As noted in Impact of the Financial Crisis on Reverse Mortgages, the crisis eliminated private reverse mortgages, leaving only the Federal program of Home Equity Conversion Mortgages (HECMs) insured by FHA. The HECM program is very powerful, however, and offers borrowers multiple options for drawing funds. These options are the subject of this article.
The Net Principal Limit
The different options can be visualized
as different ways of removing money from a pot with a fixed amount in
it. HECM borrowers can draw a maximum amount immediately and none
thereafter; take a credit line on which they can draw at their
convenience; take a fixed-payment annuity over a period of their choice;
or some combination of the last two. The starting point for all the
options, however, is the amount in the pot at the outset.
Assume a hypothetical owner Smith aged
70 with a house worth $400,000 and no existing mortgage, selecting a
monthly adjustable-rate HECM. Based on the shopping I did for Mr. Smith
on December 1, 2009, the “principal limit” (PL) on his house was
$216,800. The PL is the value of Smith’s house now to an investor who
must wait for Smith to die or move out permanently before they can take
possession. The PL is
affected by the borrower’s age, the value of the house, and the interest
rate.
But Smith can’t actually draw the PL
without paying all the upfront expenses connected to a HECM: origination
fees, mortgage insurance, third party closing costs, and a servicing-fee
set-aside. These expenses are deducted from the PL to yield a “Net
Principal Limit” (NPL), which is $193,340. NPL is the money in the pot
that Smith could withdraw as a lump sum immediately, or use to support
the other withdrawal options discussed below. It is a critically
important number on which borrowers can base their shopping, as I’ll
explain in the next article in this series.
Selecting a Credit Line
Most HECM borrowers take a credit line
for the full NPL, and use a sizeable chunk of it right away. They pay
off debts, fund overdue maintenance, or treat themselves, perhaps to a
long-deferred vacation. They may use the balance of the credit line to
fund a monthly payment, but more often they hold it as a reserve against
future contingencies.
The portion of the line that is not used
grows over time at a rate equal to the rate the borrower pays on the
HECM. Some conservative borrowers limit their draws to the growth in
their line, husbanding the entire NPL for the future. In the example,
Smith could draw about $7500 a year without cutting into the NPL.
Selecting a Monthly Annuity Payment
The borrower can also elect to receive
monthly annuity payments over any period. Where the credit line provides
maximum flexibility, monthly payment options provide discipline and
convenience.
If the entire NPL is used to purchase an
annuity, Smith could draw about $3860 for 5 years, $2250 for 10 years,
$1480 for 20 years, or $1269 for life. Smith would commit, although not
irrevocably, to using up the NPL over the period selected.
If Smith elects to take $3860 a month for 5 years, for example, the
entire NPL of $$193,340 is set aside for this purpose. So long as Smith
is on this path, he can’t draw any more funds. If he goes the full 5
years, he is maxed out.
But he can change his mind before the period is over. If he does, the
portion of his NPL that is unused at that point becomes available for a
new plan, which could be a different monthly payment or a credit line.
After one year of drawing $3860, for example, about $153,800 of Smith’s
NPL would remain unused and available.
Smith can also select any combination of
credit line and monthly payment. For example, he could select a 5-year
payment of $1930, which would use only half the NPL, leaving the other
half as a credit line which would grow if not used, but which could be
drawn on at any time.
Selecting an ARM Versus an FRM
Before the financial crisis, mortgage
selection involved choosing between 2 ARMS, one on which the interest
rate adjusted monthly and one that adjusted annually. But the ARM that
adjusts annually is no longer competitive while a new and very
competitive fixed-rate HECM has emerged. In December, 2009, the FRM
version was priced better than the ARM, generating a higher NPL. The
downside of the FRM is that the entire NPL must be drawn immediately. No
unused credit line and no annuities are permitted. Borrowers who want to
husband some of the NPL for future contingencies, or purchase an annuity
will select the ARM.
The FRM meets the needs of one important
group of seniors: those who want to sell their existing house and buy
one that better meets their current needs. They may want to exchange a
large house for a smaller one, for example, or move to a condominium in
a retirement community. The FRM is appropriate for this purpose because
its NPL is larger than that of the ARM, although this could change.
Under a “HECM for Purchase” program
authorized by Congress in 2008, seniors can buy a house and take out a
reverse mortgage on that house at the same time. Absent this program,
the senior would have had to purchase the new house with a forward
mortgage, then take out a HECM to retire the forward mortgage, incurring
two sets of settlement costs in the process. With the fixed-rate HECM,
the senior incurs only one set of settlement costs.