This article describes the three major decisions that must be made in taking out a reverse mortgage. The purpose is to alert potential borrowers to the information they will need to make the best decisions possible, and where to get it. A second purpose is to help those who are on the fence about whether or not a reverse mortgage is in their interest, to make up their minds.
I will illustrate with the example of Mary, who is 65 and has a house worth $300,000 and no debt, but also has significant financial needs. To see whether a home equity conversion mortgage, the Federal Housing Administration’s reverse mortgage program, would meet those needs, Mary considers the three decision points based on market conditions on April 15, 2016.
–Take a fixed-rate or an adjustable rate? The fixed rate HECM is primarily for seniors who plan to use all or most of their borrowing power right away. Their intent is to pay off an existing mortgage, buy a house, purchase a single-premium annuity, or transact for some other purpose that requires a large immediate payment. Mary could draw up to $95,700 in cash for any such purposes. The fixed-rate HECM does not allow the borrower to reserve any borrowing power for future use. The rate on April 15 was 4.5 percent with zero origination fee.
The adjustable rate HECM allows seniors to draw funds at closing, and also to draw funds after the closing. Mary could draw $93,200 cash at closing and another $65,880 12 months later. Alternatively, she could draw $869 a month for as long as she lives in the house, or $1,727 a month for 10 years. Or she could do none of those and instead opt for a credit line which would begin at $159,080 and grow month by month so long as it is not used. The line can be accessed at any time, but the longer it is held unused the larger it becomes. In addition, Mary can combine these draw options, as noted below.
Most seniors opt for adjustable rate HECMs because of their greater flexibility. The initial interest rate is also lower on the adjustable. On April 15, it was 3.955 percent with a zero origination fee.
To make an informed decision between fixed and adjustable rates, prospective borrowers need access to all the information used by Mary, including draw amounts, rates and fees.
–For those taking an adjustable, what is the best combination of draw options? The number of possible combinations from which Mary can make a selection is unlimited. Here is just one: she could take $20,000 in cash, $400 a month for life, and $65,937 as an unused credit line. Or she could take $5,000 in cash, $1,600 a month for five years, and $67,158 as a credit line.
To make an informed decision about the different draw options on an adjustable rate HECM, Mary needed to know what the tradeoffs are. If the upfront cash draw is increased by $X, and the monthly payment by $Y, for example, how much lower will the credit line be?
–What is the best combination of interest rate and origination fee? The interest rate and origination fee used at the first two decision points are tentative. Loan providers offer a range of interest rate and origination fee combinations from which borrowers can choose after they have selected their draw options. Their choice should be governed by their objectives.
If Mary wants to reserve as much equity as possible for her estate, she will select the combination that results in the smallest loan balance at the end of the period that is her best guess as to how long she will have the mortgage. This turns out to be a rate of 2.185 percent with an origination fee of $3,500. While Mary has only the vaguest idea of how long she will have the HECM, that rate/fee combination is the best over any period from 5 years to 35 years.
To make an informed decision about the rate/fee combination that minimizes loss of equity, Mary needed to know the loan balance on all rate/fee combinations at the end of any future year.
It is possible, however, that Mary is less concerned about the loss of equity than she is about her future credit line. If that is the case, she will choose the rate/fee combination that maximizes her unused credit line in the future rather than one that minimizes her loan balance. It turns out that a rate of 3.955 percent with a fee of $2,500 will maximize her unused credit line over any period between 6 and 35 years.
To make an informed decision about the rate/fee combination that maximizes credit line growth, Mary needed to know the unused line on all rate/fee combinations at the end of any future year.
The data Mary used to explore the three decisions were obtained from my HECM calculator, which uses prices submitted by 9 lenders. To my knowledge, there are no lenders who provide all the required information, which is why I developed the calculator. You can pin down your decisions using the calculator. Once you have made all the critical decisions, you can approach any lender with the confidence that comes with knowing your own deal better than the lender.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
©2016 Jack Guttentag
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