Understanding HECM loan’s dual interest rates

What seniors should know if borrowing costs start to rise

This is a great time for senior homeowners to take out a home equity conversion mortgage (HECM), especially if they don’t need the extra money now! Sounds crazy? It isn’t, so read on.

The federal HECM reverse mortgage program allows seniors 62 or older who own and occupy their homes to take out a mortgage against it. What makes it a "reverse mortgage" is that the amount owed tends to rise over time, whereas on a standard mortgage it tends to decline.

This difference arises from another one, which is that no payment is required on a HECM until the senior sells the house, moves out of it permanently, or dies. On standard mortgages, as every borrower knows all too well, they must begin making payments immediately.

Another important difference between HECMs and standard mortgages is the role of interest rates. A feature unique to HECMs is that every transaction involves two interest rates.

The expected rate is used to calculate the amount the senior can draw under the different options. Seniors can draw cash, take a credit line, or receive monthly payments for life or for a specified term. The higher the expected rate, the smaller the amount obtainable under any of these options.

For example, at an expected rate of 4 percent, which has been a common rate during 2013, a senior 62 years old with a home worth $300,000 can draw an initial credit line of about $174,000. At an expected rate of 6 percent, the line drops to $140,000, and at 10 percent it falls to $54,000.

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Now is a good time to take a HECM because the probability that expected rates will decline from current levels is very low, while the probability that they will rise within the next few years, perhaps steeply, is very high. The current expected rate is only slightly above the low point of 3.81 percent, reached in July 2012, but it is far below the highest levels reached in earlier years. In July 2000, it was 9.6 percent.

The second interest rate on a HECM is the accrual rate, which is the rate used to calculate the interest due the investor every month, exactly the same as on a standard mortgage. The only difference is that on a standard mortgage the borrower must pay the interest due every month, whereas on a HECM the interest is added to the loan balance.

The accrual rate on a HECM can be fixed or adjustable, but the fixed rate is available only on transactions in which the borrower draws the maximum amount allowable in cash. Borrowers who want a credit line or a monthly payment plan must accept an adjustable rate.

Some seniors have been frightened away from adjustable-rate HECMs because they have heard horror stories about borrowers who were bludgeoned by rising rates. But rising rates endanger borrowers only when they result in rising required payments, as they do on standard adjustable-rate mortgages. But there is no required payment on HECMs. Furthermore, rising rates on HECMs can benefit borrowers who play their cards right.

Since interest on a HECM is not paid but is added to the balance, the accrual rate determines how fast the borrower’s debt will grow. But the accrual rate on a HECM has another role that is unique to HECMs. The unused portion of a HECM credit line grows at the same rate as the borrower’s debt. Hence, future increases in the accrual rate will result in faster growth in unused credit lines.

The implication is very clear: The optimal strategy for a senior expecting interest rates to start rising in the next few years is to take a credit line now while rates are still low, but leave most of it unused for a few years in order to benefit from rising rates.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at

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