How to Choose a Reverse Mortgage Payment Plan

There are six different ways that you can receive the proceeds from the most popular type of reverse mortgage: the home equity conversion mortgage (HECM). The U.S. Department of Housing and Urban Development (HUD), which regulates HECMs, calls the first five choices “payment plans.”

• Option 1: Tenure Plan
• Option 2: Term Plan
• Option 3: Line of Credit Plan
• Option 4: Modified Tenure Plan
• Option 5: Modified Term Plan

The sixth option for receiving funds from a reverse mortgage is via a lump-sum payment at the loan closing. Regardless of the payment method, a home equity conversion mortgage (HECM) can provide much-needed income to those age 62 or older from the equity in their home.

The plan that you choose will affect how much money you receive in the short and long runs, how quickly you use up your home equity, and how effectively a reverse mortgage assists your financial goals. Discover how the reverse mortgage payment plans work, along with their pros and cons.

Key Takeaways

• A home equity conversion mortgage (HECM) is a type of reverse mortgage available to homeowners age 62 or older.
• A reverse mortgage allows those with equity in their primary, single-family residence to convert their home equity into income or cash.
• Reverse mortgages offer several ways to receive and repay your loan proceeds.
• An HECM allows you to tap a line of credit as needed or receive a fixed stream of monthly income payments.
• Reverse mortgages also offer a lump-sum payment or a combination plan that includes a line of credit and monthly payment.

Adjustable-Rate Payment Plans

The first five reverse mortgage payment plans all have adjustable rates. If you choose one of these, your interest rate will adjust annually based on an index plus a margin established by the lender and stated in your mortgage contract. The rate can’t increase by more than two percentage points from one year to the next. Also, the rate can’t increase above the starting rate by more than five percentage points.

In other words, if your starting rate is 3%, it can’t be higher than 5% the following year and can’t be higher than 8% ever.

A significant change in interest rate with a reverse mortgage doesn’t put you at risk of foreclosure like it can with a forward mortgage. However, a higher interest rate reduces your home equity, meaning you receive less if you sell the home. The impact of the interest rate on your home equity might be an important consideration if you don’t plan to stay in your home for the rest of your life.

Warning

Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or HUD.

When you are applying for a reverse mortgage with an adjustable interest rate, the illustrations of your payment plan options will use an expected interest rate. This is the lender’s best guess at what the adjustable interest rate will average out to over the life of your loan. It’s one of the three key factors in determining how much you can borrow; the other two are the youngest borrower’s age and the property’s value.

Now that we have reviewed how adjustable-rate plans work, let’s explore the five payment options. Remember that “payment” in this context refers to how you’ll receive the loan proceeds.

Option 1: Tenure Payment Plan

How It Works

In a tenure payment plan, you get equal monthly payments as long as at least one borrower lives in the home as a principal residence. Monthly payments are calculated under the assumption that you’ll live to be age 100. If you don’t expect to live that long, a term payment plan, discussed next, might be a better option. If you live longer, you’ll continue receiving payments. If you want to receive a steady monthly payment for the rest of your life in your home, the tenure payment plan is a good choice.

Pros

“Tenure payments are great for those who think they will live in the home a long time, and who need stable monthly income,” says Casey Fleming, a branch manager at Fairway Independent Mortgage Corp. in San Jose, Calif., with more than 30 years of mortgage industry experience. You don’t have to worry about running out of reverse mortgage proceeds with a tenure payment plan as long as you continue to meet the loan’s other terms.

Cons

If you have any large bills to pay off, this plan won’t help you pay them. Also, while this payment plan seemingly provides guaranteed income for life, if you have to move out of your home for health reasons—or if you fail to keep up with required property charges, such as homeowners insurance, property taxes, and basic maintenance—then the reverse mortgage will be due and payable (this is true under any payment plan), and you won’t receive any further payments unless you cure the default.

You or your heirs will receive whatever money is left from the sale of your home after the reverse mortgage is paid off. However, in a worst-case scenario of a depressed real estate market combined with high interest rates, you might not come out with much cash.

Option 2: Term Payment Plan

How It Works

You get equal monthly payments for a set period of time, or term payment plan, that you choose—10 years, for example. “Term payments are best if you have a clear idea of how long you will live in the home,” Fleming says. “Older folks—80 and up—or those who want to move away in a few years may select this type.”

Pros

The monthly payout is higher compared with a tenure payment plan. Although you will not receive additional monthly payments after you reach the end of the loan term, you will be able to keep living in the home as your principal residence until you die or move out (as long as you continue to meet the other loan conditions, such as paying your property taxes). 

Cons

You won’t get a steady income for life unless you happen to die during the loan term. You might use up your home equity too early in your life and not have another source of funds to rely on.

Option 3: Line of Credit (LOC)

How It Works

With a line of credit, you get access to money as you need it without any obligation. You can decide when to draw upon your credit line and how much to take as long as your balance is below the principal limit. Your lender can’t require you to withdraw either a minimum amount or a minimum sum on a set schedule. 

Pros

A line of credit provides a lot of flexibility. You can withdraw a large lump sum upfront, then borrow additional funds over time, and you get access to that additional equity that remains locked up with the fixed-rate payment plan.

You can also leave the line untouched for years in anticipation of a day when you might need it. You can withdraw equal or similar amounts each month, too. Basically, you can customize your withdrawals to your needs and adjust them as your needs change.

A line of credit can work like a lump-sum, tenure, or term plan, but you have more control. Also, the unused portion of your line of credit grows over time at the same interest rate that you’re paying on the amount that you’ve borrowed.

