Many people get nervous at the idea of having an adjustable rate mortgage; even on a reverse mortgage where there are no actual payments to be made.  The reason for this is people know that interest rates can change dramatically over time.  Even if no payments are made out of pocket, the interest rate on a reverse mortgage affects how quickly the balance is growing, which in turn affects how much equity will be passed on to your heirs.

Being informed about your adjustable and fixed rate options is important when homeowners are considering a reverse mortgage.  The pros and cons do not need to be decided based on generalities however.  You can ask your loan officer to prepare a comparison for you, so you can see how the interest rate will affect your balance over time.

A reverse mortgage is calculated based on the senior homeowner’s age, county, property value, the amount owed on the home, and current interest rates, which are based on the 1 year Constant Maturity Treasury (CMT) index or the 1 year London Inter Bank Offer Rate (LIBOR).

For our example, we will use 67 year old, Ron Homeowner, who lives in a $400,000 house in Orange County, California.  He owes $175,000 on his house.  As of March 4, 2008, the interest rate for a Monthly Adjustable Reverse Mortgage is 3.48%.  There is also 0.5% mortgage insurance.   This makes the rate effectively 3.98%.  The interest rate for a fixed reverse mortgage HECM is 5.46%.  With the 0.5% mortgage insurance the effective interest rate is 5.96%. 

With these assumptions, Ron qualifies for his mortgage to be paid off, and to receive $46,999.37 at closing with the Fixed Rate reverse mortgage.   With the adjustable reverse mortgage, he would qualify to receive: $46,016.16 at closing, a $46,016.16 line of credit, $261.97 for as long as he lives in the home, or a larger monthly payment for a pre-determined term (such as $880.68 every month for five years.)  Currently, the fixed rate reverse mortgage only offers the cash in a lump sum at closing.

At an effective interest rate of 5.96% for the fixed rate HECM, in 10 years, the mortgage balance will be $412,393.  Assuming a conservative 4% rate of appreciation, the home value will have gone from $400,000 to $592,000 during that time, leaving $154,072 in equity – almost as much as the $161,000 in equity that was there when the loan was taken out.

If Ron had taken out the adjustable rate mortgage, then the balance will have grown more slowly – if interest rates remained low.  Since there is no easy way to know what interest rates will be in the future, we will just calculate what his balance will be in 10 years if rates were to stay at the effective rate of 3.96%.  If rates stayed that low, in 10 years, Ron’s balance would only grow to $344,883.  Based on 4% appreciation, his home would still be worth $592,098 in 10 years, which would leave $232,806 in equity – more than when he took his reverse mortgage out!   (At least, before you take into account inflation…)  This would be a difference of $78,734 in remaining equity – if rates stay low.

On the other hand, there is always the risk that rates could go back up.  This would turn these numbers the other way, and would be compounding monthly.   The Fed has recently done several rate cuts.  These are not permanent however, and at some point, the Fed may decide to start raising rates again. 

Let’s say that by year 5 of our example rates have gone up just over 1 point to an effective rate of 6%.  And then by year 6, rates have gone up to an effective rate of 8%.  By the 10^th year of the loan, you would actually still have a balance $2,000 less than if you had taken the effective fixed rate of 5.96%. 

But what happens after that?  At this point, Ron would be 77.  Many people live well past that age.  Let’s say rates drop back down to 6.5% from the 8% (remember this is including 0.5% mortgage insurance.)   From the 10^th year on, Ron’s balance would be growing faster than if he had taken out the fixed rate mortgage originally.  If rates stay at just 6.5% from the 10^th year to the 20^th year, Ron’s balance will be $800,081 on the adjustable rate reverse mortgage, versus $708,486 if he had gone with the fixed rate reverse mortgage.  At that time, his home is projected to be worth $876,449, so that $91,595 in equity accounts for a pretty big difference in what Ron could leave to his heirs.      

Despite the potential for interest rate increases, many people still choose the adjustable rate reverse mortgage because it allows for monthly payments, or a line of credit feature, which is not currently available on the fixed rate reverse mortgage.

Remember to ask your loan officer to show you the amortization schedules of your different options.  They are easier to look at than you might think!  They clearly show the loan balance, your home’s projected value and the remaining equity for each of 30 years from the date of the application.  Look into the history of the CMT index and the LIBOR, and discuss with your family and financial advisor which reverse mortgage would be best for you.