The Hidden Value of a Reverse Mortgage Standby Line of Credit
December 9, 2014
by Wade Pfau
Several recent research articles published in the Journal of Financial Planning have investigated how opening a standby line of credit through a reverse mortgage and strategically spending from this line of credit can help improve the sustainability of retirement income strategies. In this article, I show that the benefits of opening a home-equity conversion mortgage (HECM) line of credit extend beyond meeting spending needs.
With the current HECM rules, those living in their homes long enough could reap a large windfall when the line of credit exceeds the home’s value. This potential windfall is amplified by today’s low interest rates. Even if the value of the home declines, the line of credit will continue to grow without regard for the home’s subsequent value.
Combining this with the fact that a HECM is a non-recourse loan means that the HECM provides a very valuable hedging property for home prices.
The home equity conversion mortgage (HECM)
Reverse mortgages have a relatively short history in the United States. The first was offered by a bank in Maine in 1961. In 1989, the federal government systematized reverse mortgages through the Home Equity Conversion Mortgage (HECM) Program under the auspices of HUD. In recent years, HUD frequently updated the administration of the HECM program to help ensure that any problems are corrected and reverse mortgages are used responsibly, and descriptions of the program can become quickly outdated. Most recently in September 2013, the government streamlined the program to offer a single HECM option, eliminating what had previously been two options: the HECM Standard and HECM Saver.
I will summarize how the current HECM program works. For a more detailed explanation of the program, I recommend financial planner Tom Davison’s post, “Reverse Mortgages: How Large Will A Line of Credit Be?” at his Tools for Retirement Planning blog. There are many other great educational resources about reverse mortgages on the Internet, but anything published prior to September 2013 will not be describing the system as it exists today.
The important factors for determining how much credit is available through the HECM include the appraised home value, the age of the younger spouse (for joint owners and one spouse must be at least 62), a lender’s margin (Tom Davison estimates these values are usually between 2.25% and 3%), and the 10-year LIBOR swap rate. Together, the lender’s margin and 10-year swap rate sum to the “expected rate.” This is used with the age of the younger spouse to determine the principal limit factor (PLF), or the percentage of the home’s value that may be borrowed.
If the home’s value exceeds $625,000, the borrowing amount is based on a $625,000 maximum. For homes worth more than this, the potential benefits described below will be more limited, as it will be easier for the home value to keep pace with a relatively more limited line of credit.
When the line of credit is opened, fees include a 0.5% upfront mortgage insurance premium payment (which ensures that the lender will be repaid in whole), origination fees, and other settlement costs. These fees can be paid in cash, or they can be borrowed from the line of credit. These fees do represent the costs associated with this strategy, which, in turn, provide a way to create liquidity for the home value to build a more efficient retirement income strategy and/or to otherwise hedge the home’s value and potentially receive a large payoff later in life.
Once determined through the PLF, the initial line of credit grows automatically at a variable rate equal to the lender’s margin, a 1.25% mortgage insurance premium (MIP) and subsequent values of 1-month LIBOR rates. These LIBOR rates are the only variable part for future growth, as the lender’s margin and MIP are fixed at the beginning. Somewhat counterintuitively, someone seeking to maximize the gains from using the line of credit as a hedge for the home’s value would actually prefer to pay a higher lender margin. This will help the line of credit to grow more rapidly to surpass the value of the home. A key feature of the HECM, again, is that it is a non-recourse loan. No matter how much is borrowed, the amount due cannot exceed the home’s value at the time of repayment.
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