FHA-insured reverse mortgages, called Home Equity Conversion Mortgages (HECMs), can be a life-saver for elderly homeowners short of income. While aftershocks from the financial crisis have caused the amounts that homeowners can draw under the program to be reduced, as discussed in my previous articles in this series, borrower s now have more options than they had before the crisis.
The HECM Saver
On forward mortgages, borrowers have long had the option of selecting from multiple combinations of interest rate and points. Borrowers who expect to have their mortgage a long time and have the cash to pay upfront charges can select a low-rate/high-point combination. Borrowers with a short horizon and short on cash can select a high-rate/negative-point (rebate) combination.
The Saver provides a similar option for HECM borrowers with short time horizons who don’t want to use up all their equity in the house. The initial mortgage insurance premium is reduced from 2 percent of home value to 0.1 percent, while the maximum amount that can be drawn is reduced by 15-20 percent, depending on the borrower’s age. The Saver is a useful option for owners who intend to sell their home in a year or two and pay off the HECM with the proceeds. It will be bypassed by owners who expect to remain in their homes and want to extract as much from it as possible.
The HECM FRM
For the first 20 years of the HECM program, borrowers were offered only loans with adjustable rates (ARMs), but in 2008, FHA authorized fixed-rate HECMs. Today, borrowers have a choice between HECM ARMs on which the rate adjusts monthly, and HECM FRMs on which the rate is fixed.
An important difference between HECM FRMs and HECM ARMs is that FRM borrowers must withdraw the entire amount for which they qualify, called the net principal limit, or NPL, in cash at the beginning. ARM borrowers, in contrast, have that option along with others. They can take a lifetime or a term annuity, or they can withdraw cash equal only to a part of the NPL leaving the remainder as a credit line. The unused credit line then grows monthly at the ARM rate. ARM borrowers can also mix and match, using part of their NPL to take an annuity while leaving the remainder as an unused credit line.
Choosing between an ARM and an FRM
About two-thirds of all HECM borrowers today are opting for FRMs, which is the best choice for borrowers who want to draw as much as they can as quickly as they can. This includes those purchasing a house with a HECM, who usually want to pay as much of the price as they can with HECM proceeds. (Note: The HECM for Purchase program, another recent innovation, is discussed next week).
The borrower who takes a HECM FRM knows at the outset exactly how his debt will grow. If in several years interest rates and house prices begin to rise, which is widely expected, the debt of the borrower with a HECM FRM will rise at the same fixed rate. If the borrower maintains the property and pays the taxes, an attractive refinance opportunity will arise. That’s the case for the HECM FRM.
However, for those who don’t intend to use all or most of the NPL at the outset, the FRM becomes expensive because borrowers are paying interest on money they aren’t using. Borrowers who want to use only a small part of their NPL at the outset, leaving most of it for future years, will do better taking a credit line on an ARM. As interest rates rise, the unused portion of the line will increase at a faster rate, more than offsetting the increased growth rate of their debt. Borrowers who want a stream of income, either for life or for a specified period, also must select an ARM because this option is not available on an FRM.
I would like to be much more specific about the circumstances in which an ARM would work out better than an FRM, and vice versa, but it turns out to be a very complicated problem that requires modeling to fully understand. I’m working on a calculator that hopefully will provide more precise answers.
Another option in the wings?
A logical extension of the existing menu of HECM products would be one that carries a fixed rate on an initial draw that does not use the full NPL, and a variable rate on the unused credit line that remains. This would be perfect for the borrower who wants to use part of the HECM immediately while reserving part of it for the future. I am told that such a product is now being discussed.
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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