The question arises because the maximum amounts that can be drawn on a HECMÂ are based on the lower of appraised value, sale price and the FHA maximum claim amount, which currently is $636,150. The owner of a million dollar house, or a $10 million dollar house, canâ€™t draw any more funds from a HECM than the owner of a house worth $636,150.Â
If the house securing a HECM reverse mortgage is worth more than the FHA maximum, the borrower is in effect posting excess collateral, reducing the risk of loss to FHA but without reducing the insurance premium paid to FHA. However, this is meaningful to the borrower only in the atypical case where the borrowerâ€™s excess collateral prevents a loss to FHA. In most cases, the equity behind the excess collateral is retained by the borrower or the borrowerâ€™s heirs.Â
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% a year, which is the assumption used by HUD 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.Â
Now consider the case where things donâ€™t go as planned â€” the houses appreciate by only 3% a year instead of 4%. In that case, Jonesâ€™ house value does not cover the HECM loan balance and 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% appreciation. The heirs now get only about $320,000. Smithâ€™s excess collateral has protected FHA at the expense of Smithâ€™s heirs.Â
I donâ€™t know what percent of HECM transactions result in losses for FHA, because the agency does not release that information. My guess would be 2-3%, maybe 5% at the most. If 5% were the right number, it would mean that in 95% 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 reverse mortgage.Â
This conclusion would require modification if the alternative was more attractive.
The alternative to posting excess collateral on a 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% as compared to HECM fixed rates of 4.0-5.1%, though this sizeable difference is partly offset by the absence of mortgage insurance premiums on jumbos.Â
Jumbos are for owners of high-value homes who want to extract more equity from them upfront than is possible with a 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 a HECM.Â
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Direct comments and questions to http://www.mtgprofessor.com.
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