HECM Market Is Dysfunctional

The simplest illustration of the conflict in objectives is the difference between a 30-year and a 15-year home mortgage. On Aug. 18 when I wrote this, a 30-year mortgage for $100,000 at 4.25 percent had a monthly payment of $492 while a 15-year mortgage at 3.375 percent had a payment of $709 — 44 percent higher. After five years, however, the amount owed on the 15-year mortgage had been reduced by $27,900 compared with a reduction of $9,192 on the 30-year. Home equity growth on the 15-year mortgage is three times as large.

Since World War II, public policy has prioritized affordability over equity growth. This affordability bias reached its peak in the years leading up to the financial crisis. That period saw the emergence of interest-only provisions tacked on to the first five or 10 years of 30-year mortgages, which meant that for five or 10 years there was no paydown in the loan balance at all.

Option ARMs went even further, allowing borrowers to make payments that didn’t fully cover the interest, which resulted in an increase in the loan balance — called “negative amortization.” These instruments are gone and good riddance, but the conflict between affordability and equity growth remains.

Policy bias will shift toward equity growth.

The reason is that the United States is moving into a retirement-funds crisis as net worth at retirement declines and life expectancy rises. Home equity is a potential buffer against economic hardship after retirement.

This shift in priorities raises the critical question of how to give advantages to homeowners who build equity more quickly, if possible without reducing affordability. As an important example, we would like to see more homebuyers finance their purchase with 15-year mortgages rather than a 30-year, without eliminating the 30-year as an option for those who really need it.

One simple way to encourage home equity growth is to amend the tax code so principal payments rather than interest payments are deductible. The existing system encourages debt, when we should be encouraging debt repayment. It would be plausible to provide a larger deduction for extra payments than for contractually required amortization payments.

We should also make it easier for homeowners to develop extra payment programs as part of their household budgets.

But by far the greatest challenge to a federal effort to encourage equity growth is a widespread belief that home equity is what you leave to your estate, which is not a great motivator. Since 1990, the federally sponsored home-equity conversion mortgage program has been available to convert home equity into spendable funds without jeopardizing the owner’s right to live in the house indefinitely.

But the reverse mortgage program is not widely understood and is viewed with suspicion. Fewer than a million HECMs have been written since the program began, and the current annual rate is only about 60,000.

In comparison, about a million homeowners retire every year. The first priority for dealing with the retirement funds crisis is to bring the HECM program to life.

Dysfunction in the HECM market rivals that in the medical services market. Confusion on the part of seniors about how HECMs work is widespread — they are very different from the mortgages with which they purchased their homes.

The product at issue is obscure because seniors often do not know how they want to receive money under the HECM — whether as upfront cash, monthly payments, a credit line, or a combination. Further, there is no way for borrowers to compare the deal offered by one lender with the deal offered by another.

I call it a “gotcha market” because lenders seek to attract potential borrowers into making contact, then collecting the information needed to entangle the prospect in a process that encourages them to take a HECM but discourages them from looking elsewhere. Borrowers may exit the process because they get cold feet, but they don’t exit to get a better deal elsewhere.

The HECM market is unique in mandating that all borrowers be counseled before they commit to lenders, but counselors are not part of the market mechanism.

HUD says: “The job of the counselor is not to steer or direct you towards a specific solution, a specific product, or a specific lender.”

The purpose seems to be to prevent sins of commission by assuring that borrowers are not committing themselves based on erroneous beliefs, or on failure to consider alternatives. That’s OK, but it ignores the much more important sin of omission, where seniors who need help don’t consider reverse mortgages because of unwarranted fears, ignorance or erroneous beliefs. Those seniors never see counselors.

The key to bringing the HECM program to life is in converting the dysfunctional market into a shoppers market with 3 central features:

• A credible source of basic information on HECMs for seniors exploring the concept.
• A credible source of current transactional information on available draw amounts, for seniors who want to try out the concept without contacting a lender.
• Credible sources of current pricing information from multiple lenders that allows shoppers to select the lender whose HECM provides the best value for the particular metric in which the borrower is interested.

When the cause of market dysfunction is either excessive market power or neglect of important externalities, we look to regulatory agencies for a fix. But when the cause is ignorance and misinformation in the face of product complexity, and the product is insured, we should look to the insurer for a fix because market dysfunction raises insurance costs.

That is the case with HECMs, for which the Federal Housing Administration insures lenders against loss and borrowers against lender default. The information required to implement the three components of a shoppers market are readily available to HUD/FHA at no cost.