Reverse Wrinkle

In this column, I return to reverse mortgages. Often touted as the answer to seniors’ financial dilemmas and tainted with a history of unscrupulous sales practices, I’ve found reverse mortgages infrequently provide a satisfactory solution to an older person’s money problems. But sometimes a reverse mortgage is the right answer.

First, a brief review. In a reverse mortgage, a homeowner borrows against the equity in his or her home, but makes no payments to the lender. Instead, the loan balance accrues over time, to be repaid upon death or sale of the home.

Reverse mortgages come in three basic flavors: a lump sum payment set at a certain percentage of available equity, monthly “tenure payments” that look and feel something like an annuity, and a line of credit with an adjustable interest rate.

Previously, I discussed the lump sum and tenure payment options. Because tenure payments cease when you move out of your home (by choice or necessity), and because the tenure payments are typically much lower than what a borrower could obtain by taking the lump sum option and purchasing a low-cost immediate annuity, the tenure payment option never makes sense.

The lump-sum option may benefit the borrower in a limited class of cases, as we explored in my November 2009 column [“Reverse Mortgage Annuity”]. However, a broader set of circumstances justify the use of a line of credit known as a Home Equity Conversion Mortgage (HECM).

The HECM program includes federal mortgage insurance that insures the line of credit will always be available to the borrower. What makes the HECM especially intriguing is that, if properly done, the line of credit available to the homeowner will continue to grow even if the house does not increase in value.

Sarah (not her real name), age 73, had a balance of $280,000 remaining on her 30-year fixed-rate mortgage. Her home was appraised at $675,000. Monthly mortgage payments of $1,800 ate up much of Sarah’s income from her part-time case management practice and social security benefits. Sarah had modest financial resources, primarily some savings and certificates of deposit. With no spouse, children or dependents, Sarah felt no need to leave her home as a legacy to others.

A key to making the HECM work for Sarah was that she was confident she wouldn’t use the reverse mortgage as a piggy bank—she wouldn’t take further cash advances except in the case of true future need or emergency. What makes the HECM powerful is that the unborrowed portion of the line of credit continues to grow and is guaranteed to be available to the borrower regardless of the home’s value. In other words, Sarah can draw against the line of credit even if the amount owed later exceeds the equity in her home.

At the outset of an HECM mortgage, a principal limit is calculated based on the borrower’s age, the prevailing interest rate and a lending limit (currently $625,000), without regard to loan origination and closing costs. In Sarah’s case, the principal limit was $400,000. Against this, Sarah received a cash advance of $280,000 to pay off her existing mortgage. She was charged 2 percent of the amount borrowed for the federal mortgage insurance premium. That and other origination fees and closing costs brought the total initial loan balance to $300,000. Subtracting the loan balance of $300,000 from the Principal Limit of $400,000 means Sarah had another $100,000 available to her from her HECM lender.

As the loan progresses, Sarah will pay the applicable interest rate, plus 2 percent for the continuing mortgage insurance premium, on the loan balance. At first glance, this sounds risky for Sarah, because the interest rate is adjustable, not fixed. No worries, because Sarah earns the same rate of interest (plus the 2 percent) on the unborrowed portion of the principal limit. Any increase in the rate charged against funds borrowed is offset by the interest credited against the unborrowed funds.

Here’s how the numbers work for the first year of the loan (assume an interest rate of 5 percent and a $30 monthly service fee charged by the lender):

While the loan balance has increased, so has the principal limit, by the same applicable rate plus 2 percent.

Now Sarah has $105,221 available to draw against her line of credit. The credit available to Sarah will increase relentlessly. In our example, if there’s no increase in the value of Sarah’s house, her loan balance will exceed the total value of the house by year 14. Nevertheless, at the end of year 14, Sarah will be able to draw $206,531 from the line of credit.

Sounds impossible—or at least too good to be true. What kind of lender would put itself in a position that it had to advance large sums to someone who has no equity in his or her home? Only one participating in a federal government guarantee program, that’s who.

A common problem with reverse mortgages is that, if one moves out of their home, the mortgage is called and the lender can force the sale of the property, at which time there will likely be no equity left. Again, no problem for Sarah. If she must move to receive care in other than a home setting, she simply draws out whatever portion of the principal limit is available to her when she moves out.

Best of all, Sarah has permanently reduced her monthly expenses by $1,800. Because of her limited income, the mortgage interest deduction was of little or no value to her, so, effectively, it’s as though Sarah received $1,800 of tax-free income a month. Her HECM line of credit cannot be withdrawn, and the loan is non-recourse to her or her estate. Pretty sweet.