What is negative amortization, and how does it work with reverse mortgages?
Investopedia.com defines negative amortization as follows:
Negative amortization is a financial term referring to an increase in the principal balance of a loan caused by a failure to cover the interest due on that loan. For example, if the interest payment on a loan is $500, and the borrower only pays $400, then the $100 difference would be added to the loan’s principal balance. (https://www.investopedia.com/terms/n/negativeamortization.asp)
The Consumer Finance Protection Bureau defines negative amortization this way:
Amortization means paying off a loan with regular payments, so that the amount you owe goes down with each payment. Negative amortization means that even when you pay, the amount you owe will still go up because you are not paying enough to cover the interest.
These are both good and accurate definitions, but how does this apply to reverse mortgages?
Both definitions talk about payments being made by the consumer, but people with reverse mortgages are not required to make monthly payments. They can if they want, but they are not required. When a borrower does not make a payment on their Home Equity Conversion Mortgage (HECM)*, the interest and mortgage insurance that is charged that month is added to the loan balance. Because of this, the loan balance increases every month.
That brings me to another concept we need to discuss – compound interest and compound mortgage insurance premium (MIP). Compound interest is a type of interest calculation where the interest is added to the principal amount of the loan and then interest is calculated on that new total. The same concept goes for the MIP on the FHA insured HECM.
Every month the interest and mortgage insurance for the month are calculated on the new principal balance from the previous month, which includes the interest and MIP that was charged last month.
For example, if you look at the attached “Amortization Schedule” you will see that the beginning mortgage balance highlighted in the upper right corner is $192,338.50. This is the amount of the new loan that Mr. & Mrs. Sample just took out.
You can see a little below that, also highlighted, is the line of credit of $59,661.50 as well as the ongoing MIP of 0.50% of the loan balance per year (compounded monthly). You can also see that the interest rate, highlighted on the upper left side is 7.05%.
You can calculate the dollar amount of interest that will be charged over the year by simply multiplying the loan balance of $192,338.50 x the interest rate of 0.0705 to arrive at $13,559.86 over the next year. However, if you look at the table in the lower portion of the example, you will see the interest for the first year is highlighted at $14,039, which is almost $479 more than we just calculated. The difference is due to compound interest.
The interest is compounded on a monthly basis. What we need to do to calculate the actual amount of interest charged every month is multiply the loan balance of $192,338.50 x the interest rate of 0.0705 to arrive at $13,559.86. But then we need to take it one step further and divide by 12. This will give us the first month’s interest of $1,129.99. We then do the same process with the MIP to arrive at $80.14. We then add both of these numbers to the beginning loan amount to arrive at the new principal balance of $193,548.63.
We would then need to apply the same formula to calculate the compounded interest and MIP for month two, but this time we start with the new balance of %$193,548.63. This calculation would give us interest charges for month two of $1,137.10 and an MIP charge of $80.65. When we add the interest and the MIP together, you can see that they total $7.62 more than in month one.
This small increase doesn’t seem like much, but you can see how it adds up over time buy looking at the amount of interest and MIP charged in year five.
I know this article seems like I am trying to talk you out of getting a reverse mortgage by either confusing you with math or scaring you with this example, but this is not the case at all.
I tell people that this page (the Amortization Schedule), is the most important page you will see in all the reams of paper we have you sign. Reverse mortgages are designed to relieve financial stress, not create it. If you decide to get a reverse mortgage, you will receive a statement every month and you will see your loan balance increasing. If looking at that statement causes you more financial stress than the loan relieves, you should NOT get a reverse mortgage.
I can honestly say that in over 20 years and 1,000+ reverse mortgage loans closed, I have never had a customer, or a family member, tell me that they have regretted getting a reverse mortgage. I believe that it’s because I make sure all of my customers understand the concept of negative amortization and compound interest and how it relates to their loan.
By the way, one of the benefits of compound interest works in your favor if you have money in the line of credit. As you can see in the chart, the initial line of credit for this example is $59,661.50, but after just one year that grows by $4,663.50 to $64,325. In just five years, it grows to $86,921.
The line of credit has a growth rate that is equal to 0.5% above the rate you are charged on the loan. In this example the LOC growth rate is 7.55% (7.05% + 0.5%). I have written other articles and recorded videos and radio shows on how this works. The benefits of the LOC is not what this article is about so I won’t be going into detail about it here, but you can always call me with any questions. My contact information is below.
Bruce E. Simmons, CRMP, CLTC
Reverse Mortgage Manager
American Liberty Mortgage, Inc.
1932 W 33rd Ave
Denver, CO 80211
Office: 303-458-3778
Direct: 303-467-7821
E-Mail: bruce@almortgageinc.com
www.reversemortgageradio.net
*HECM is the name of the Federal Housing Administration (FHA), insured reverse mortgage program.
