Deciding when to take a reverse mortgage

A prospective home buyer who needs a mortgage to make the purchase is under the gun to have it approved and fully processed before the sale date.

By contrast, a senior homeowner contemplating a reverse mortgage has no deadline to meet and can be as deliberate and careful as he or she wants.

Having the opportunity to consider all options without feeling pressured is a good thing. But it can be a bad thing if the conditions that affect the terms of the reverse mortgage for which a senior qualifies change in an unfavorable way during deliberation.

The purpose of this article is to indicate the kinds of changes that can affect the reverse mortgage available to prospective borrowers who wait for a while before taking the plunge. A rational decision to proceed or to wait should be based on a clear understanding of these factors.

My test case is a homeowner of 62, the minimum age for reverse-mortgage eligibility, with a home worth $200,000 and no existing mortgage. On April 4, she could have obtained a credit line of $99,420, a monthly payment of $551 for as long as she lives in the house, or a payment of $1,098 for 10 years.

If she waits for, say, three years, three things will change.

She will grow older. We know this with complete certainty. We also know that if everything else stays the same, her credit line and monthly payment draws will be larger. For example, her credit line will increase to $103,020, or by 3.6 percent. If her existing needs are not pressing, that supports a decision to wait.

Her house may appreciate. Most homes appreciate in value most of the time, but not all the time. In modeling the market for its reverse mortgage (also known as a home-equity conversion mortgage, or HECM), the Federal Housing Administration assumes that home prices on balance will appreciate by 4 percent a year.

Using that assumption over a three-year wait, the homeowner's credit line will grow to $116,312, or by 17 percent. This reflects the combined effect of the borrower being three years older and her property appreciating by 4 percent a year over three years. Monthly payment increases would be similar. Although she cannot be as certain that her house will appreciate as she is that she will be older, in most cases the prospect of appreciation strengthens a decision to wait before taking out a reverse mortgage.

My surmise is that many seniors intuitively understand that delaying a decision on a reverse mortgage will work to their advantage. What they are less likely to understand is that a rise in interest rates can torpedo their plans, while there is no possibility a fall will benefit them.

The potential spoiler. To summarize, a starting credit line of $99,420 for a person age 62 with a $200,000 house would increase to $116,312 by waiting three years, during which period the house appreciated by 4 percent a year. These credit lines were based on an adjustable-rate mortgage with a start rate of 5 percent, assumed to be unchanged over the three years. Now, let's consider the implications of a change in rates.

They are grim: Interest-rate increases will have a large negative impact. If the rate goes from 5 percent to 6 percent, the credit line drops to $94,715, or by 18.6 percent, wiping out the favorable impact of the borrower's greater age and property appreciation. If the rate goes to 7 percent, the decline will be 36.8 percent. If the rate goes to 8 percent, it will be 51.4 percent.

These are not unusual rates. I have had two mortgages in my life, one at 6 percent, the other at 8 percent, and I lived through an episode where rates hit 17 percent.

In today's market, furthermore, the exposure of potential reverse-mortgage borrowers to interest rates is completely asymmetrical. A decline in rates below 5 percent will have zero impact on the draw amounts available to borrowers.

As the insurer of all HECM reverse mortgages, HUD determines draw amounts and has set maximums at a rate of 5 percent. Future reverse-mortgage borrowers will not benefit from a drop in rates, but they will lose big from an increase.

Bottom line. It might be prudent for seniors on the fence about a reverse mortgage to engage in watchful waiting. But for those who are sure, procrastination could cost them dearly.

Jack Guttentag is professor emeritus of finance at the Wharton School. http://www.mtgprofessor.com.