans, like Longbridge Platinum, the minimum age drops to 55 in some states.10
- You must have significant equity in your home.
- You must live in the home as your primary residence.
Tying it all Together
We’ve covered the expected interest rate (EIR) and principal limit factor (PL factor) and how they are used in calculating the principal limit, which is the amount of proceeds you can receive from a reverse mortgage.
Interest rates are an important part of reverse mortgage loans, but not necessarily for the reasons you may think! We know that in general a higher interest rate results in higher monthly payments. However, this can be a non-issue for reverse mortgage borrowers because their required monthly mortgage payment starts at $0 and goes up to $0! They do of course need to continue paying their property taxes and insurance and maintain their home.
So, what issue do reverse mortgage borrowers face with higher interest rates? A smaller loan amount. When interest rates go up on reverse mortgages, lenders can loan out less money to borrowers. This is by government design.
With careful consideration and the right guidance, a reverse mortgage can be a valuable financial tool for older Americans who are looking to find greater financial flexibility and peace of mind in retirement. If you’re considering a reverse mortgage, it is important to take all the different factors into account, including the principal limit factor and expected interest rate.
If you’re ready to take the next (or first) step in the process, it’s important to work with a lender who can provide you with guidance, transparency, and superior customer service. And that is where Longbridge comes in! We’re committed to helping you find the right fit for your retirement. Contact us today to get started.