The Federal Housing Administration’s home-equity conversion mortgage, or HECM, reverse mortgage offers multiple options that are designed to meet a wide range of senior needs and capacities. This is a major strength of the program, but it can also be a weakness. Multiple options make the program complex, which opens the door to poor decisions that can be costly.
There are four steps involved in finding the reverse mortgage that best meets a senior’s needs.
The purpose of this article is to provide a road map for the decisions that must be made at each step.
My colleagues and I have developed a calculator that generates the information needed to make the best decisions possible at each step. If taken one step at a time, with the help of the calculator, none are difficult. Without the calculator, though, you will be guessing.
Step 1
Entering your information: The validity of the results depends on the accuracy of the information you provide at the outset. My illustration assumes a John Doe who is 68 years old, has a house worth $500,000 with an existing mortgage balance of $170,000, and who expects to have a reverse mortgage about 10 years. Under the rules, the existing mortgage balance must be paid off with the proceeds of the reverse mortgage.
Step 2a
Choosing fixed-rate or adjustable-rate: With fixed-rate HECMs, the senior has only one option for drawing funds: Whatever amounts are drawn must be taken entirely at closing.
The most that Doe can draw with a fixed-rate (in addition to the $170,000 balance payoff) is $32,000. With an adjustable-rate mortgage, or ARM, Doe could draw $32,000 at closing, and another $105,000 just 12 months later.
Alternatively, with the ARM, Doe could draw funds monthly or take a credit line that defers any draws until later.
In sum, anyone who wants to draw funds in the future will select an ARM. The only seniors for whom an fixed-rate mortgage makes sense are those who have an immediate need for funds that can be met with the fixed-rate mortgage, and want to minimize their loss of equity.
Step 2b
Deciding between an 0.5 percent mortgage insurance premium and a 2.5 percent premium: The higher premium applies to transactions on which the borrower uses 60 percent or more of his borrowing power upfront, to draw cash or pay off an existing mortgage.
The $32,000 that Doe could draw upfront was based on the 2.5 percent premium. With the 0.5 percent premium, Doe could draw only $15,000.
Those who select an fixed-rate mortgage might elect the higher premium because of the larger cash draw. In contrast, those who select an ARM because of their interest in future draws, will not find the higher premium option of any value because it reduces monthly payments and future credit lines. I assume Doe selects the ARM with the lower insurance premium.
Step 3
Selecting the arm payment options: Doe has the following single draw options.
- A cash draw of $19,600 and another draw of $128,000 in 12 months; or
- An unused credit line for the same amounts, which will grow at the mortgage rate if not used; or
- $940 a month for as long as Doe resides in the home, called a “tenure” payment; or
- Larger amounts for shorter periods, which Doe can specify _ for example, $1,577 a month for 10 years.
In addition, Doe can combine these options in an unlimited number of ways: For example, Doe could select a cash draw of $5,000, a monthly tenure payment of $500, and a credit line of $60,000.
Step 4a
Selecting the best combination of interest rate and origination fee: Lenders offer multiple combinations of interest rate and origination fee.
For example, on the combination transaction I described above, one of the lenders who delivers reverse mortgage price data to my website this week quoted a rate of 3.776 percent and an origination fee of $3,000, and also a rate of 3.901 percent and an origination fee of negative $5,042 — a rebate.
Which set is better for the borrower depends on his objective. If it is to minimize his loss of equity, he wants the price combination that results in the lowest loan balance at the end of the period he expects to have the mortgage. The calculator shows that this is the high rate/rebate combination.
On the other hand, borrowers whose focus is mainly on husbanding a credit line until they need it will probably prefer a price combination that results in the largest unused credit line sometime in the future. My calculator allows the user to rank lender price quotes by that criteria as well, and also to vary the length of the period used in the calculations.
Step 4b
Selecting the lender offering the best deal: This last step is anti-climactic.
Unless you have some other basis for choosing a lender, you will select the one offering the price combination that results either in the lowest debt or the largest unused credit line, depending on which of these objectives dominates your plan, over the period you specify.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
