Age matters when taking out HECM credit line

How, when and why to take a reverse mortgage

By Inman News Feed
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How, when and why to take a reverse mortgage

Jack Guttentag
Inman News®

Editor's note: This is the fourth in a multipart series. Read Part 1, Part 2 and Part 3.

One of the valuable features of the Home Equity Conversion Mortgage (HECM) is the multiple options for cashing out equity in the house. Borrowers can take cash, a credit line that grows in size if it is not used, a tenure annuity that pays a monthly stipend for as long as the senior lives in the house, and term annuities that pay a monthly stipend for a period selected by the senior. These options allow HECMs to be used for a variety of purposes, some of which were discussed last week. Some more are considered here.

Invest to generate income

With few exceptions, using a HECM to finance investments is a bad idea. The cost of funds is the HECM interest rate plus the FHA mortgage insurance premium. In August 2012, this was over 5 percent. To make money, the senior has to earn a return on investment above the cost, which in today's market is generally not possible except by purchasing financial assets that carry substantial default risk.

One exception could be the senior who has a thriving business with great promise that needs additional funding. If I had such a business and if it came down to using a HECM to keep it afloat or letting it die, I would probably use the HECM. But few seniors have thriving businesses.

Another exception would be the senior who has very high-cost debt, on credit cards for example. Paying off a credit card balance on which the senior is paying 20 percent is an investment yielding 20 percent, or well above the HECM cost.

If a senior is determined to use the HECM to finance the purchase of financial assets, he should use the fixed-rate version. Using the adjustable-rate version, the senior would be assuming interest rate risk on top of default risk, because the ARM rate adjusts monthly and could balloon in a very short period.

Use a credit line to meet unanticipated or special occasion cash needs

Many seniors have retirement income that covers their basic recurring expenses, but not much more. When an appliance unexpectedly breaks that costs money to fix or a special occasion arises that costs money to celebrate, they can't cope. A HECM credit line is an excellent way to meet such contingencies.

A HECM credit line can be drawn on at any time to meet unanticipated expenses, or for special occasions such as a wedding or a trip abroad. Credit lines are available only on adjustable-rate HECMs; on fixed-rate HECMs seniors can draw cash only.

Seniors selecting the credit line option should have sufficient discipline to avoid drawing on the line impulsively, which could use it up in a short period. Those who don't trust themselves should select a monthly payment option.

For those who take a credit line, forbearance is rewarded by continual growth in the unused portion of the line at the interest rate on the mortgage plus the FHA's 1.25 percent annual mortgage insurance premium. At current rates, the line will grow about 5 percent a year. Some prudent seniors have adopted the policy of drawing on the growth in the line each year for "luxury" items, leaving the original line intact for emergencies.

In today's market, I advise seniors to take a credit line ASAP, which is when they reach 62 and become eligible. Their line will then begin growing at about 5 percent a year. When interest rates rise, the growth rate will automatically increase.

If the senior waits instead, the initial line he can draw will rise over time because he is getting older and his house value may be rising. However, growing older increases his line by only about 1 percent a year, which means that the senior's house value has to rise by 4 percent a year to match the growth in an unused credit line. But few houses today are appreciating at 4 percent a year. For most seniors, HECM borrowing power will increase more rapidly by taking out a credit line as soon as they can -- as opposed to waiting to grow older.

Next week: using a HECM to strengthen retirement plans.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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