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Guiding borrowers to the right decisions Protecting borrowers from mortgage predators |
In my father‘s generation, very few people still had a
mortgage to pay when they reached retirement age. Now it is
common. But retired homeowners may now have an option my
father did not have: if they have enough equity in their
home, they can pay off the balance of their mortgage with
the proceeds of a HECM reverse mortgage, which does not have
a required payment.
Is converting a standard mortgage into a reverse mortgage a
good idea? The letter below started me thinking about this
question.
“…will I be better off 10 years down the road if I take out
a reverse mortgage in order to pay off the balance on my
standard mortgage? I am paying 3% on that mortgage, and have
been told that reverse mortgages are available at 2.5% or
less. If I did this, I would invest the $2107 I am now
paying monthly for principal and interest. I am 76, the
house I live in is worth $626,000, and my current mortgage
balance is $380,000.”
I decided that whether or not this shift made sense depended
heavily on the objectives of the senior borrower. Broadly,
they fall into two groups.
The author of the letter asks whether transitioning to a
reverse mortgage would make him wealthier after 10 years
than staying with his current mortgage. He is a “wealth
maximizer”, probably because he is looking ahead to sell his
home at some point, or wants to leave as large an estate as
possible.
However, paying off his mortgage with the proceeds of a
reverse mortgage would reduce his wealth.
If he stays with his current mortgage, his $380,000 balance
would be paid down to $218,253 in 10 years. If instead he
pays off the balance now with the proceeds from an
adjustable rate HECM, currently available at 2.154%, in 10
years he will owe $704,343. Investing the monthly payment of
$2107.48 at 1%, which is about the highest super-safe return
that is available today, would generate $218,253 over 10
years. But that still leaves him with $267,837 less wealth
than if he had stayed with the standard mortgage.
Of course, he might earn more than 1% on the monthly
payment, but he would have to earn 6.55% to equalize the two
strategies.
The transition to a reverse mortgage would reduce his wealth
primarily because HECM reverse mortgages require mortgage
insurance. An annual premium of 1.25% raises the interest
cost to 3.404%, bringing the total cost above the 3% he is
now paying. In addition, his HECM loan balance would include
financed settlement costs.
The loss from transitioning would be even higher if this
borrower itemizes his tax deductions, because he would lose
the right to deduct his interest charges. Interest charges
are deductible not when they accrue but when they are paid.
On a HECM, interest ordinarily is not paid until the
borrower dies or moves out of the house.
Another senior of the same age with the identical standard
mortgage, offered the identical HECM reverse mortgage, would
find it advantageous if her objective was to maximize
consumption rather than wealth. By converting to the HECM,
the senior would have an additional $2107 every month to
spend, consisting of the payment on her standard mortgage
which goes away.
Consumption maximizers don’t anticipate selling their home,
and the size of their estate is not important. The potential
for increased consumption outweighs the decline in wealth
resulting from growth of the reverse mortgage balance.
Many seniors are conflicted about whether they are wealth
maximizers or consumption maximizers, which may invite
intrusion by other interested parties. In most cases, their
children will want them to be wealth maximizers who shun the
HECM. Loan officers, in contrast, will want them to be
consumption maximizers because they are selling HECMs.
Seniors should ignore both and decide for themselves who
they are.