One of the primary benefits of taking out a reverse mortgage is that it can give you a stable source of income for the rest of your life. Under the right conditions, you can enjoy the proceeds from a reverse mortgage loan to live comfortably while staying in your home for the rest of your life.
There are several types of reverse mortgage payment plans available, and each plan has its own benefits. In some cases, it is even possible for your line of credit to grow over time. The sooner you open a reverse mortgage line of credit, the more the line of credit can grow over time.
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What are the different types of reverse mortgage payment plans?
When you take out a reverse mortgage, there are six different ways you can receive your funds. Each one carries varying levels of risk for homeowners; choosing the right one is imperative to avoid using up all your proceeds too early.
1. Fixed-rate lump sum
The fixed-rate lump-sum payment plan is the only type of reverse mortgage that has a fixed interest rate. When you take out a reverse mortgage with this type of payment plan, you receive the entire fund all at once. For homeowners who can manage their money well, receiving their reverse mortgage proceeds as a lump sum can be ideal since they know exactly what they will have to repay (due to the fixed interest).
. It is important that those who opt for a fixed-rate lump-sum payment create a strong financial plan to manage the large sum. Receiving everything all at once allows for more freedom, however, it also necessitates more responsibility on the borrower’s behalf.
2. Term reverse mortgage
With a term reverse mortgage payment plan, you receive equal monthly payments until a predetermined stop date, at which you have reached the loan’s principal limit. If you outlive your loan, you can still stay in your home as long as you meet the loan obligations (paying property taxes and homeowner’s insurance, keeping the home in good shape)–but you won’t be receiving any more proceeds.
3. Modified term reverse mortgage
A modified term reverse mortgage allows you to receive your proceeds on a fixed monthly payment for a certain number of months, as well as a line of credit. If you choose the straight term plan, your monthly payments will be smaller. If you choose the straight line of credit plan, your line of credit will be smaller.
With this type of payment plan, you can receive monthly payments up to a certain period and have access to a line of credit until it is exhausted. You can even increase your line of credit if you rely solely on your monthly payments until the predetermined stop date, which can help you avoid running out of money too early.
4. Tenure reverse mortgage
Tenure payment plans provide equal monthly payments until you die, as long as at least one borrower uses the home as their primary residence. These plans have adjustable interest rates
and pose the least risk of running out of money–as long as loan obligations are met (taxes, maintenance, insurance).
5. Modified tenure reverse mortgage
A modified tenure reverse mortgage payment plan gives you fixed monthly payments for life as well as access to a line of credit. Like a modified term payment plan, your line of credit is smaller if you choose the straight line of credit plan; and your monthly payments are smaller if you choose the straight tenure payment plan.
6. Line of credit
Taking out a reverse mortgage with a line of credit payment plan provides the most potential of growing your retirement income, depending on how you use your credit. In general, you can access up to 60% of your principal limit in the first year. In the second year and beyond, you gain access to the remaining 40% as well as whatever you didn’t use in the first year.
Moreover, your available line of credit only decreases once you use it, and the interest and mortgage insurance that you have to pay will only be for the money that you borrow. In addition, you can also choose to repay what you’ve borrowed to increase your line of credit, and this does not warrant a prepayment penalty.
How can a reverse mortgage line of credit grow?
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The unused portion of your line of credit grows at the same interest rate for what you’ve already borrowed. The principal limit, loan balance, and available line of credit grow at the same rate throughout the duration of the loan, regardless of changes in your home’s value.
The principal limit is the sum of the line of credit, loan balance, and any set-asides. Lenders charge interest and mortgage insurance premiums on the loan balance, not on the line of credit or set-asides. However, both the line of credit and set-asides grow as if they have been charged.
This means that the less money you borrow, the larger your line of credit grows over time. When you leave your line of credit unused, the line of credit can grow to be the largest proportion of the principal limit instead of the loan balance. Wade Pfau, Professor of Retirement Income and Co-Director of the Retirement Income Center at the American College of Financial Services, speculates that the Home Equity Conversion Mortgage (HECM) was designed based on the assumption that borrowers will use their money sooner rather than later.
