The Mortgage Professor: Borrower decisions on a HECM reverse mortgages

When weighing whether to take out a home equity conversion mortgage (HECM), the reverse mortgage offered through the Federal Housing Administration, there are three key decisions to consider.

The first applies to the draw options - the combination of up-front cash, monthly payment, and credit line that best meets the borrower's needs. Though this is the least challenging of the three decisions - I have addressed it before and won't go into it here, because most borrowers understand their needs better than anyone else - this decision may influence the two others.

The second decision: to select one combination of interest rate and origination fee over other combinations. Borrowers in the forward-mortgage market make similar decisions.

There are no points on HECM reverse mortgages, only origination fees, which are a flat dollar amount. That makes the decision on the best interest rate/fee combination a little easier. On the other hand, the best combination may depend on the borrower's draw options.

To illustrate, I am going to look at a hypothetical 66-year-old with a $300,000 house in two polar situations. In one, the homeowner only wants to draw cash at the closing table using a fixed-rate HECM, while in the other she wants a credit line for possible future use, which is available only with an adjustable-rate HECM.

Wearing her cash-only hat, the homeowner is offered the following two deals on a fixed-rate HECM: an interest rate of 4.50 percent with an origination fee of $3,000, or a rate of 4.99 percent with a fee of minus $1,000. A negative fee means the lender will contribute to the borrower's settlement costs. (These as well as the prices cited below were actual May 16 quotes from the lenders on my website, www.mtgprofessor.com.)

If the homeowner takes the higher rate and negative fee, she can draw $96,700 at the closing table, or $4,000 more than if she took the lower rate.

On the other hand, she will owe more in the future because of the larger loan and the higher rate. After 20 years, for example, she will owe $32,000 more.

Which is the better outcome depends on whether the borrower values the larger initial draw more than the higher future debt. What is important is that the borrower is offered the choice, and information needed to make an intelligent decision.

On my site, lenders offer multiple rate-fee combinations, and our calculator shows the corresponding draw amounts plus future debt over the period selected by the borrower. Off the site, more lenders than not show only a single rate-fee combination, and we have yet to find one that allows borrowers to calculate future debt.

Next, consider the same consumer with a mind-set focused on the future rather than the present, who doesn't want to draw any cash upfront. Her interest is in a credit line that she doesn't expect to use for many years, if ever. Credit lines are available only on adjustable-rate HECMs.

Among the price quotes on a monthly adjustable available to her May 16 from lenders on my site was one from lender A at a start rate of 2.188 percent with an origination fee of $3,500. A second quote, this one from lender C, was at 3.188 percent and $3,750. Choosing between those quotes looks like a no-brainer, since the first quote has both a lower rate and a smaller fee. However, the credit-line feature of the HECM, which has no counterpart in the forward-mortgage market, could invalidate that conclusion.

The interest rate on an adjustable-rate HECM has a dual role: It is used both to determine the future loan balance and the future credit line. Debt and credit line grow at the same rate. If the credit line is not used, after 20 years it will be $396,600 on the 2.188 percent loan, and $483,300 on the 3.188 percent loan. The higher interest rate works to the advantage of a consumer who has decided not to borrow for a long period.

The astute consumer, however, will not take the 3.188 percent loan from lender C, for either of two reasons. The first is that he may well want to begin drawing on his line sooner rather than later, and in that case the higher rate would cost him dearly.

But even if his plans to defer drawing on the line are firm and he wants a higher rate, he won't take it from lender C because C has the highest origination fee. He will take the HECM from lender D who has the lowest origination fee, and ask D to raise the rate. Any lender will be happy to do so on an HECM because a higher rate commands a higher price in the secondary market.

Bottom line, the consumer who is taking a credit line as insurance against the risk of outliving her money should select the lowest origination fee, and request that the rate be increased to match the highest quotes in the market.

The third decision the reverse-mortgage borrower must make is the loan provider. However, most of them see only a single provider, which is why identical transactions with different lenders can carry markedly different prices.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.