Executive Summary

• Reverse mortgages have been highly marketed and promoted over the past few years, with the dominant product being the Federal Housing Administration’s home equity conversion mortgage, or HECM. 
• The majority of information on the HECM has bypassed the financial planning community, with AARP, the FHA, and the Federal National Mortgage Association (FNMA) focusing their consumer education and marketing materials on seniors. Mortgage lenders have used this generic information to furnish the public with a general but incomplete view of the HECM product. The shortage of expert analytical presentations has limited the opportunity of many financial advisors to fully appraise, and adequately explain, this financial planning option.
• This article is designed to help financial advisors thoroughly understand the mechanics of the HECM, compare it with other retirement options such as a home equity line of credit, and determine if the HECM should be considered as a component within a client’s long-term financial plan.
• This article provides an in-depth review of the main formulas and variables that make up the HECM. Through a series of cash-flow illustrations, it presents the costs and benefits of using various home-equity based strategies to increase cash flow in retirement. Particular attention is paid to the client’s risk tolerance and personal preferences.
• A sidebar is included that lists important HECM program information regarding eligibility, limitations, requirements, and costs.

Douglas Skarr is a published author and researcher in the field of municipal finance, based in Sacramento, California. He can be reached at (916) 642-3696 or skarr@surewest.net.

Reverse mortgages are a fast-growing retirement product originally developed by the U.S. Department of Housing and Urban Development (HUD). Over the past few years, they have been promoted by everyone from major financial institutions to older, trusted Hollywood celebrities. The dominant product in the reverse mortgage market is the federal government’s guaranteed home equity conversion mortgage, or HECM. As of December 2007, the HECM represented approximately 90 percent of the market. HECM loan volume has increased steadily from 18,000 in 2003 to 107,000 in 2007, with significant growth projected for the future.¹
 
As the product gains acceptance and credibility as a viable retirement option, the financial community can take the lead in providing a clear and objective discussion of its use within a long-term financial plan. This article provides an overview, the mechanics of reverse mortgages, and a detailed analysis of the HECM reverse mortgage as it compares with other home-equity-extraction retirement funding strategies. Information contained here can help financial planners understand the HECM, compare it with other options, and determine if it should be considered as a component of a client’s long-term financial plan.

Overview

The HECM reverse mortgage was established in the 1990s as a HUD “demonstration project” to assist senior citizens over the age of 62 in borrowing against the equity in their homes. It allows seniors to defer the principal and interest payments until they leave their home or die. In general, the HECM works like a zero coupon bond, where the interest expense is charged on a periodic basis, but paid at maturity. When defining a HECM in bond terms, principal is the original loan balance, coupon rate is the loan rate, and maturity is when the client sells, moves, or dies.
 
The main HECM product is a variable rate mortgage loan tied to the one-year U.S. Treasury bill. Fixed and LIBOR-based (London Interbank Offered Rate) loans are currently being considered because of their expanded liquidity in the secondary market. The loan distributions received from a HECM are tax-free. HECM proceeds do not trigger tax events related to distributions from other government programs like Social Security, state disability insurance, and Medicare.
 
HECMs are considered “non-recourse” loans. Loans of this type use the property as exclusive collateral. The client and their heirs can never be held responsible for any loan balance (principal and interest) over and above the value of the property. This feature is particularly valuable in a declining property value environment. The HECM loan balance must be repaid when the client sells or vacates the home. In the case of the client’s death, the loan can be extended up to 360 days, giving the heirs ample opportunity to sell or refinance. HECMs are not restricted by living trusts.
In circumstances where a loan balance is greater than the actual property value, the FHA insures the lender against any shortfall. The FHA’s ability to provide this insurance is paid through mortgage premiums at loan origination and a monthly interest rate add-on.
 
One of the most attractive features of the HECM is the variety of ways the homeowner can take the loan proceeds. The following methods can be used alone or in combination.
 
 • Lump sum
 • Line of credit
 • Monthly payment for life
 • Monthly payment for a fixed period
 
Having these choices can help the financial planner structure cash flows to satisfy both immediate and long-term needs. All closing costs can be paid from loan proceeds. (For more information and requirements on the HECM program, see sidebar.)

