What Is the Downside of an HECM Loan?

A Home Equity Conversion Mortgage (HECM) offers senior homeowners a way to access home equity without requiring monthly mortgage payments. This financial tool provides liquidity by converting home value into cash, received as a lump sum, a line of credit, or regular monthly disbursements. While HECMs can be advantageous for retirement finances, borrowers should evaluate specific aspects.

How the Loan Balance Increases

An HECM loan balance grows over time, unlike a traditional mortgage where payments reduce principal. Interest accrues daily and is added to the outstanding balance monthly, compounding on disbursed funds, accrued interest, and financed fees. This results in “negative amortization,” where the total amount owed increases even without borrower payments, due to added interest and annual mortgage insurance premiums.

As the loan balance grows, the homeowner’s equity decreases. The rate of increase is influenced by the interest rate, which can be fixed or adjustable. Adjustable-rate HECMs fluctuate with market rates, often tied to an index. This increasing balance means the amount to be repaid will be considerably higher than the initial amount borrowed.

Costs Associated with an HECM Loan

HECM loans involve various fees and expenses, many of which can be financed into the loan. A significant cost is the origination fee, charged by the lender for processing the application. This fee is capped by the Federal Housing Administration (FHA) at the greater of $2,500 or 2% of the first $200,000 of the home’s value, plus 1% of any amount over $200,000, not exceeding $6,000.

Another substantial cost is the Mortgage Insurance Premium (MIP), which protects both the lender and borrower. This includes an upfront MIP (UFMIP) and an annual MIP. The UFMIP is a one-time fee of 2% of the home’s appraised value or the FHA lending limit, typically financed into the loan. The annual MIP is 0.5% of the outstanding loan balance, accruing monthly and added to the loan balance.

Borrowers also incur various closing costs similar to traditional mortgages. These third-party fees can include appraisal fees, title search and insurance, escrow fees, recording fees, and document preparation fees. Servicing fees, typically $30 to $35 monthly, are charged by the loan servicer throughout the HECM’s life and are usually added to the loan balance. Financing these costs reduces upfront out-of-pocket expenses but increases the initial loan balance, leading to more interest accrual.

Ongoing Borrower Obligations

Even though an HECM eliminates monthly mortgage payments, borrowers have ongoing responsibilities to keep the loan in good standing. A fundamental requirement is timely payment of property taxes. Failure to pay property taxes can lead to the loan becoming due and payable, potentially resulting in foreclosure.

Borrowers must also maintain homeowners insurance. Similar to property taxes, allowing insurance to lapse can trigger a default, making the entire loan balance immediately due. Lenders may conduct a financial assessment to determine how borrowers will pay for these ongoing property charges.

The home must remain the borrower’s primary residence. If the last remaining borrower fails to occupy the property for over 12 consecutive months, the loan can be called due and payable. Borrowers must also keep the home in good repair. Failing to maintain the property’s condition can constitute a default, potentially leading to foreclosure.

Effect on Home Equity and Heirs

An HECM loan significantly impacts the remaining equity in the home, affecting what might be left for a borrower’s heirs. As the loan balance grows due to accruing interest and financed fees, the borrower’s equity steadily diminishes. While the HECM provides access to funds during the borrower’s lifetime, it can consume a substantial part, or even all, of the home’s value over time.

Upon the last borrower’s passing or permanent departure from the home, the HECM loan becomes due and payable. Heirs typically have several options to settle the debt: repay the loan balance, often by selling the home, or refinance it with a new mortgage. If heirs wish to keep the home, they must pay off the loan, which could involve obtaining their own financing.

A notable protection for heirs is the “non-recourse” feature of HECM loans. This means neither the borrower nor their estate can owe more than the home’s value when sold, even if the loan balance exceeds its worth. The FHA mortgage insurance covers any shortfall, protecting heirs from personal liability. While this safeguards heirs from personal debt, the home’s equity may be largely or entirely consumed by the loan, leaving little to no real estate inheritance.