FHA insured reverse mortgages, called HECMs, allow seniors to withdraw cash from their home while retaining the right to live there indefinitely. They are a potentially powerful tool for helping seniors live better lives during their retirement years. However, the benefits can also be frittered away, with little lasting benefit to the senior, and all too many seniors are doing just that.
The Lure of Cash Upfront
A large segment of HECM borrowers withdraw the maximum amount of cash possible at closing, which leaves them with no borrowing power for the future. While some seniors have compelling reasons for withdrawing the maximum amount of cash at the outset, many make a mistake in leaving nothing for the future.
Late in 2013, HUD changed the rules to limit upfront cash draws, because they viewed cash-draw HECMs as a source of loss to the insurance reserve fund. Borrowers who took maximum cash at the outset frequently forgot to pay their property taxes or their home insurance policies. Under the revised rules, borrowers could draw 60% of their available total at the outset and the remainder after one year. But this constituted a minor inconvenience to cash-hungry borrowers.
HUD Guidance Doesn’t Help
HUD provides no guidance to borrowers on how cash draws are used, with one exception: it warns them about the hazards of using their cash withdrawal to purchase an annuity. The irony of this is that an annuity purchase is the only sure method of converting cash draws at origination into a flow of income over the borrower’s lifetime. An incidental effect would be a marked reduction in defaults that generate losses to the insurance reserve fund.
The Lure of Fixed Interest Rates
The lure of cash upfront is enhanced by the lure of fixed interest rates. Most senior homeowners had one or more forward mortgages during their life, from which experience many emerged with a bias against ARMs. They may not have had one, but they heard about them and knew that they were risky. So when offered a choice of fixed or adjustable rate HECMs, they opt for the fixed, which requires that the full value of the HECM be taken in cash.
But this bias against HECM ARMs is misconceived. On forward mortgages, borrowers are exposed to the risk that a future interest rate increase will make the monthly payment unaffordable. On a HECM, however, there is no such risk because borrowers have no required monthly mortgage payment. Indeed, seniors who reserve all or part of their HECM borrowing power as an unused credit line, benefit from an ARM rate increase because the line grows at that rate.
Lender Incentives Reinforce Borrower Bias
Lenders earn revenue from origination fees paid by borrowers, and yield-spread premiums paid by the wholesalers to whom the originators sell the HECMs.
HUD limits the origination fees that borrowers can be charged to 2% of the first $200,000 of property value, plus 1% of the amount above $200,000 but with a cap of $6,000.
Yield spread premiums, which are set by the market, are based on the loan amount. While premiums vary from day to day, on a $400,000 home owned by a senior of 72, the orders of magnitude are about as follows:
*$20,000 if the borrower draws maximum cash on a fixed-rate mortgage.
*$13,000 if the borrower draws maximum cash on an adjustable rate mortgage.
*$600 if the borrower elects an option on which the initial loan consists only of the financed settlement costs. These options are credit line, term payments, and tenure payments.
Borrower bias against ARMs combined with lender financial interest in maximum cash withdrawals make for a perfect marriage. But not one made in heaven.
HECMs Are Complicated
Underlying the mistakes that seniors make is the complexity of HECMs and the fact that few seniors understand them. While there is no way to make HECMs simpler, or to raise the IQs of senior borrowers, the likelihood of bad decisions can be reduced by improving the quality of advice that they receive, and the quality of the information to which they have access. I have attempted to play a role in that effort.
Information Available to Borrowers
While HECMs are complicated, we live in an information age replete with sophisticated tools for expositing complicated ideas. Lucid exposition of the full implications of each possible course of action can overcome a borrower’s preconceived bias and the entreaties of interested loan originators.
For the most part, however, the tools available to HECM borrowers are a sorry lot. The existing calculators focus entirely on how much the borrower can draw, without any supporting information on the future consequences of a given selection. So I decided to develop my own. See Calculate Your HECM Reverse Mortgage Options.
Counselors Don’t Help Much
Every HECM borrower must be counseled by a HUD-approved HECM counselor, but the ability of counselors to prevent borrowers from making serious mistakes is quite limited. The major problem is that the counseling process views HECMs as a stand-alone instrument rather than as part of an integrated retirement plan.
Even if counselors were financial planners qualified to advise seniors on how a HECM can fit into a retirement plan, which most are not, HUD rules discourage this approach. While selecting the right HECM option is essential to developing a retirement plan that best meets borrower needs, counselors are told not to recommend one HECM option over another.
Concluding Comment on the Unserved HECM Market
The existing HECM market is dominated by seniors who have pressing and immediate financial problems. Their numbers are small relative to the millions of seniors who do not have pressing problems, but whose lives might nonetheless be improved with a HECM.
This much larger group of seniors are not aware of what a HECM might do for them. Their information is likely to be limited to what they have heard in advertisements or solicitations, to which they understandably react with caution and suspicion. While there are places they can go to obtain unbiased information, including my site, most are not aware of such resources, many don’t use the internet, and they are not being driven by financial need to take any action. They represent a potential market of enormous size that is not being served.
The solution will emerge this year. It is called the Retirement Funds Integrator (RFI) and it will be offered widely. Stay tuned.