I frequently get questions from homeowners about home-equity conversion mortgages, the type of reverse mortgage backed by the Federal Housing Administration.
And it's not surprising: HECMs are complicated and meet a wide variety of homeowner needs.
Furthermore, HECMs are not at all like the standard "forward" mortgages most people use to purchase their homes.
What follows is a sampling of questions.
Q: Which seniors should reject a HECM, and which should consider one?
A: Seniors who should say no:
- They don't need it because their financial status is secure.
- They want to pass on a debt-free house to their heirs.
- They want those now living in the house, who cannot be included in the reverse mortgage contract, to be able to continue living there after the senior's death.
Some seniors who should say yes:
- Their incomes will drop upon retirement while their mortgage payments continue.
- They will retire before 65 but want to wait until they are 65 before going on Social Security.
- They are living on Social Security or small pensions and want to supplement their income indefinitely.
- They are living in retirement on a nest egg, or planning to do so, and are fearful that if they live too long their money will run out.
- They seek protection against a sudden drop in their income.
- They want to buy a house but don't want a monthly payment.
- They seek an effective way to manage fluctuating incomes.
- They need a way to meet occasional or unexpected expenses.
- They plan to sell their homes within three to seven years but need to supplement their income in the meantime.
- They have multiple needs that require multiple payment options.
Q: What is "reversed" in a reverse mortgage?
A: The reversal is in the typical pattern of loan balance change.
On a standard mortgage, the balance usually is at its highest point when the loan is made, declining steadily thereafter until it reaches zero at the end of the term or when the balance is prepaid.
On a reverse mortgage, in contrast, the initial loan balance is relatively low, it grows over time as borrowers draw funds and as interest adds to it.
Related to the reversal in loan balance change is reversal in payment flows. On a standard mortgage, the borrower is required to make a monthly payment, whereas the reverse mortgage borrower has an option to draw a monthly payment, or irregular amounts against a credit line.
Q: Does taking a reverse mortgage result in no home equity passing to my heirs?
A: It could, but need not. It depends on how the borrower uses the HECM, on how long the borrower lives, and on the rate at which the property appreciates.
Here are three possibilities among many:
Possibility 1: The borrower draws the largest available monthly payment for as long as she resides in the house, she lives to 100, and her house doesn't rise in value. The outcome would be zero equity available to heirs.
Possibility 2: The borrower draws a credit line that is used sparingly for special needs or occasions and half of it is unused on her death at age 80. House appreciation is average. The outcome would be that significant (but not full) home equity becomes available to heirs.
Possibility 3: The borrower draws a credit line to hold as insurance against the hazard of running out of money but dies before that happens. The outcome would be that heirs would inherit almost all the equity in the house.
Q: Since the amount of money I can draw on a HECM is only about 50 percent of the value of my house, why must I pay for mortgage insurance? When I took out a mortgage to buy my house, mortgage insurance was not required on loans that were less than 80 percent of property value.
A: On the standard mortgage you used to purchase your home, the loan amount was at its highest point at the beginning. Every month thereafter, the balance declined as you made monthly payments. Since your equity in the property increased month by month, the mortgage insurance charge was based on your initial equity.
On a reverse mortgage, in contrast, the loan amount is at its lowest point at the beginning. Since there is no required payment, the interest that accrues every month is added to the loan balance. Since your equity in the property tends to decline month by month, the mortgage insurance charge is based on estimates of what the equity will be at the termination of the process.
Note that on a standard mortgage, the insurance premium covers losses mainly associated with payment default by the borrower, whereas on a reverse mortgage, the premium covers losses mainly associated with the borrower living too long.
Q: What happens if I take a HECM and the value of my house goes down
A: Nothing happens. The terms you received at the outset were based on the assumption that your house would appreciate by 4 percent a year, and that assumption is not changed.
If your house value goes down, your loan balance when your HECM terminates will exceed the house value and the FHA will take a loss. That loss is covered by the mortgage insurance premiums paid by all HECM borrowers.
Q: What happens if my house value appreciates by more than 4 percent a year?
A: Nothing happens with your current HECM, but you might find it advantageous to pay off your existing HECM, refinancing into a new one based on the higher current value.
Q: How do I know whether a fixed-rate or an adjustable rate HECM is better for me?
A: If you are looking to a HECM to provide funding during your retirement years, which is the major purpose of the program, you will take an adjustable rate because only adjustable rate HECMs can fund you in the future.
On a fixed-rate HECM, you can draw funds only at closing. Borrowers take the maximum amount available and that ends it. They cannot draw any more, except possibly by refinancing, and that would work only if the value of their home appreciates substantially -- by more than the 4 percent assumed by the FHA in setting draw amounts.
Q: What are the advantages and disadvantages of waiting before taking out a reverse mortgage?
A: Waiting results in a small but certain increase in draw amounts because the senior is older, and a potentially larger but less certain increase based on appreciation in house value.
However, both of these effects can be swamped by a rise in interest rates, which reduces draw amounts. The best strategy for borrowers who have no current need for funds but anticipate that they will sometime in the future is to take a credit line now and let it sit unused while it grows in size. That way, if market interest rates rise, the reduction in draw amounts that result will be at least partially offset by a rise in the unused credit line.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.