Editor’s note: This is the first of a multipart series.
FHA-insured reverse mortgages, also called home equity conversion mortgages, or HECMs, allow seniors to withdraw cash from their home while retaining the right to live there indefinitely. They are a potentially powerful tool for helping seniors live better lives during their retirement years, and new HECM options enlarge the possibilities.
However, the benefits can also be frittered away, with little lasting benefit to the senior, and all too many seniors are doing just that. About two-thirds of all HECM borrowers today withdraw the maximum amount of cash possible at closing, which leaves the senior with no borrowing power for the future. While some seniors have compelling reasons for withdrawing the maximum amount of cash at the outset, many are making a mistake.
HECMs are complicated
Underlying the mistakes that seniors make is the complexity of HECMs and the fact that few seniors understand them. The new options increase the complexity. While there is no way to make HECMs simpler, or to raise the IQs of senior borrowers, the likelihood of bad decisions can be reduced by improving the quality of advice that they receive, and the quality of the information to which they have access.
The role of counselors
Every HECM borrower must be counseled by a Department of Housing and Urban Development-approved HECM counselor, but counselors are not preventing borrowers from making serious mistakes. Even if counselors were financial planners qualified to advise seniors on how a HECM fits into a retirement plan, which most are not, under HUD rules, counselors are not supposed to recommend one HECM option over another. Many HECM borrowers, furthermore, turn off their hearing aids during their counseling session.
HUD limits the origination fees that borrowers can be charged to 2 percent of the first $200,000 of property value, plus 1 percent of the amount above $200,000 but with a cap of $6,000. In addition, lenders collect a premium paid by the wholesalers to whom they sell the HECMs. On the day in July that I checked, these premiums were 7.625 percent on fixed-rate standard HECMs, and 4.875 percent on standard adjustable-rate HECMs. Premiums are paid on the initial loan balance only.
Thus, a senior of 72 with a $400,000 home will generate premium income for the lender amounting to $20,600 if he draws maximum cash on a fixed-rate mortgage; $13,200 if he draws maximum cash on an adjustable-rate mortgage (ARM); and $600 if he elects an annuity on an ARM. In the last case, the initial loan upon which the premium is based consists only of the financed settlement costs. Note: The reasons for this enormous spread in originator income will be discussed in another article.
The bottom line is that lenders have a strong incentive to encourage borrowers to withdraw cash upfront. Unfortunately, in many cases, borrowers don’t need much if any encouragement.
Borrower bias against ARMs
Most senior homeowners had one or more forward mortgages during their life, from which experience many emerged with a bias against ARMs. They may not have had one, but they heard about them and knew that they were risky. So when offered a choice of fixed- or adjustable-rate HECMs, they opt for the fixed, which requires that the full value of the HECM be taken in cash.
Borrower bias against ARMs combined with lender financial interest in maximum cash withdrawals make for a perfect marriage. But not one made in heaven.
Borrower bias against HECM ARMs is misconceived. On forward mortgages, borrowers are exposed to the risk that a future interest rate increase will make the monthly payment unaffordable, but there is no such risk on a HECM because borrowers have no mortgage payment to make.
A future increase in the rate on a HECM does result in a more rapid increase in the senior’s loan balance, but this hurts only borrowers who use all or most of their borrowing power by drawing cash at the outset. To the extent that the senior reserves some part of his HECM borrowing power as an unused credit line, future ARM rate increases work to his benefit because the line grows at that rate.
The upshot is that seniors with needs best met by an annuity payment, and/or by husbanding a credit line for future use — which is most of them — should not shrink from taking an ARM.
Information available to borrowers
While HECMs are complicated, we live in an information age replete with sophisticated tools for expositing complicated ideas. Lucid exposition of the full implications of each possible course of action can overcome a borrower’s preconceived bias and the entreaties of interested loan originators.
The tools available to HECM borrowers, however, are a sorry lot. The existing calculators focus entirely on how much the borrower can draw, without any supporting information on the future consequences of a given selection. So I decided to develop my own. Keep tuned.