When a borrower is weighing whether or not to take out a home equity conversion mortgage — the reverse mortgage offered through the Federal Housing Administration — there are three key decisions to consider.
The first applies to the draw options — the combination of upfront cash, monthly payment and credit line that best meet the borrower’s needs. I have written about this in the past and will not discuss it further here.
While it is the least challenging of the three decisions — most borrowers understand their financial needs better than anyone else — the decision may influence the other decisions discussed below.
The second decision is to select one combination of interest rate and origination fee over other combinations.
Borrowers in the forward market make a similar decision the loan amount.
There are no points on HECM reverse mortgages, only origination fees, which are a flat dollar amount. That makes the decision on the best interest rate-fee combination a little easier.
On the other hand, the best combination may depend on the borrower’s draw options, which introduces greater complexity.
To illustrate, I am going to look at a consumer of 66 with a $300,000 house in two polar situations. In one, the consumer only wants to draw cash at the closing table using a fixed-rate HECM, while in the other she wants a credit line for possible future use, which is available only on an adjustable-rate HECM.
On May 16, wearing her cash-only hat, the consumer is offered the following two deals on a fixed-rate HECM: an interest rate of 4.50 percent with an origination fee of $3,000, or a rate of 4.99 percent with a fee of minus $1,000. (A negative fee means the lender will contribute to the borrower’s settlement costs). These as well as the prices cited below are actual quotes from the lenders on my web site.
If the consumer takes the higher rate and negative fee, she can draw $96,700 at the closing table, or $4,000 more than if she took the lower rate.
On the other hand, she will owe more in the future because of the larger loan and the higher rate. After 20 years, for example, she will owe $32,000 more. Which is better depends on whether the borrower values the larger initial draw more than the higher future debt. That should be her call, not mine or the lender’s.
What is important is that the borrower is offered the choice, and the information needed to make an intelligent decision.
On my site, all the lenders offer multiple rate-fee combinations, and our calculator shows the corresponding draw amounts plus future debt over the period selected by the borrower. Off the site, more lenders than not show only a single rate-fee combination, and we have yet to find one that allows borrowers to calculate their future debt.
Next, consider the same consumer with a mindset focused on the future rather than the present, who doesn’t want to draw any cash upfront.
Her interest is in a credit line that she doesn’t expect to use for many years if ever. Credit lines are available only on adjustable rate HECMs.
Among the price quotes on a monthly adjustable available to her on May 16 from lenders on my site was one from lender A at a start rate of 2.188 percent with an origination fee of $3,500. A second quote, this one from lender C, was at 3.188 percent and $3,750.
Choosing between these quotes looks like a no-brainer, since the first quote has both a lower rate and a smaller fee.
However, the credit line feature of the HECM — which has no counterpart in the forward mortgage market — could invalidate that conclusion.
The interest rate on an adjustable rate HECM has a dual role. It is used to determine the future loan balance, and it is used to determine the future credit line.
Debt and credit line grow at the same rate. If the credit line is not used, after 20 years it will be $396,600 on the 2.188 percent loan, and $483,300 on the 3.188 percent loan. The higher interest rate works to the advantage of a consumer who has decided not to borrow for a long period.
The astute consumer, however, will not take the 3.188 percent loan from lender C, for either of two reasons.
The first is that he may well want to begin drawing on his line sooner rather than later, and in that case the higher rate would cost him dearly.
But even if his plans to defer drawing on the line are firm and he wants a higher rate, he won’t take it from lender C because C has the highest origination fee. He will take the HECM from lender D who has the lowest origination fee, and ask D to raise the rate.
Any lender will be happy to raise the rate on a HECM because a higher rate commands a higher price in the secondary market.
Bottom line, the consumer who is taking a credit line as insurance against the risk of outliving her money should select the lowest origination fee, and request that the rate be increased to match the highest quotes in the market.
The third decision the reverse mortgage borrower must make is the loan provider.
However, most of them see only a single provider, which is why identical transactions with different lenders can sometimes carry markedly different prices. There are a number of reasons for this, including the lack of market-wide data on lender prices.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