Basic Formulas for Calculating Loan Amount

This section describes the basic formulas for calculating the amount a client can borrow and the amount it will cost the client over time. The two formulas are:
 
 • Principal Limit = Original Loan Amount (dollar amount the client can borrow)
 • Loan Balance = Accumulated Principal and Interest (dollar amount the client will owe at maturity)

Calculating the Principal Limit

The following formula calculates the theoretical principal limit:²

where
 • Maturity = client’s remaining life expectancy at loan origination
 • Maximum claim amount = appraised home value or FHA loan limit at time of loan origination
 • Discount rate = published ten-year Treasury bond rate at time of loan origination plus a spread determined by the Federal
   National Mortgage Association (FNMA).
 • Growth rate = forecasted rate of growth in residential real estate values over the holding period (normally close to the Consumer
   Price Index).

Variables

The key variables of growth rate, home value, maturity, and discount rate will be discussed individually and in combination with the other formula variables to gain an understanding of how the HECM works and how best to use it.
 
Growth rate. HUD uses a proprietary methodology to forecast growth in the value of residential housing. Growth rates are based on past changes in the housing sector, along with future estimates of home price changes. Over time, the growth rate is similar to the inflation rate as defined by the U.S. Consumer Price Index. These rates can vary. They are calculated and available through HUD. A high relative growth rate, determined by rapidly increasing prices over an extended period of time, will provide the borrower a higher principal limit than a lower projected growth rate. The opposite would be true for periods of rapidly decreasing values, as evidenced in today’s market environment.
 
Maximum claim amount. The maximum claim amount is either (1) the appraised value of the property or (2) FHA limits based on geographical areas within the United States.
 
With the home being the collateralized asset, the lender makes a prudent and conservative estimate of value. The HECM is an FHA product and has certain lending limits based on geographical area. The current maximum appraisal limit for the continental United States is $362,790. Alaska and Hawaii are higher. (The FHA Modernization Bill (HR 1852, S 2388), initiated in 2007, calls for a “national limit” of $417,000.) The FHA appraisal is more rigorous than conventional appraisals, with loan proceeds escrowed to pay for required repairs.
 
The HECM is not suited to clients with high value properties due to the FHA maximum appraisal limit and a restriction that the HECM must be the first mortgage on the property. For clients who have significant home equity but also have a mortgage loan(s) outstanding, these limitations reduce the ability of the HECM to deliver a loan balance large enough to justify the closing costs.
 
As shown in Table 1, even though the client has $600,000 in equity, the FHA appraisal limit and non-subordination requirement eliminates the HECM advantages. In contrast, a “free and clear” property that appraised at the maximum FHA limit would provide the maximum benefits to the client.

 
Maturity. Maturity is a function of the client’s age and an actuarial forecast of life expectancies. HECMs assume that the entire loan balance will be borrowed at loan origination and interest will accrue from day one to maturity. With the loan having no maturity other than the client’s death or decision to move, HECMs must use actuarial tables to estimate the loan balance at the maturity date. As shown earlier, maturity plays a significant part in the equation. The longer the client is expected to live, the greater the discount factor (denominator), and in turn, the more the home is expected to be worth when the loan comes due (numerator).
 
All things being equal, the older the client, the more they will be able to borrow. The principal limit formula will pay out approximately 2 percent more for each year over age 62. For example, an 80-year-old will receive a principal limit approximately 30 percent greater than a 65-year-old borrower. For clients with both spouses living in the home, the age of the younger spouse is used to determine the principal limit.
 
Forecasting a client’s time horizon in the home can be one of the most important considerations in using an HECM. HECMs work best when the client remains in the home for an extended period of time. This will allow the client to extract the maximum financial benefits from the loan and compensate for the initial closing costs (discussed later).
 
Discount rate. The discount rate is equal to the coupon-bearing ten-year U.S. Treasury bond at the time of loan application, plus a credit market spread. The ten-year U.S. Treasury bond is used because it is highly correlated with movements in the conventional mortgage rate.³
 
As shown through the formula, the loan discount rate performs a similar function as those used to price stocks and bonds. Changes in the discount rate can have a significant effect on the amount eligible to borrow. All things being equal, an HECM loan originated in a high interest rate environment will produce a lower principal limit than one originated during a low interest rate setting.

Example of Principal Limit Formula

The following example describes the principal limit calculation using actual values for each variable.

where
 
 • Maturity = 20 (client’s remaining life expectancy at loan origination; client 75 years old).
 • Maximum claim amount = $300,000 (appraised home value or FHA loan limit at time of loan origination).
 • Discount rate = 5% (published ten-year Treasury bond rate at time of loan origination = 3.5% plus a spread determined by the
Federal National Mortgage Association = 1.5%).
 • Growth rate = 3% (forecasted rate of growth in residential real estate values over the holding period, normally close to the
Consumer Price Index). 
 
