Picking an Interest Rate

The Home Equity Conversion Mortgage (HECM) is the only reverse mortgage that lets you choose your interest rate. You can select one that can change every year, or one that can change every month.

The "annually-adjustable" rate goes up or down each year by the same amount as the increase or decrease in the one-year U. S. Treasury Security rate (T-rate). But it cannot change by more than 2 percentage points up or down a year. And it can't change by more than 5 total points up or down over the life of the loan. These interest rate "caps" protect you if rates increase by more than these limits allow.

The "monthly-adjustable" rate goes up or down each month by the same amount as the increase or decrease in the T-rate. But the only cap on it is that it cannot change by more than 10 percentage points over the life of the loan.

At present (January, 2005), the annually adjustable rate is one and six-tenths of a percentage point greater than the monthly adjustable rate. For example, on January 6, 2005, the annual rate was 5.87% and the monthly rate was 4.27% - a difference of 1.6%.*

Since both rates will be tied to the T-rate for the rest of the loan, the monthly rate on these loans will always be 1.6% less than the annual rate — except when the interest rate caps go into effect.

The advantages of the monthly adjustable rate are:

• you get larger loan advances;
• when rates fall, your rate drops sooner than an annually adjusting rate;
• your rate is lower than an annually adjusting rate for as long as increases in the T-rate are less than 3.6 percentage points per year or 6.6 points over the life of the loan; and
• your rate can decrease by more than 2 points per year and by more than 5 points over the life of the loan.

How much greater would the loan advances be when selecting a monthly versus an annually adjusting interest rate? On January 6, 2005, a 75-year-old single borrower living in a $200,000 home in California could have gotten a creditline of about $102,100 from an annually adjustable HECM versus about $126,500 from a monthly adjustable HECM.

The main advantage of the annually adjustable rate is that it has tighter limits on interest rate changes. These stronger caps give you a lower interest rate on your loan whenever T-rate increases are higher than 3.6 points per year, or 6.6 points over the life of the loan. Also, when rates increase, an annually-adjustable rate does not rise as soon as a monthly adjusting rate does.

Which rate should you select? It depends on how much you value the extra cash you would get with the lower, monthly adjustable. It also depends on what you think may happen to interest rates. How likely do you think it is that future T-rates will rise more than 3.6 points in a given year, or 6.6 points over the life of the loan?

Most HECM borrowers select a monthly adjustable rate because they prefer the greater cash advances and the lower initial rate. Some may also believe the T-rate won't exceed the annual rate's caps for long amounts of time. Others prefer the larger advances even if they believe that rising interest rates may cost them more.

Borrowers who choose an annual rate are generally concerned that rising rates might exceed the annual rate's caps for long periods. Without the protection of these caps, they fear that their loan balances will grow faster, so there may be a lot less equity left for them or their heirs when the loan is over.

*Technical Note: At present (1/06), the annually adjustable rate is 3.1 percentage points higher than the T-rate. The monthly adjustable rate is 1.5 percentage points higher than the T-rate. These 3.1% and 1.5% "margins" are set by Fannie Mae, the company that supplies the money that is loaned to you in the HECM program. Fannie has changed these margins only a few times over the past decade. When changes are made, they only apply to HECM loans closed after the change is made.

Here is an example of how the T-rate plus the margin equals the interest rates charged on HECM loans. Since the one-year T-rate for January 6, 2005 was 2.77%, the annually adjustable rate charged on HECM loans was 5.87% (2.77% T-rate plus 3.1% margin).The monthly adjustable rate was 4.27% (2.77% T-rate plus 1.5% margin).