The What, How, & Why of the HECM (Reverse Mortgage)

retired black coupleMany seniors struggle to make ends meet each month. At the same time, they often own thousands of dollars of real estate in the form of equity in their home. But unless they take action, that equity remains untouchable, unable to help them out with basic living expense. What’s worse is that mortgage payments further reduce their available cash each month to pay crucial expenses.
A Henry J. Kaiser Family Foundation report states that more than three of four seniors over the age of 65 have equity in their homes ranging from $67,700 to $325,200. One in 20 have home equity greater than $398,500, and 1% have more than $799,850.
And yet almost half of elderly Americans depend upon Social Security for at least one-half or more of their income, while one of eight depend solely on Social Security. But many of these seniors have home equity that could be converted into cash income.
If you or your parents are “house-rich” but cash-poor, it is time to consider whether a reverse mortgage on the family home is a better alternative to traditional avenues of converting home equity into a cash asset.

Traditional Methods to Convert Home Equity Into Cash

For seniors who anticipate and desire to live in their current residence for the foreseeable future, there are a few traditional ways (not including the reverse mortgage) to convert home equity into cash:

Home Equity Loans

A home equity loan is essentially a loan extended to the homeowner secured by the lender’s receipt of a second mortgage lien on the real estate. The underlying loan may be as high as a 100% of the owner’s equity, depending upon the lender’s criteria, the credit rating of the borrower, and the negotiated repayment terms. For example, a homeowner with equity can usually borrow a lump sum equal to an amount between 80% and 100% of the equity.

Home Equity Line of Credit

A home equity line of credit (HELOC) is a line of revolving credit in an amount up to the equity value, usually with an adjustable interest rate, so payment amounts vary from month to month. Like other personal loans, the terms of the loan and the amount of credit that may be available is subject to negotiation between borrower and lender.

Cash Out Mortgage Refinancing

As interest rates move lower and/or their equity grows, many homeowners refinance so they can reduce the interest rate on the underlying loan and subsequently reduce their monthly payments or convert a portion of their equity into cash. For example, say a homeowner bought a new home in 2000 for $312,000. The 30-year, 6% fixed rate loan requires a monthly payment of $1,824.40. Today, the home has an appraised value of $350,000 and interest rates have fallen to 3.5%. The owner subsequently refinances the home at a 3.5% rate for 30 years with a monthly payment of $1,582.85. As a consequence of the refinancing, the homeowner pays off the initial mortgage, reduced his payment by over $240, and is able to pull out $30,000 of cash from built-up equity.
Though these methods are a means to access locked equity, they all share a host of disadvantages:

Continued Exposure to Real Estate Declines

Since the lender has “full-recourse” to the property owner if the mortgage loan is not repaid, the homeowner is liable if the proceeds of the sale of the property are less than the outstanding mortgage. Real estate with a value less than the mortgage is considered to be “underwater,” a condition in which many homeowners found themselves following the mortgage securities crisis of 2008-2009.

Payments Required for Term of New Mortgage

The homeowner refinancing his home in our example had made almost 14 years of the 30 years of payments. The refinancing – with a new loan – restarts the clock for another 30-year term, essentially adding 14 years of payments to the old due date. Retired seniors may lack sufficient income to comfortably make payments after retiring.

Delinquent Mortgage Payments Trigger Foreclosure by Lender

The legal obligation to make payments to the lender exists for the loan term. Failure to make payment can result in foreclosure and sale of the property. If the mortgage is underwater, the seniors not only lose their home, but must make up the difference between sale proceeds and the outstanding mortgage loan.
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