As shown through the previous discussion, the decision to use and the ability to extract the maximum benefit from a HECM is contingent on many macroeconomic and client-specific criteria. These include the overall climate for housing, long-term interest rates, client age, and inflation. Given financial planners’ ability to professionally track and analyze these variables, they can provide valuable advice on the use and optimal timing of an HECM.

Calculating the Loan Balance

Because the client never makes payments, the loan balance on an HECM continues to grow. The current month balance is defined as the prior month balance plus interest plus new amounts borrowed during the month.
 
Interest rate calculation. The primary HECM product is a variable rate loan with monthly adjustment. The index equals the one-year U.S. Treasury bill plus a spread of 1.5 percent. This should not be confused with the 10-year Treasury used to determine the discount rate described in the principal limit formula. In addition, FHA charges a .5 percent mortgage insurance premium on the current balance (see Table 2).

 
Interest expense. The monthly interest expense will vary based on the method of receiving loan proceeds. As mentioned previously, the HECM allows the client to receive funds using one or more of the following options: lump sum, credit line, monthly payment for life, and monthly payment for a fixed period. From highest to lowest interest expense, they are:

• Lump sum: A lump-sum distribution assumes all proceeds are disbursed to the client at the time of the loan closing. The monthly interest rate will be applied immediately to the total outstanding loan balance leading to significant interest expense.
• Fixed period: A fixed-period distribution allows the client to define the period of loan distributions. This can help advisors schedule the start and stop dates of cash flows provided by the HECM to coincide with additional cash flows from deferred accounts such as 401(k)s, pensions, and Social Security.
• Lifetime option: The lifetime option distribution allows the client to receive a fixed dollar amount each month for life. This can provide cash flow to clients who require a permanent income supplement without the risk of a shortfall later on in their retirement years. Payouts are based on the age of the client.
• Line of credit: The LOC distribution allows the client to use the HECM as a credit line, taking periodic payments when needed. This approach generates interest expense on the LOC balance only. Most borrowers choose this option.⁴

As mentioned earlier, the principal-limit formula assumes a lump-sum distribution (all proceeds are provided to the client at the time of the loan closing). Given this assumption, and the fact that the client is not taking all proceeds at once, the FHA will allow the unused balance on the credit line to “grow” at the monthly variable interest rate. For clients who seldom use the LOC, this feature leads to growth in available credit that can far exceed the principal limit.
 
Extending the Table 3 calculations through a multi-year time horizon will verify the LOC’s ability to grow well beyond the principal limit. HECM calculators, available from AARP and the National Reverse Mortgage Lenders Association, allow planners to test various scenarios. 

Comparing Financial Strategies

This section provides a financial analysis and comparison of common real estate equity extraction strategies used to supplement monthly cash flow. There are three well-known alternatives:
 
 • Home equity line of credit (HELOC)
 • Home equity conversion mortgage (HECM)
 • Sale of the property: downsizing or moving to rental housing

The following alternatives use a hypothetical client with the following financial profile:
 
 • Client owns (free and clear) $300,000 property
 • Client can borrow up to $200,000
 • Client needs $1,500 a month in supplemental income
 • HELOC based on prime rate at 6.0 percent
 • HECM reverse mortgage at 4.0 percent (one-year Treasury 2.0% + 1.5% spread + .5% FHA mortgage insurance premium)
 • Client is in the lowest marginal tax bracket

Alternative #1: Home Equity Line of Credit

Table 4 illustrates the ability of a home equity line of credit to generate the $1,500 supplemental income ($18,000 a year) necessary to satisfy the client’s needs. Remember, no monthly payments are made with the HECM and sale of the property alternatives. So, in order to do an “apples-to-apples” comparison, we must assume the client uses only the HELOC (no out of pocket) to make the required minimum monthly HELOC interest payments. As shown in the analysis, the HELOC will be able to provide the client the required $1,500 supplemental income, along with paying the interest expense, for approximately nine years. After that time, the HELOC will be exhausted, the balance will be due, and the client will need to refinance or sell the home to repay the HELOC.

Alternative #2: HECM Line of Credit Option

Table 5 represents a client who acquires an HECM and chooses the line of credit (LOC) option. The client pays closing costs of $13,000 from proceeds at loan origination and extracts $1,500 a month ($18,000 a year) in supplemental income.

 
Table 5 shows that the HECM line of credit will be able to provide the client the required $1,500 monthly supplemental income for approximately ten years. After that time, the LOC will be exhausted. As described in Table 3, the HECM line of credit has the growth feature that allows the unused balance to grow at the monthly interest rate. This feature, along with the lower relative interest rates available on an HECM, allows a one-year cash flow extension relative to the HELOC.
 
