A common criticism of reverse mortgages is that they are expensive, resulting in the view that they should only be used as a last resort, when a senior has nothing left but their home equity.

But, most people don’t understand the structure of these costs, which are reasonable compared to the alternatives.

A reverse mortgage allows the borrower to convert home equity into cash, receiving a stream of tax free payments.  The loan is secured by the home and is repaid when the homeowner dies or ceases to live in the home permanently.

About 90% of all reverse mortgages are Home Equity Conversion Mortgages (HECM), insured by the Federal Housing Administration (FHA). The FHA requires a Mortgage Insurance Premium (MIP) of 2% of the “maximum claim amount” and also allows an originator fee of the same amount. There is an additional annual insurance fee of 50 basis points on the loan balance and a monthly servicing fee of $30-35. The “maximum claim amount” is the home’s assessed value capped at the county lending limit, which, for many urban and suburban neighborhoods, is $362,790. These upfront fees (plus normal closing costs like appraisal, title search, etc.), typically amount to about $17,000, which is accrued to the loan at closing. No out-of-pocket payments are generally required.

Once a reverse mortgage is initiated, interest accrues monthly over the life of the loan. Rates are usually low; as this is written, a monthly adjustable HECM (the most popular option) has an APR of 3.66%. The Total Annual Cost of Ownership (TALC), which must be disclosed to borrowers at closing, is a calculation that combines all cash flows over the mortgage’s life into one net present value cost. The TALC starts out high in the loan’s initial years, drops steadily, and reaches quite reasonable levels as the loan gets older. In other words, the closing costs are amortized over the life of the loan, so the longer it runs, the lower the TALC gets.

The whole point of the HECM is to keep people in their home until they die or leave the home, whichever comes first. The life expectancy of a 62 year old female is 21.89 years, which is ample time for amortization. Thus, the most obvious way to get a “low-cost” HECM is to get it early in life and let it run for a long time.

Consider two examples:

1. A 75-year old with an appraised property value of $365,000 gets a line of credit HECM and never uses it. That’s a worst case, since the borrower never gets any value from the loan.  Yet, even in this worst case scenario, the TALC is only 6.73% after 6 years and 5.54% after 12 years.
2. The same 75-year old takes all the money they can get as an initial draw - $246,266.57. In two years time, the TALC is 7.9% and in 6 years it is 5.48%, which is a pretty reasonable rate – not expensive at all. At longer periods in this example, the home appreciation rate kicks in. At 0% appreciation, after 12 years, the TALC is only 2.71%, a positive steal. After 17 years, it’s only 1.91%. This is because the balance has caught up and exceeded the home value. HECMs are non-recourse and the homeowner essentially never pays back the “underwater” portion.

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