Seize the moment! Remember all those women on the Titanic who waved off the dessert cart. – Erma Bombeck
One of the biggest stories of 2020 was the record-low mortgage rates that continued to favor borrowers. Mortgage rates fell to record lows 16 times throughout 2020, feeding a home purchasing and refinancing frenzy.1
Driving the steady decline in mortgage rates were several factors. Panicked by the COVID-19 virus and soaring unemployment numbers, private investors began pouring money into safe investments like U.S. bonds. Simultaneously, the Federal Reserve announced the central bank would make unlimited purchases of government debt (bonds and other securities) until the financial crisis eased.2 This powerful convergence drove bond prices up and bond yields down (bond prices and yields move in opposite directions), which created the historic homebuying and refinancing boom.
For their part, mortgage lenders typically peg their loan rates to a loan index (derived from the auction of various bonds with different maturities) to which they attach a margin, which is the profit they use to pay for overhead and services rendered in producing the loan.
Because 2020 market forces combined to lower the cost of funds for lenders, lenders in turn passed much of their savings to borrowers. Remember, lenders make their money not on the index, but on their margin. While the interest rate index can change often, the margin once set will remain the same throughout the loan term.
That Was Then, This is Now
On December 24, 2020, the average rate on mortgage giant Freddie Mac’s 30-year fixed rate home loan fell to 2.66%, the lowest rate on record, providing a gift for holiday homebuyers and borrowers looking to lock in a lower rate ahead of the new year.3
Rates, of course, can rise just as easily. Interest rates are the product of many related factors, such as the economy’s expected rate of growth and its close cousin, inflation. If the economy overheats and grows too quickly, this pressure can drive up demand for raw materials, goods, services, and the labor needed to produce those goods and services. Too much demand and too few supplies for these goods and services often leads to inflation. Meanwhile, the Federal Reserve constantly monitors a basket of economic indicators, like the cost of producing goods and services, to assess the threat of inflation. If it feels prices are getting too frothy, it can make accessing credit more expensive, impacting banks, businesses, and yes, borrowers who want to finance the purchase of a home or refinance an existing home loan.
That brings us to 2021. As the United States economy rebounds from the depths of the COVID-19 pandemic, growth is expected to accelerate. If economic growth doesn’t stoke inflation beyond the Fed’s ideal 2% target, bond prices, which influence mortgages, may be little affected. But if projections for growth are more robust — in the wake of the $1.9-trillion COVID-19 relief package signed into law on March 11, 2021, plus the prospect of thousands of businesses reopening — inflation, reflected in everyday items from restaurant meals to mortgages, could be headed higher.
It appears the growth scenario is winning the day. As of April 1, 2021, the last weekly average provided by Freddie Mac, rates stood at 3.15%. Remember, that compares with a rate of 2.66 on Dec. 24, 2020. Historically speaking, 3.15 is still a low rate, but if you’re shopping for a home or considering a refinance, you should know every basis point counts. (One basis point is equal to 1/100th of 1%, so there are 100 basis points in 1%.)
So, what if rates were to increase 1%? How would that seemingly slight rise affect a mortgage? For a forward or traditional mortgage, an uptick of 1% is easy enough to calculate, and the result could be enough to keep you from buying or refinancing.
Let’s create a scenario. For the following example, we used the Freddie Mac loan calculator4 and a home listing price of about $350,000, which was the median at the end of 2020.5
So, were you to purchase a $350,000 house with 20% down ($70,000) and finance the rest ($280,000) at 3% over a 30-year term, your monthly payments would be $1,180, not including property taxes and homeowners insurance.
If you wanted to purchase the same $350,000 house with the same 20% down payment at 4%, just a 1% increase, your payments would jump to $1,337 a month, not including property taxes and homeowners insurance. Just that 1% rise in interest rates would create a more than 13% rise in your monthly mortgage payments.
The Impact of a 1% Increase in Mortgage Rates on Reverse Mortgages
With a reverse mortgage, of course, monthly mortgage payments are not the issue. But interest rates are an important factor in determining the amount of cash you are eligible to receive from your lender, in addition to determining the interest accrued on the cash you receive, or on any portion of a reverse mortgage line of credit that you choose to exercise. So, the big takeaway (or small takeaway if the cash amount is less than you had hoped) is that your payout will typically be larger when interest rates are low and smaller when interest rates are higher.
Looming over the entire reverse mortgage process is the Federal Housing Administration (FHA), which is part of the Department of Housing and Urban Development (HUD). The FHA is the insurer of all Home Equity Conversion Mortgages or HECMs, the most popular of all reverse mortgages. Reverse mortgage borrowers pay an upfront premium and an annual premium for this insurance. To find out if a reverse mortgage loan is right for you, click here.
FHA insurance provides the following protections:
- When the reverse mortgage becomes due and payable, neither the borrower nor the estate will be responsible for repaying a balance larger than the home’s sales price.
- If the loan exceeds the value of the home, lenders are repaid for their losses.
- If the lender goes out of business, borrowers still receive their payments.
The FHA likes insuring loans in a lower-interest rate environment because the borrower’s debt accrues more slowly at the lower rate, making defaults and foreclosures less likely.
The definition of a few terms will also be helpful in showing you how much a 1% rise in the interest could affect your reverse mortgage. Again, they all work together.
5 Important terms:
- Expected Interest Rate (EIR): This is the rate of interest your lender will use to calculate the amount of proceeds that will be available to you when your reverse mortgage loan closes. It is NOT the actual rate that your loan will accrue at, but an expectation or assumption of what the interest rate will likely be at the time of your loan closing.
- Age of the Youngest Borrower or Non-borrowing Spouse: Another key factor in computing your payout is the age of the youngest borrower or non-borrowing spouse. The older this applicant is, the larger the expected payout is likely to be, since the interest should statistically have less time to accrue.
- Principal Limit Factor (PLF): Once the expected interest rate of the loan and the youngest age of the borrower are known, the lender takes these two values to find a corresponding PLF in tables published by HUD (Age and Expected Interest Rate = Principal Limit Factor). The PLF is listed in decimal form (e.g., 0.562 equals 56.2%). The lender will then multiply this PLF by the appraised value (also called the Maximum Claim Value – see below) of your home to determine your payout.
- Maximum Claim Amount (MCA): This is the appraised value of the home, not to exceed the FHA’s maximum lending limit of $970,800 in 2022. If you have a home value higher than the limit, say $980,000, the MCA would still be $970,800, the FHA’s cap.
- Principal Limit (PL): This is the limit or the most amount of money you can expect the lender to loan you. The PL is the product of multiplying the MCA by the given PLF (PLF x MCA = PL).
Put Your Knowledge to Work
Now let’s compute using the five terms above, how a 1% increase in the Expected Interest Rate can negatively reduce a borrower’s payout, even though the prospective borrower’s age and home value are the same in the two scenarios. Notice how a lower EIR produces a higher PLF, which produces a higher PL. Conversely, a higher EIR produces a lower PLF, resulting in a lower payout.
As you can see, just a 1% bump up in the interest rate could decrease your payout by more than $30,000. So, if you suspect interest rates are going up, you may want to lock in your reverse mortgage loan now versus waiting.
Whether you’re planting a garden, planning a vacation, or considering a reverse mortgage for your retirement, timing means everything. Yes, rates could fall again to last year’s record-setting lows, but if they don’t, you could be leaving a lot of money on the table! To find out if a reverse mortgage loan is right for you, click here.
We hope this article has given you some help with things to think about. Of course, every situation is different. This information is intended to be general and educational in nature and should not be construed as financial advice. Consult your financial advisor before implementing financial strategies for your retirement.