Reverse Mortgage Rate Analysis – Monthly vs Annual HECM
One of the important decisions Home Equity Conversion Mortgage (HECM) borrowers need to make is choosing between an interest rate that adjusts once each year or one that adjusts monthly. Here’s a summary of the choices:
| Monthly Adjusting | Annual Adjusting | |
|---|---|---|
| Index for Determining Loan Amount | 10-year US Treasury | 10-year US Treasury |
| Index for Actual Interest Charges | 1-year US Treasury | 1-year US Treasury |
| Margin Added to Index | 1.50% | 3.10% |
| Annual Interest Rate Cap | None | 2.00% |
| Lifetime Interest Rate Cap | 10.00% | 5.00% |
| Advantages | 1) Larger Upfront Loan Amount; 2) Lower Starting Interest Rate; 3) Quicker to Adjust When Rates Fall |
1) More Protection Against Rising Interest Rates; 2) Higher Initial Growth Rate on Unused LOC; 3) Slower to Adjust When Rates Rise |
| Disadvantages | 1) Less Protection Against Rising Interest Rates; 2) Lower Initial Growth Rate on Unused LOC; 3) Quicker to Adjust When Rates Rise |
1) Smaller Upfront Loan Amount; 2) Higher Starting Interest Rate; 3) Slower to Adjust When Rates Fall; |
| Rule of Thumb | Good Choice if Rates Increase > 6.60% over Life of Loan | Good Choice if Rates Increase < 6.60% over Life of Loan |
For the borrower the decision is to buy or not buy limited protection against future interest rate increases. You “pay” for this protection when you select the annual-adjusting loan by 1) accepting a starting interest rate that is 1.60% higher than the starting rate on the monthly-adjusting option and, 2) accepting a smaller loan (or line of credit) than you could get with the monthly option.
Most HECM borrowers select the monthly-adjusting option simply because it results in more money being available to them.
However, the decision is an important one and should not be made hastily. Future interest rate increases have no effect on the loan amount, line of credit or monthly loan payments set at closing. But they do affect how fast interest accrues, how fast the loan balance will grow and, ultimately, how much home equity remains when the loan ends.
Some useful rules of thumb, combined with data from The Reverse Mortgage Interest Rate tool can help you make an informed decision.
Rule of Thumb #1: Interest rates will need to increase more than 6.60% over the life of the loan for the interest protection afforded by the lifetime cap to kick in.
For example, at today’s rates (monthly 6.53%/annual 8.13%), the monthly rate would need to rise above 13.13%. This is because the annual lifetime cap is set 5% above the initial annual rate (8.13% + 5.00% = 13.13%).Rule of Thumb #2: Interest rates will need to increase more than 3.6% in a given year for the interest protection afforded by the annual interest rate cap to kick in.
Using the same analysis as above, at today’s rates (monthly 6.53%/annual 8.13%), the monthly rate would need to rise above 10.13%. This is because the annual lifetime cap is set 2% above the initial annual rate (8.13% + 2.00% = 10.13%).
Keeping these rules in mind, you can use the Reverse Mortgage Interest Rate tool to make an informed decision about which option – monthly or annual – is best for you:
- For example, you can easily see how rates have acted in the past. Does the swing between the high and low rates over five- and ten-year periods suggest that buying the 5% lifetime cap would have been a wise decision in the past? Does the graph for these periods show a great deal of volatility? Is the high rate more than 6.60% higher than the average rate for the period? As always, past results are no guarantee of future results. Still having a feel for historic volatility in these rates will help you make a sound decision.
- What about the future interest rate expectations? Watching the “spread” between the expected and the initial HECM interest rates gives some idea of the direction the market thinks interest rates are headed. Longer term rates – like the 10-year Treasury rate used to calculate the “expected” rate – typically will be higher than shorter term rates – like the 1-year Treasury used for calculating the “initial” rate. This is because investors usually expect to receive a higher rate for tying their funds up for longer periods. A wide spread between expected and initial rates indicates that most investors believe interest rates will be on the rise. Conversely, a small or negative spread (as exists today) is an indication that rates are expected to drop.
- How do today’s rates compare to recent trends? Are current rates at or near the high or low marks for various periods? Is there a wide variation between todays rates and past period averages?
There is no way to determine for certain where interest rates will head in the future. But the Reverse Mortgage Interest Rate tool can provide a basis for you to make an informed decsion.
Article Series - rate tool
- Shedding Light on Reverse Mortgage Interest Rates
- Reverse Mortgage Rate Analysis – Monthly vs Annual HECM
- Reverse Mortgage Interest Rate
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