Reverse Mortgages Are An Excellent Hedge Against Property Value Risk – Especially Now

February 23, 2021

Part of the
motivation to be a homeowner is the opportunity to
accumulate growing equity in a home. Equity growth, however,
is heavily influenced by market changes over which the owner
has little control. House prices appreciate much more in
some areas than in others, and there are some areas in which
there is no appreciation at all.

A homeowner reaching 62 can begin
converting home equity into spendable funds by taking out a
HECM reverse mortgage. In calculating the amounts that a
senior can draw using a HECM, the Government assumes the
borrower’s house will appreciate by 4% a year. This was the
average rate for all areas over a period of many decades.

The individual taking out a HECM
reverse mortgage today could experience 4% appreciation, but
more likely the rate will be higher or lower. The way the
program is designed, the borrower is protected against the
adverse consequences of a rate below 4%, and allowed to
enjoy the benefit of a rate above 4%. The HECM program
allows the owner to hedge her property value risk. Here is
an example.

Jane Doe is 64, has a house worth
$200,000, and wants to draw the maximum amount possible
every month for as long as she lives in the house – called a
“tenure payment”. As of February 15, 2021, the largest
amount available from any of the 6 lenders who deliver their
prices to my web site turns out to be $415 a month.

Now consider the implications of
two extreme assumptions about the future value of Jane’s
property. In assumption 1, appreciation is zero, meaning the
property value remains at $200,000. Jane’s HECM debt,
however, rises every month. Assuming the initial interest
rate of 2.57% on her reverse mortgage continues, her equity
will be reduced to $47,000 after 20 years.

However, there is little chance
that the initial rate will hold for 20 years. The more
plausible assumption is that the rate will quickly rise to
the maximum on her mortgage, which is 7.57%. At that rate,
the loan balance after 20 years would exceed the property
value by $83,000.

Nonetheless, neither Jane nor her
estate will be liable for the deficiency. There are no
deficiency judgments in the HECM program. Losses such as the
one described above are taken as a charge against the
Government’s reserve account, which is replenished by
insurance premiums paid by Jane and all other HECM
borrowers.

In sum, Jane continues to receive
the payment calculated on a 4% appreciation assumption, even
though her house has not appreciated at all.

Now consider the implications of
an alternative assumption, where Jane’s house appreciates at
a rate of 8%. That means that after 20 years, her house will
be worth $932,000. Assuming that the interest rate jumps to
the maximum, her loan balance would rise to $283,000,
resulting in equity of $649,000.

Jane could leave the equity for
her estate, or she could convert it into a larger monthly
payment by refinancing. That means paying off the balance on
the first HECM, and drawing a tenure payment on a new HECM.
Her new monthly payment would be about $2800, many times
larger than the first one, reflecting both the equity growth
and Jane’s advanced age.

In sum, the HECM program allows
eligible homeowners to benefit from unusually large house
price appreciation without bearing the risks associated with
low or no appreciation. Unusually low interest rates
increase the benefits.