The True Cost of Compounding Interest Over 20 Years
Key Takeaways
- Reverse mortgages use negative amortization (the balance grows).
- Interest is charged on the principal, plus previously accrued interest, plus the FHA MIP.
- A $100,000 loan can grow to over $350,000 in 20 years at current rates.
The most defining feature of a reverse mortgage is that you do not have to make monthly payments. While this provides incredible relief for your monthly budget, it invokes a powerful mathematical force: Negative Amortization.
Because you aren't paying the interest every month, the lender simply adds it to your loan balance. The next month, you are charged interest on the original amount plus the interest from the previous month. This is compounding interest.
Let's look at the raw math to understand what happens to a reverse mortgage over a 20-year retirement.
The Mathematical Model
Assume the following scenario: - You borrow a lump sum of $100,000. - The fully indexed interest rate is 7.00%. - The ongoing FHA Mortgage Insurance Premium (MIP) is 0.50% annually. - Total compounding rate = 7.50%. - You make absolutely no voluntary payments.
Year 1
- Starting Balance: $100,000
- Interest & MIP added: $7,763 (compounded monthly)
- End of Year 1 Balance: $107,763
Year 5
- You are now paying 7.5% interest on the new, larger balance.
- End of Year 5 Balance: $145,329
Year 10
- The compounding effect begins to accelerate aggressively.
- End of Year 10 Balance: $211,206 (Your debt has more than doubled).
Year 15
- End of Year 15 Balance: $306,945
Year 20
- End of Year 20 Balance: $446,081
What This Means for Your Heirs
As you can see, borrowing $100,000 at age 65 means your loan balance will be nearly $450,000 by the time you are 85.
If your home only appreciates at 2% a year, the loan balance will eventually eclipse the value of the home.
This is why the Non-Recourse Guarantee is so vital. If you pass away in Year 20 and the home is only worth $300,000, your heirs are completely protected. They hand the keys to the bank, and the FHA insurance fund absorbs the $146,081 loss. Your heirs will not inherit a penny of that debt.
However, if you hope to leave significant home equity as an inheritance to your children, a reverse mortgage is usually the wrong financial tool, as compounding interest will inevitably consume that equity over a long retirement.