Let’s explain this further using a simple example:
Person A and Person B take out a reverse mortgage at the same time with a principal limit of $200,000. Assume that ten years later, the principal limit has grown to $400,000 for both borrowers.
Person A uses the entire $200,000. At this point, their loan balance is $200,000. Ten years later, their principal limit and the loan balance is $400,000 (the $200,000 they received and $200,000 in insurance premiums and accumulated interest).
On the other hand, Person B does not touch their line of credit. After ten years, their line of credit is $400,000 assuming that premiums and interest have been accruing, even though no funds are being used. They can take out that $400,000, having bypassed the growth of interest and insurance, to the expense of the mortgage lender and the insurance company. On the other hand, Person A only has the initial $200,000 that they took out, and their loan balance is $400,000 due to the accrued interest and premiums.
When should you open a reverse mortgage?
The previous section supports the idea that taking out a reverse mortgage on a line of credit is more beneficial when done earlier rather than later. The sooner you open a reverse mortgage line of credit, the more line of credit you have available in the future–as long as you delay its use.
Furthermore, today’s low interest rates mean that the available Principal Limit Factor (PLF) is higher. Higher interest rates in the future would increase the effective rate and, in turn, catalyze the growth of the principal limit. Pfau also states that only enormous growth in home prices could allow more credit in the future by taking out a reverse mortgage later in life.
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However, higher home prices would certainly be caused by higher inflation, which would also cause higher interest rates and lower PLF. With that in mind, it can be said with conviction that starting a reverse mortgage earlier will lead to more line of credit than waiting to start it later.
Currently, there are no limitations to line of credit growth for individuals who take out reverse mortgages to grow their line of credit by leaving it unused.
However, borrowers who take out a reverse mortgage today with the intent of leaving their line of credit untouched may be contractually protected–so long as they take out a loan under today’s rules.
What are the risks of opening a line of credit early?
In most circumstances, opening a line of credit with the intent to let it grow unused is only ideal for borrowers who have other sources of retirement income. Realistically, one wouldn’t be able to leave their line of credit unused for too long when they need money.
It is also important to note that a line of credit is much like a credit card. It is prone to mismanagement, which can lead you to maximize your principal limit too soon. If you use up your entire line of credit and are left with no other sources of income, you risk losing your home to foreclosure unless you are still able to meet the loan obligations (paying interest, insurance, and maintenance).
With that in mind, a reverse mortgage with a line of credit payment plan is recommended for individuals with the ability to manage their finances responsibly and those that have other sources of funds if an unexpected expense were to arise.
What are the alternatives?
If you are not confident with your money management skills, choose a reverse mortgage with a term/modified term or tenure/modified tenure payment plan. Similarly, it is advisable to wait for as long as possible before taking out a reverse mortgage with these payment plans to reduce the risk of outliving your loan.
If you have already taken out a reverse mortgage and are at risk of running out of money, talk to your lender about changing your payment plan. You can change your payment plan as long as you did not receive your funds all at once, and can stay within the principal limit. It is easy to do and most lenders will only charge a minimal administrative fee.
Bottom line
Can you grow your line of credit by leaving it unused?
The short answer is yes, especially with today’s low interest rates and higher rates in the future. You can grow your retirement income significantly and maximize your loan’s potential. But before you decide that this is the best type of payment plan for you, take note of these tips:
- Talk to a reverse mortgage counselor. You are already required to undergo counseling before taking out an HECM loan. But if you have more questions, it won’t hurt to extend your counseling sessions.
- Consult with a financial advisor. Figure out how you can manage your assets in such a way that your line of credit will be your last resort. If your home is your only asset, you will have to learn how to manage your income (from pensions, government benefits, etc.) to minimize the use of your line of credit.
- Do due diligence. If you or a loved one is planning to apply for a reverse mortgage, learn about the pros and cons of each payment plan, as well as what you can do to avoid outliving your reverse mortgage.
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