In addition, you only pay interest on the money that you actually borrow, which can make it easier to sell and move later or potentially leave money to your heirs. Unlike a home equity line of credit, a reverse mortgage line of credit cannot be revoked, even if your home’s value decreases or your financial situation worsens.

Cons

You can burn through a line of credit by borrowing the 60% maximum of your principal limit in year one and the remaining 40% on day one of year two. If you do that, you’ll be out of access to funds.

Also, it can take up to five business days to receive the funds that you request from your line of credit, so you must make sure that you keep enough cash in your checking account for urgent needs.

Option 4: Modified Tenure Plan

How It Works

You get fixed monthly payments combined with access to a line of credit for as long as one borrower occupies the home as a principal residence. The fixed monthly payments will be smaller than if you get a straight tenure plan, and the line of credit will be smaller than if you get a straight line of credit plan, but you’ll have access to the same total amount of funds. 

Pros

You have flexibility both in establishing your monthly payments and choosing the size of your credit line. If you want larger monthly payments, you can choose a smaller credit line. If you want a larger credit line, you can opt for smaller monthly payments.

It lets you meet your regular monthly cash flow needs without borrowing more than you have to. This option keeps your interest expense down and puts you at less risk of using up all your equity and not being able to afford to move should you want or need to later.

Cons

If you need a large sum right away, this payment plan probably isn’t your best option.

Option 5: Modified Term Plan

How It Works

You get a fixed monthly payment for a predetermined number of months, plus access to a line of credit for as long as one borrower maintains the home as their principal residence. The fixed monthly payments will be smaller than if you get a straight term plan, and the line of credit will be smaller than if you get a straight line of credit plan, but you’ll have access to the same total amount of funds. 

Pros

You have flexibility in establishing the size of your monthly payments and for how long you’ll receive them, and they will be higher than they would be under a modified tenure plan, assuming the same size credit line. You also get flexibility in choosing the size of your credit line.

At the end of the term, you’ll still have access to loan proceeds if you haven’t used up your line of credit. As with the modified tenure plan, you can keep your interest charges down and possibly have enough equity left to move later on.

Cons

You could run out of reverse mortgage proceeds. You only receive monthly payments for a set number of months or years, so you must use your line of credit carefully if you expect to need income beyond the end of the term. This plan also isn’t the best choice for large, up-front cash needs.

Option 6: Fixed-Rate, Lump-Sum Payment

If you want a fixed-rate reverse mortgage, you only have one payment plan option: a single-disbursement lump-sum payment.

How It Works

You receive a large amount all at once as soon as your reverse mortgage closes. Interest accrues on that amount, on the ongoing monthly mortgage insurance premiums, and on any financed closing costs until the reverse mortgage becomes due and payable. The initial interest rate is higher than it is with the adjustable-rate plans, but the expected interest rate over time is lower.

Pros

You should use this type of loan to pay off a high mortgage balance or cover another large expense. “Lump-sum distribution works best for folks who have a large existing mortgage that they need to pay off,” Fleming says. This option is best if you need all or most of your available proceeds at once.

Cons

You cannot receive any additional proceeds from this loan in the future. Borrowers who aren’t good at managing money or whose health has diminished their ability to do so are at risk of squandering the proceeds or spending them too quickly. Scammers (including relatives) sometimes convince seniors to take out this type of loan or target homeowners who recently took one out.

Fleming says the biggest drawback is that “for almost all cases, the maximum draw in year one is 60% of the initial principal limit. Since this option has only one draw, the maximum amount of the loan is quite low.” You retain the other 40% as home equity. You can’t ever borrow against that 40%, but having it can come in handy if you want to sell your home and pay off your reverse mortgage.

To access all of your equity over time, you need to choose an adjustable-rate payment plan.

Important

Reverse mortgages come with costs that typically include an upfront mortgage insurance premium of 2% of your home’s value and 0.5% annually of the loan balance thereafter. Also, third-party fees that include taxes, credit check, inspection fees, and an origination fee get added to the loan’s closing costs.

What Reverse Mortgage Payment Plans Are Available?

The five reverse mortgage payment plans are tenure, term, line of credit, modified tenure, and modified term. Each of these plans has an adjustable interest rate. The sixth option has a fixed rate and gives you a lump sum at closing.

Remember that a reverse mortgage payment plan refers to how the lender gives you money; homeowners don’t have to make monthly payments on this type of loan.

Can I Change My Reverse Mortgage Payment Plan?

Yes. During your loan term, you can change how you receive your reverse mortgage proceeds without refinancing your loan, as long as you are switching among the adjustable rate plans. You cannot switch between an adjustable- and a fixed-rate plan after closing.

What Is the Best Reverse Mortgage Payment Plan?

“Which option is best depends entirely on the client’s situation and needs,” Fleming says.

However, “as a general rule, I favor the line of credit over tenure or term payments.” The line of credit lets you take monthly withdrawals, just as you could with a tenure or term plan, but gives you the flexibility of taking out more in an emergency and accrues interest savings if you don’t need to use it. 

The Bottom Line

Reverse mortgages offer many payment plans because senior homeowners have different financial needs. No particular option is universally good or bad. For some, the ability to tap a line of credit as needed might work, while others might prefer a fixed stream of monthly income payments. Still, a lump-sum payment or a combination payment plan might work better. In any case, be sure to do your research and ask questions of your lender and reverse mortgage counselor to determine the payment plan that best fits your financial needs.

Read the original article on Investopedia.