October 24, 2012

In prior articles on HECM reverse mortgages, I lamented the tendency for most seniors entering the program to draw the maximum amount of cash allowed at the outset – as opposed to taking a credit line. I pointed out the obvious, that if you use up all your borrowing power today, you won’t have it tomorrow, when your needs might be greater.  

But there is a lot more to it than that. The borrowing power you don’t use today but place in a credit line is much larger tomorrow because it grows at a compound rate. In 10 years, it could be twice as large as the amount you could draw now, or even more. This makes the selection of a HECM credit line a type of investment, except that the return is much higher than the return on any low-risk financial assets available in the market.  In addition, the senior who retains borrowing power in an unused credit line enjoys property value protection. Seniors who elect to purchase a tenure annuity, under which they receive a monthly payment for as long as they live in their home, enjoy almost the same benefits as those who reserve all their borrowing power in an unused credit line.  

To illustrate these points, I developed the accompanying table which shows what happens over a 10-year period to three seniors of 70 with houses worth $300,000 who select three different HECM options. One draws the maximum cash allowed using a fixed-rate HECM. The second draws no cash at all but allows her credit line on an adjustable-rate HECM to grow over the 10 years. The third, also using an adjustable rate HECM, elects to receive a fixed monthly (tenure) payment over the entire period she lives in the house. 

Rising Credit Line as an Investment 

A comparison of senior one and two shows the potential benefit of deferring the cash draw. The first senior who withdraws $192,900 at 70, at age 80 has equity in his home of only $82,195 (assuming a 4% appreciation rate), and has no access to additional funds. The second senior at 80 has a credit line that has grown to $272,960 and equity of $428,093. The first senior would have to invest the $192,900 cash draw at 5.85% to be as well off as the second senior at age 80. For most seniors, that is not possible. 

It is very likely, furthermore, that the advantage of the second senior at age 80 will be much larger. The numbers cited above assume that the initial ARM rate of 2.49% continues over the 10-year period. The likelihood is very high that ARM rates will be higher in the future, which works to the advantage of senior two because the unused credit line grows at the ARM rate plus the mortgage insurance premium rate of 1.25%. If the ARM rate turns out to be 6%, for example, the credit line at age 80 will be $387,117 instead of $272, 960, and at 8% it will be $474,181.  

Property Value Protection  

The right-most column in the table shows the senior’s credit line, which is the amount he can draw, less his equity in the property, which is the amount he can realize if he sells his home. If this number is positive, which it will be if interest rates escalate more than property values, the senior who has decided to leave his home, for whatever reason, does better by drawing as much as possible from his line before moving out. FHA will be stuck for the loss.  

I doubt that anyone intended that the HECM program provide property value protection, it is most likely an inadvertent consequence of program design. But seniors who take all their cash up-front do not have this protection. 

The Monthly Tenure Option Has It All

 Senior 3 draws a monthly (“tenure”) payment for the entire period she lives in the house, but can switch to a credit line at any time.  Her credit line is not as large as that of senior 2 because of the monthly payments she receives, but it will be larger at higher interest rates. To access it senior three has to notify her servicer that she wants to switch out of the monthly tenure payment plan into a credit line plan, and pay $20. 

The beauty of the monthly tenure option is that the senior supplements retirement income immediately, yet is free to adjust to changing circumstances by switching to a credit line. She can do this in order to draw more, or the reverse. If she does not need any cash draws for three years, for example, she can switch to a credit line and allow the line to grow untouched for three years, then switch back to a monthly tenure payment that would be larger than the one she had earlier. Note further that senior three has exactly the same property value protection as senior two. The monthly tenure option has it all.  

Status of Three Seniors at Age 80 Who Take HECMs on $300,000 Homes at Age 70:

Senior 1 Takes Maximum Upfront Cash, Senior 2 Takes Maximum Credit Line, and Senior 3 Takes Maximum Monthly Tenure Payment