The home equity conversion mortgage, the Federal Housing Administration’s reverse mortgage program, is a beautifully designed financial instrument that can meet a wide variety of senior needs.
Unfortunately, these mortgages, known as HECMs, offer so many options that selecting the best option can be a challenge.
The challenge has two parts: part one (the subject of this article) is to determine which HECM is best suited to a senior’s specific situation. Part two, to be discussed next week, is to select the loan provider offering the best terms on the desired type of HECM.
The process of selecting the best HECM is simple if the senior understands the consequences of her choices.
Fixed Rate Versus Adjustable Rate
HECMs are available with both fixed-rate mortgages, or FRMs, and adjustable-rate mortgages, or ARMs.
FRMs are limited to upfront cash draws, including repayment of existing mortgages. Monthly payment and credit line options that involve future draws are available only with adjustable rates.
Seniors who use all their borrowing power upfront to pay off an existing mortgage, to draw cash at closing, or some combination of the two, can select either an FRM or an ARM. The choice should be based on differences in the amounts that can be drawn in each case, and differences in the future loan balance.
In most cases, differences in draw amounts favor the ARM because, in addition to a cash draw at closing about equal to the cash draw on an FRM, the ARM borrower will be able to draw additional funds on a credit line after 12 months.
The future loan balance depends on interest rates over the life of the loan, which are known for the FRM but not for the ARM. Although the interest rate on the FRM is higher than the start rate on the ARM, the ARM rate can rise by 5 percent or 10 percent. Many seniors in this situation select the FRM because of the rate certainty and the much publicized likelihood that interest rates (including those on ARMs) will rise in the future.
High Versus Low Mortgage Insurance Premiums
There are two upfront insurance premiums on both FRMs and ARMs.
On transactions in which 60 percent or less of the senior’s borrowing power is used upfront to pay off an existing mortgage or draw cash, the premium is 0.5 percent of the property value. Above 60 percent, the premium is 2.5 percent. Seniors who pay the higher premium do it to increase their upfront cash draw, disregarding the larger future debt that results.
But you don’t need to know these rules so long as you know what your options are.
For example, a transaction I am now examining allows a cash draw that is $21,000 higher with the 2.5 percent premium, but after seven years the borrower would owe $44,000 more because of the higher premium.
While this would be a tough choice, the borrower who has this information is positioned to make it.
Low Interest Rate With High Origination Fee Versus High Rate With Low Fee
Both FRMs and ARMs are available with different combinations of interest rate and origination fee.
For example, on the day I wrote this, I could have obtained either of the following one-year ARMs: one had a start rate of 2.97 percent, a maximum rate of 7.97 percent and an origination fee of $2,000. The other had a start rate of 3.22 percent, a maximum rate of 8.22 percent, and zero origination fees.
My upfront draw (whether cash or credit line) was larger on the zero fee ARM but the higher rate resulted in a more rapid growth in the loan balance. Since I knew what the draw and future balance amounts were, I could have made a thoughtful decision.
ARMs With High Initial Rate But Low Risk of Rate Increases Versus ARMs With Lower Initial Rate But Greater Vulnerability to Rate Increases
In addition to the ARM referred to above with a start rate of 2.970 percent, a maximum rate of 7.970 percent and annual rate adjustments,
I had access to an ARM with a start rate of 2.322 percent, a maximum rate of 12.322 percent, and monthly rate adjustments. The origination fees were the same.
The borrower attempting to minimize future debt might choose the ARM with the lower start rate if her time horizon is short enough that the likelihood of a rate increase larger than 5 percent appears small. Borrowers with long time horizons will likely opt for the ARM with the higher start rate.
However, borrowers who reserve a large portion of their borrowing power for a credit line may view these options very differently.
The greater the increase in future interest rates, the faster the growth of an unused credit line. Such borrowers may well prefer the ARM with the higher maximum rate, especially if their time horizon is long.
The Upshot
The easy but risky way to make these selection decisions is to let the loan officer make them for you.
The better way is to make them yourself with the help of an easy-to-use HECM calculator that shows the implications of all the decisions a senior makes in selecting the best HECM.
I have spent a lot of time and money developing that calculator, it is freely available on my website, and it can be used anonymously without eliciting sales calls from anyone.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