Unlike the HELOC in alternative #1, the client will remain in the home while the interest on the HECM balance grows. The ending loan balance, up to the value of the home, will become due and payable after the client either moves from the home or dies.

Case Study: HECM Versus HELOC

Given most clients’ varying profiles, choosing between the HELOC and HECM can be a difficult one. With this in mind, Table 6 provides a matrix for determining the appropriateness of each product based on the client’s profile.

Alternative #3: Sell Property—Downsize or Rent

Selling the home and downsizing or renting is a common, although somewhat desperate, method of increasing monthly cash flow in retirement. As with the HELOC and HECM, there are costs associated with these selling alternatives.
 
Table 7 provides a conservative case scenario for selling a property to extract equity. Changes in macroeconomic or individual circumstances can increase risks significantly. For many clients, the results presented under the “sell and downsize” and “sell and rent” alternatives will not be satisfactory.
 
Using the same $1,500-a-month supplemental income requirement as described in the financial profile section, the sell-and-downsize and sell-and-rent alternatives are discussed.
 
Sell and downsize. Table 7 illustrates the client downsizing to a $150,000 property. The client would retain $129,750 investment capital after closing costs and sales commissions, and use it to generate the required supplemental income of $1,500 a month. Annuitizing the $129,750 at a 6.5 percent annual rate of return (the standard expected return on a “balanced investment portfolio” used by most financial planners) will allow the client to withdraw $18,000 ($1,500 a month) in yearly supplemental income for ten years. (Due to the wide variation in property tax rates and insurance premiums based on geographical location, the example does not take them into consideration.)

 
Sell and rent. If the client sold the $300,000 property and rented for $1,000 a month, the client would retain $282,000 investment capital used to generate the additional $1,500 a month in supplemental income. Annuitizing the $282,000 at a 6.5 percent annual rate of return will provide $29,991 a year. This will afford the required withdrawals of $30,000 a year ($1,500/month + $1,000 monthly rent) for 15 years.
 
Considerations, such as the interest rate and inflationary environment, rental market conditions, and the client’s ability to capture tax deductions from interest and property taxes, can have a significant impact on the relative cost of renting versus buying. Although this option provides the longest term for receiving additional income, the uncertainties of renting will make it one of the least desirable for many seniors.

Comparative Analysis

The above alternatives illustrate that the client can use the equity in their home to supplement their income for 9 to 15 years depending on the equity extraction strategy they choose. There are important financial considerations related to the interest rate environment, trends in the housing market, and costs that need to be considered. Along with the pure financial considerations, personal preferences related to the willingness and ability to move must be addressed. The main considerations are discussed below.

Time in the Home

Clients who are planning to live in their homes five years or less have little risk of exhausting their HELOC. As shown in Table 4, a $200,000 HELOC at 6 percent will last approximately nine years.
 
For those planning a longer stay, the advisor must determine the client’s ability and willingness to move when the HELOC is exhausted. Even if the monthly cash-flow supplement can be adjusted downward to provide a longer distribution horizon, many newly originated HELOCs carry a maximum maturity of ten years.
 
Older clients placed in the unenviable position of being forced to sell the home to pay off a maturing HELOC may incur significant closing costs and capital gains taxes, along with the stress of moving.
 
The HECM product removes the timing risk of selling in a down market, eliminating the added expenses of the forced sale, along with the emotional stress. The HECM allows the client or heirs the option to plan the home sale without being pressured.

Interest Rate and Credit Environment

The HELOC and HECM variable interest rate structures carry interest rate risk. For both options, rate increases will increase the index and interest expense, exhausting the funds available much earlier than planned.
 
A major difference with the HECM is the “growth” feature as described in Tables 3 and 5. As rates increase, interest expense increases, subtracting from the credit reserve (“Available to Spend”). But the growth component of the HECM will add to the credit reserve. For reserve balances greater than outstanding loan balances, additions to the reserve made possible by the growth component will always be greater than deductions from the reserve due to interest expense.

Trends in the Housing Market

The interest rate environment also dictates the current and future real estate market. Homes are not liquid assets and not guaranteed to increase in value over the short run. The HELOC loan-to-value “cushion” must be large enough to permit the client to repay the maturing HELOC after selling the property, paying commissions, closing costs, and any capital gains taxes. But the significant losses in the residential property market over the last two years, along with lenders restricting customer HELOC withdrawals, are a stark illustration of the risks associated with this option. With the HECM, the non-recourse feature shifts a significant amount of risk to the FHA. The consequences of declining home values are muted for the HECM client.

