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
If the entire NPL is used to purchase an annuity, Smith could draw about $3,860 for five years, $2,250 for 10 years, $1,480 for 20 years, or $1,269 for life. Smith would commit, although not irrevocably, to using up the NPL over the period selected.
If Smith elects to take $3,860 a month for five years, for example, the entire NPL of $193,340 is set aside for this purpose. So long as Smith is on this path, he can’t draw any more funds. If he goes the full five years, he is maxed out.
But he can change his mind before the period is over. If he does, the portion of his NPL that is unused at that point becomes available for a new plan, which could be a different monthly payment or a credit line. After one year of drawing $3,860, for example, about $153,800 of Smith’s NPL would remain unused and available.
Smith can also select any combination of credit line and monthly payment. For example, he could select a 5-year payment of $1,930, which would use only half the NPL, leaving the other half as a credit line, which would grow if not used, but which could be drawn on at any time.
Selecting an ARM Versus an FRM: Before the financial crisis, mortgage selection involved choosing between two adjustable-rate mortgages (ARMs), one on which the interest rate adjusted monthly and one that adjusted annually. But the ARM that adjusts annually is no longer competitive, while a new and very competitive fixed-rate HECM has emerged.
In December 2009, the fixed-rate mortgage (FRM) version was priced better than the ARM, generating a higher NPL. The downside of the FRM is that the entire NPL must be drawn immediately. No unused credit line and no annuities are permitted. Borrowers who want to either husband some of the NPL for future contingencies or purchase an annuity will select the ARM.
The FRM meets the needs of one important group of seniors: those who want to sell their current home and buy one that better meets their current needs. They may want to exchange a large house for a smaller one, for example, or move to a condominium in a retirement community. The FRM is appropriate for this purpose because its NPL is larger than that of the ARM, although this could change.
Under a "HECM for Purchase" program authorized by Congress in 2008, seniors can buy a house and take out a reverse mortgage on that house at the same time. Absent this program, the senior would have had to purchase the new house with a forward mortgage, then take out an HECM to retire the forward mortgage, incurring two sets of settlement costs in the process. With the fixed-rate HECM, the senior incurs only one set of settlement costs.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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