If you own a home worth $1 million, would it ever make sense to take out a reverse mortgage?
The question arises because the maximum amounts that can be drawn on a home equity conversion mortgage â€” the type of reverse mortgage program available through the federal government â€” are based on the lower of appraised value, sale price and the Federal Housing Administration maximum claim amount, which currently is $636,150. The owner of a $1 million house, or a $10 million dollar house, canâ€™t draw any more funds from an HECM than the owner of a house worth $636,150.
If the house securing an HECM is worth more than the FHA maximum, the borrower is in effect posting excess collateral, reducing the risk of loss to the FHA but without reducing the insurance premium paid to the FHA. However, this is meaningful to the borrower only in the atypical case in which the borrowerâ€™s excess collateral prevents a loss to the FHA. In most cases, the equity behind the excess collateral is retained by the borrower or the borrowerâ€™s heirs.
Here is an example. Jones and Smith, both 62, have houses worth $636,150 and $1 million, respectively. Both obtain the maximum monthly tenure payment of $1,854, and both remain alive and well in their homes until they reach age 100. At that point, assuming unchanged interest rates, both will owe about $2,750,000. If both houses appreciate by 4 percent a year, which is the assumption used by the Department of Housing and Urban Development in calculating draw amounts, Jonesâ€™ heirs will receive about $70,000, while Smithsâ€™ heirs will receive about $1.7 million. The excess collateral posted by Smith 38 years earlier grows into a nice windfall for Smithâ€™s heirs.
Now consider the case in which things donâ€™t go as planned: The houses appreciate by only 3 percent a year instead of 4 percent. In that case, Jonesâ€™ house value does not cover the HECM loan balance, and the FHA must absorb an $800,000 loss. In Smithâ€™s case, however, because of the excess collateral at the outset, there is enough equity to cover the loan balance, even with 3 percent appreciation. The heirs now get only about $320,000. Smithâ€™s excess collateral has protected the FHA at the expense of Smithâ€™s heirs.
I donâ€™t know what percent of HECM transactions result in losses for the FHAÂ because the agency does not release that information. My guess would be 2-3 percent, maybe 5 percent at the most. If 5 percent were the right number, it would mean that in 95 percent of the cases, posting excess collateral is costless for the borrower. Bottom line, having a home worth more than the FHA maximum claim amount is not a good reason to avoid taking a HECM.
This conclusion would require modification if the alternative was more attractive.
The alternative to posting excess collateral on an HECM is to take a jumbo reverse mortgage, which is not subject to a legal maximum claim amount. However, jumbos are currently available only in 13 states and are fixed-rate only. Because there are no adjustable rate jumbos, owners can draw cash only at closing. There are no monthly payment options or credit lines. The rate on jumbos right now is 7.75 percent as compared to HECM fixed rates of 4.0-5.1 percent, though this sizeable difference is partly offset by the absence of mortgage insurance premiums on jumbos.
Jumbos are for owners of high-value homes who want to extract more equity from them up front than is possible with an HECM, possibly to pay off a large existing loan balance. For example, a borrower who owes $1 million on a $5 million home can pay it off with a jumbo if the property is in California, Florida or 11 other states, but there is no way to pay it off with an HECM.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
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