Many elderly homeowners are house rich but income poor. That is the plight of the widow who wrote me in 2001.

"I am a recently-widowed 54-yar old with a house worth $1.1 million, a high-rate mortgage of $450,000, but not much income. I can only afford to pay $2,000 a month on principal and interest, plus taxes and insurance.  I am prepared to use up my equity of $650,000 to stay in the house, but don’t know how to do it.  A mortgage broker suggested two options.  One is to refinance into a monthly negative amortization ARM that has a payment I can afford. The other is to borrow more than $450,000 on a fixed-rate mortgage and invest the difference to supplement my income. The broker didn’t know which was better and suggested I ask you." 

The Option ARM Is a Poor Remedy

Your broker is considering an option ARM as a remedy to your problem. See Tutorial on Option ARMs. Based on information provided by your broker, the payment on this ARM is $1885 for the first year, which is why she thought it might be suitable for you.  This payment, however, doesn’t cover the interest in the first year, which results in negative amortization; the balance grows over time before it begins to decline.  As a result the payment must also rise.

If market interest rates are stable, the payment on this ARM will rise by 7.5% in month 13 to $2026, in month 25 to $2178, in month 37 to $2342, and in month 49 to $2517.  In month 61, it will jump to $3295 because of a recast provision that requires that the payment at that point be “fully amortizing” -- meaning that it will pay off the loan over the remaining term.  If interest rates rise in future years, the payment increases beginning in year 4 would be even larger. 

This ARM is for people who can expect rising incomes in future years.  In your case, the payment will become unaffordable within a few years.  Even if you can meet the 7.5% payment increases, larger increases will kick in somewhere between the 4th and 6th year, depending on what happens to market interest rates.  At that point, you will be forced to refinance and start the process again. 

In any case, the financial crisis killed option ARMs , and it is doubtful that we will ever see them again.

A Cash-Out Refinance Would Work Better

An alternative is to borrow $800,000 on a 30-year fixed-rate mortgage, investing the $350,000 cash taken out to supplement your income.  Assuming a rate of 6.625%, your mortgage payment would be $5122, or $3122 more than you can afford.  This is the amount you would have to withdraw each month from your investment fund.  If you earn 3% on the investment, your fund would last for about 11 years. 

At that point, the balance on your mortgage will be paid down to $665,000, so you will still have substantial equity.  And since you will be 65 years old, you can take out a reverse mortgage, which is a much more efficient way of living off the equity in your home.

Impact of the Financial Crisis

Flashing forward to 2010, the cash-out refinance described above would no longer be possible because the payment is too high relative to the borrower’s income -- it is not “affordable”. Because of the abuses committed during the housing bubble, when many houses were sold to people who couldn‘t afford them, underwriting affordability rules have become extremely rigid. No allowance is made for the situation where the borrower is already in the house and can’t afford the payment, and the purpose of the refinance is to allow her to remain in the house for years longer. Applying an affordability rule in this situation is ridiculous.

The homeowner who was 54 in 2001 was 62 in 2009, and therefore eligible for a reverse mortgage. Unfortunately, the financial crisis had caused all the private reverse mortgage programs to shut down, and the loan ceiling on the FHA program, although higher than it had been, was not high enough to help her. See Impact of the Financial Crisis on Reverse Mortgages.

Designing a New Instrument For House-Rich/Income Poor Homeowners

The fact is that we don’t really have a good instrument for house-rich but income-poor people under 62.  Increasing the balance on your mortgage to create an investment fund is inefficient because the mortgage rate you must pay on this money is much higher than the investment rate you will receive. There should be better ways to do it.

As one possibility, the lender making a 30-year loan at 6.625% could accept a payment of $2,000 a month for the life of the mortgage.  Over the 30-years, the balance would grow at an annual rate of 2.67%, reaching $999,000 at term.  This loan would have minimal default risk to the lender, since the balance at term would be below current property value, never mind the appreciation that is bound to occur over 30 years. 

Lenders wouldn’t make this loan, however, because of the high interest rate risk.  If market rates rise, the lender doesn’t get back any money at all to reinvest at the higher rate.  On the contrary, the lender must keep advancing new money to cover the difference between the payment and the interest. 

This risk to the lender could be sharply reduced by converting the instrument into a 7-year balloon.  Since the balance would be due after 7 years, the rate would be reset at the market at that point.  While 7-year balloons exist now, they all calculate payments that would fully amortize over 30 years.  A negative amortization balloon loan would be a new instrument, available only to borrowers who have very substantial equity.  This would be a nice niche product for an enterprising lender.