Ancillary Costs and Fees

Ancillary costs and fees vary widely within the three alternatives. Sales commissions, closing costs, moving expenses, rent, and in some cases capital gains taxes, can carry considerable weight in the decision-making process. In general, the following tenets are true.

• The HELOC is the least expensive alternative, with most lenders providing products with zero up-front costs.
• Selling the home to downsize will generate substantial costs. These include commissions and closing costs associated with the property sale, along with closing costs related to the subsequent purchase.
• Selling the home and renting will free up considerable cash for investment, but this must be tempered with selling costs and future rent outflows. Along with the standard costs associated with the sale, alternative #3 introduces moving expenses and the ancillary disruptions associated with a move.
• HECM products carry high up-front costs. These include up to 5 percent of the loan balance related to closing costs (1 percent), mortgage insurance (2 percent), and broker commissions (2 percent). These are maximum allowable charges dictated by HUD. Broker commissions are negotiable.

The comparative matrix in Table 8 delineates the criteria useful in providing an objective analysis based on the scenarios presented. It presents the relative advantages and disadvantages for each strategy. As shown in the above sample analysis, generating $1,500 in supplemental income can be accomplished in a variety of ways. Table 8 shows that no one strategy emerges as a clear winner for increasing monthly cash flow.

Conclusion

The majority of information on the HECM reverse mortgage has been presented with a focus on educating senior citizens. AARP, the U.S. Department of Housing and Urban Development, the Federal Housing Administration, and the Federal National Mortgage Association have published a significant amount of consumer education and marketing materials. Mortgage lenders have used this generic information to furnish seniors with a general, but incomplete, view of the HECM product. The shortage of detailed analytical presentations currently available to the financial planning community has limited the opportunity of many advisors to fully appraise and explain the HECM reverse mortgage.
 
This article has attempted to describe the HECM reverse mortgage and compare it with the other home equity-based strategies used to increase monthly income.
 
As with the HECM reverse mortgage, all of the home equity-based strategies have inherent costs and benefits that will require a thorough analysis by the financial planner and subjective judgments by the client. These alternative strategies are affected by the many variables associated with credit markets, housing trends, tax considerations, and personal client preference. Choosing among these alternatives requires a thorough understanding of available products and recognition of the client’s role in the decision-making process. As a general rule, choosing among any of these alternatives involves a client needs assessment, risk assessment, and a thoroughly objective financial analysis.
 
It is hoped that this article has helped readers in their evaluation and understanding of the HECM reverse mortgage and its use as a financial planning option.

Endnotes

1. “Reverse Mortgages: Polishing Not Tarnishing the Golden Years,” hearing before the Special Committee on Aging, United States Senate, December 12, 2007.
2. This is a universal formula. Results from Web-based HECM calculators will provide similar results. See AARP at www.aarp.org or National Reverse Mortgage Lenders Association at www.reversemortgage.org.
3. U.S. Federal Reserve Board. Releases and Historical Data—Selected Interest Rates (H.15 Series).
4. National Reverse Mortgage Lenders Association at www.nrmla.org.

Sidebar

HECM Program Information and Requirements

The following list describes important HECM program information regarding eligibility, limitations, requirements, and costs.

• Borrower must be 62 years or older; if married, spouse must also be at least 62.
• Property must be principal residence.
• 1- to 4-unit dwellings and condominiums are eligible.
• Borrower must maintain property and pay all property taxes and insurance.
• Borrower must be free of U.S. tax liens.
• HECM must be the first mortgage on the property.
• Borrower must complete a 20- to 30-minute HUD counseling session, in person or by phone.
• Closing costs include up to 2 percent broker commission on the principal limit (this is negotiable and can be eliminated with adjustments to spread) and all normal closing costs associated with a forward mortgage.
• Closing costs include 2 percent FHA mortgage insurance premium on the maximum claim amount.
• Loan proceeds are considered tax-free.
• Funds for home repairs based on appraisal must be escrowed from loan proceeds and applied toward repairs.
• $20–$35 monthly administrative charge for loan servicing.
• Loan closing package is upward of 35 pages for signature, allowing for many HUD disclosures and safeguards.
• 30- to 45-day period from application to loan closing.
• Borrower(s) must occupy dwelling at least 50 percent of the time.
• HECMs normally require repayment 9 to 12 months after the borrower vacates (death, move, or sale).
• Accumulated interest expense is tax deductible during the year loan is repaid.
• Borrower can have a living trust.