One of the bum raps against home equity conversion mortgages (HECMs) is that their upfront fees are too high. It is a dumb rap as well, because it is based on a comparison with standard mortgages which, aside from the fact that both are secured by a property, have very little in common.
Assessment of whether a service is priced too high can be based on the value of the service to consumers, or on the cost of providing it. HECM fees are not excessive on either basis.
Value to consumers: HECMs are hassle-free to the borrower
HECM reverse mortgages provide more value to homeowners than standard mortgages, and we should therefore expect them to cost more. An integral part of standard mortgages is a required repayment schedule. On mortgages that are fully amortizing, as most are, the repayment process begins in month one. To qualify for a standard mortgage, borrowers must document sufficient income to afford the required payment, and a credit record verifying their willingness to meet their obligations.
In contrast, there are no repayment schedules on HECMs. Loan repayment is deferred until the borrower dies or vacates her home. With no required payment, borrowers are subject to neither income nor credit requirements. Relative to standard mortgages, HECMs are hassle-free.
Cost of service: Risk of loss is greater on hassle-free loans
However, the major cost of producing reverse mortgages is the loss incurred by the lender or the insurer who protects the lender against loss. The insurer of HECMs is the Federal Housing Administration (FHA), an agency of the federal government, which also insures standard mortgages. The HECM reverse mortgage is riskier for FHA, and it charges more for the insurance to cover its losses.
On the standard mortgages that FHA insures, the borrower’s repayment obligation is a first line of defense against loss. Only in the event that borrowers default on their repayment obligations do lenders/insurers fall back on their second line of defense, which is the property that has been posted as collateral. Lenders can take the property through foreclosure in order to repay themselves the amounts owed.
On HECM reverse mortgages, there is no first line of defense against loss. The lender/insurer has only the second line of defense to protect against loss — sale of the property — AND it cannot exercise this option until the borrower dies or moves out of the home permanently.
FHA insurance premiums on HECMs
The FHA takes a loss on a HECM when the property value is lower than the loan balance at the time the balance is repaid.
If interest rates rise more than expected, or if the property appreciates at a lower rate than expected, FHA can incur a loss. Such losses are not offset by gains when interest rates rise by less or properties appreciate by more than expected. Any equity remaining in the property when the HECM balance is repaid goes to the borrower or to her estate.
FHA manages the risk by calculating HECM payments on the assumption that the borrower lives to age 100. This safety margin allows them to charge insurance premiums that are only slightly higher than those on the standard mortgages it insures. An annual premium of 1.25 percent of the HECM loan balance compares with 1.2 percent on a standard 30-year loan with 5 percent down.
The difference in the upfront premium is a little larger — on a HECM it is 2 percent of property value and on the standard mortgage it is 1.75 percent of the loan amount. But HECM borrowers can avoid the upfront premium almost entirely, as noted below.
Which upfront fees on HECMs are excessive?
The origination fee HECM borrowers pay lenders is capped by law at $2,500 on house values of $125,000 or less, at $4,000 on house values of $200,000 or less, and at $6,000 on values of $400,000 or more. There are no caps on origination fees charged on standard FHA loans. Some HECM lenders, furthermore, charge $2,500 on all HECMs, regardless of property value.
While third-party fees including title insurance vary from one part of the country to another, there are no differences between HECMs and standard mortgages.
This leaves the upfront mortgage insurance fee, which is slightly higher on HECMs than on standard mortgages. It is a small price to pay for a unique hassle-free mortgage with no required payment. Furthermore, HECM borrowers who want to leave a little more equity for their heirs don’t have to pay this charge. They can reduce the upfront premium from 2 percent to 0.01 percent by electing the "Saver" version of whatever HECM option they want. The Saver version cuts the risk to FHA by scaling down the amount the borrower can draw. It doesn’t get any fairer than that.
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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