Most borrowers realize that the greatest cost component of their HECM reverse mortgage are the FHA insurance premiums, paid both up-front and annually. Fewer understand the function of such insurance, why they are required to purchase it, and why the cost should be so significant.

The nature of reverse mortgages – that they carry no duration and that they don’t need to be repaid in monthly installments – leaves the lender vulnerable to the possibility of default. Consider what would happen if the value of the property were to fall and/or the balance of the loan were to rise, such that the reverse mortgage was characterized by negative equity (aka underwater). Under such conditions, the sale of the property alone would not be enough to repay the balance of the loan. Since reverse mortgages are no-recourse loans, the borrower cannot be held responsible for the difference.

Who absorbs this loss? You might be wondering. Ordinarily, it would be born by the lender. Due to the FHA insurance, however, it is in fact the government (HUD/FHA) that will be on the hook for the difference. In this way, the lender can originate reverse mortgages without any concern for what happens to the value of the property and the balance of the loan.

In return for this peace of mind, borrowers (not lenders, interestingly) must pay a hefty insurance premium upfront, usually equal to 2% of the value of the property. They must also fork over an additional .5% of the property value every year thereafter, for as long as the reverse mortgage remains outstanding. Of course, this premium isn’t paid directly, but rather is deducted from one’s home equity and tacked onto the balance of the loan.

The HECM reverse mortgage program (and the insurance component) is run as a not-for-profit service by the FHA. In theory, then, the size of the premium should correspond with the rate of default. Due to the housing crash, however, reverse mortgage defaults have surged, to the extent that the FHA barely has enough insurance reserves to cover its obligations to lenders. In hindsight, that means the FHA was effectively subsidizing borrowers, by enabling them to withdraw more than their homes were worth. As a result, the FHA is has already moved to raise insurance premiums and lower borrowing limits in order to bring its costs in line with the reality of the housing market.

Now you can understand why premiums are so large (and even why they are about to get even larger). Thanks to the insurance, you don’t have to worry about fluctuations in the value of your home, nor the possibility that you could owe more than your home is worth. While this is undoubtedly a great perk, you should nonetheless also be aware that while this cost is born by you, the main benefit is reaped by your lender, who assumes zero risk in lending you money.

Think about that when you are asked to hand over a check for the FHA insurance premium.