29 October 2013
by Jack Guttentag
Last month, the Federal Housing Administration announced a series of sweeping changes in its reverse mortgage program, most of which have already taken effect. The changes are a response to increasing losses suffered by the FHA in connection with the extensive misuse of the program. A disproportionate number of borrowers were drawing as much cash upfront as they could—100 percent of the principal limit, which is what the FHA calls the senior’s total borrowing power. This left them no scope for further draws in the future.
The home equity conversion mortgage, or HECM, program was originally intended to help senior homeowners remain in their homes indefinitely, not to meet short-run financial needs. Borrowers who cashed out early, furthermore, had less incentive to stay current on their property taxes and insurance, which increased losses to the FHA.
Several years ago, the FHA had tried to encourage seniors to take a longer view by creating the saver program as an alternative to the standard program. The saver program offered a sharp reduction in the upfront mortgage insurance program to seniors willing to accept a smaller principal limit. The combination of reduced upfront charges and smaller draws resulted in slower growth of future debt on saver HECMs. But the prospect of slower debt growth proved no match for the appeal of cash-in-hand, and the saver program never attracted many seniors.
Under the new rules, borrowers can no longer draw 100 percent of the principal limit unless the draws are used to comply with FHA mandates. Mandatory draws include paying off all liens on the property, including the senior’s existing mortgage if there is one; all settlement costs; and any repairs needed to meet FHA property requirements. Cash draws within the first year for other than mandated purposes — I call these “pocket draws” — are limited to 60 percent of the principal limit less mandatory draws, or to 10 percent of the principal limit, whichever is greater. The dual mortgage insurance premium feature has been retained, but now it is based on whether or not total cash draws in the first year are above or below 60 percent of the principal limit.
It has always been the case that borrowers selecting fixed-rate HECMs had to draw cash at closing; they could not defer cash draws. This did not discourage use of fixed-rate HECMs so long as borrowers could draw 100 percent of their principal limit upfront, and virtually all those who drew maximum cash used fixed-rate HECMs. But under the new rules limiting pocket draws, the only seniors likely to opt for a fixed-rate HECM are those with large existing mortgage balances. The total of mortgage loan balances, other mandated draws and pocket draws up to 10 percent can be 100 percent of principal limit.
On adjustable-rate HECMs, a borrower is now subject to the new limits on cash draws at closing, but after a year they can draw the remainder of their principal limits. FHA seems to be assuming that the most cash-hungry borrowers will be deterred by having to go with an adjustable rate, and/or having to wait a year for a second helping. I have my doubts about that. If the only change is to shift a chunk of the cash withdrawals forward a year, expect FHA to come back in a few years with more draconian restrictions.
Because the rule changes were designed to reduce FHA’s losses, and the agency’s announcement of the changes also said that principal limits were being changed, everyone (including me) assumed that they had being reduced. To see how much they had been reduced, I compared the new limits with the old ones and discovered to my surprise that the new ones were higher. On adjustable-rate HECMs, seniors can now draw more than they could before; they just can’t draw it all in the first year.
The bad news is that the HECM program is now even more complicated than it was. While it is not clear whether or not the new rules will succeed in discouraging early cash draws, it is very clear that these rules have made it more difficult for seniors to sort out their cash draw and options for mortgage insurance, or MI. Here are some illustrations:
—If mandatory draws are 10 percent of the principal limit, pocket draws can be up to 50 percent. MI is 0.5 percent.
—If mandatory draws are 50 percent of the principal limit, pocket draws can be up to 10 percent. MI is 0.5 percent.
—If mandatory draws are 55 percent of the principal limit, pocket draws can be up to 5 percent with MI of 0.5 percent, or up to 10 percent with 2.5 percent MI. The borrower has a choice.
—If mandatory draws are 61 percent of the principal limit, pocket draws can be up to 10 percent. MI is 2.5 percent.
If this makes your head spin, never mind. I had to master it in order to reprogram the HECM calculator on my website, but you don’t, and neither do seniors contemplating a HECM. What should matter to them is what their unique options are, and they can find that on my website, http://www.mtgprofessor.com/
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.