Editor’s note: This is Part 2 of a six-part series. Read Part 1, Part 3, Part 4, Part 5 and Part 6.
As noted in the first article of this series, the financial crisis eliminated private reverse mortgages, leaving only the federal program of Home Equity Conversion Mortgages (HECMs) insured by the Federal Housing Administration. The HECM program is very powerful, however, and offers borrowers multiple options for drawing funds. These options are the subject of this article.
The Net Principal Limit: The different options can be visualized as different ways of removing money from a pot with a fixed amount in it. HECM borrowers can draw a maximum amount immediately and none thereafter; take a credit line on which they can draw at their convenience; take a fixed-payment annuity over a period of their choice; or some combination of the last two. The starting point for all the options, however, is the amount in the pot at the outset.
Assume a hypothetical owner, Bob Smith, 70, with a house worth $400,000 and no existing mortgage, selecting a monthly adjustable-rate HECM. Based on the shopping I did for Mr. Smith on Dec. 1, 2009, the "principal limit" (PL) on his house was $216,800. The PL is the value of Smith’s house now to an investor who must wait for Smith to die or move out permanently before he or she can take possession. The PL is affected by the borrower’s age, the interest rate and the value of the house.
But Smith can’t actually draw the PL without paying all the upfront expenses connected to a HECM: origination fees, mortgage insurance, third-party closing costs, and a servicing-fee set-aside. These expenses are deducted from the PL to yield a "Net Principal Limit" (NPL), which is $193,340.
NPL is the money in the pot that Smith could withdraw as a lump-sum immediately, or use to support the other withdrawal options discussed below. It is a critically important number on which borrowers can base their shopping, as I’ll explain in the next article in this series.
Selecting a Credit Line: Most HECM borrowers take a credit line for the full NPL, and use a sizeable chunk of it right away. They pay off debts, fund overdue maintenance, or perhaps treat themselves to a long-deferred vacation. They may use the balance of the credit line to fund a monthly payment, but more often they hold it as a reserve against future contingencies.
The portion of the line that is not used grows over time at a rate equal to the rate the borrower pays on the HECM. Some conservative borrowers limit their draws to the growth in their line, husbanding the entire NPL for the future. In the example, Smith could draw about $7,500 a year without cutting into the NPL.
Selecting a Monthly Annuity Payment: The borrower can also elect to receive monthly annuity payments over any period. Where the credit line provides maximum flexibility, monthly payment options provide discipline and convenience. …CONTINUED
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