Buying a house is an expensive proposition, even when interest rates, both on investments and on mortgages, are at or near to historic lows. Buyers generally have two options. If they have the liquid resources, they can pay cash for the house. But most home buyers do not have, or choose not to deploy, that level of liquid resources. Instead, they leverage other people's money – they take out a mortgage and make monthly payments.
Paying cash means that one foregoes the earnings that the liquid resources might otherwise have generated. Taking out a 30 year mortgage entails paying interest for the privilege of leveraging other people's money, and it imposes a significant cash flow restraint during the lifetime of the mortgage, due to the mandatory monthly payment.
A house is not a liquid asset, and its value at the point that it is sold is determined by market conditions at that time and place, meaning that it is largely out of the homeowner's control.
Determining the foregone earnings that the cash buyer experiences is difficult, as one can only speculate what the earnings opportunities might be 10, 20 or more years from now. A very rough and conservative approximation would be the interest being paid on the 30 year Treasury bonds – 2.43% annually at the moment.
The interest payments on a 30 year mortgage are more easily quantified. A 30 year fixed rate mortgage at 3.5% for $240,000 (80% of the cost of a $300,000 house), if held to maturity, would entail payments totaling $387,973, of which $147,973 would be interest.
Persons 62 years of age and older have a third option – to purchase the home using a down payment and a HECM (Home Equity Conversion Mortgage - the FHA-insured reverse mortgage). The HECM requires a larger down payment than a regular mortgage, but the reverse mortgage does not require any payment of principal and interest while the home is the residence of at least one borrower. The larger down payment does entail foregoing the earnings on the larger quantity of liquid assets than a regular mortgage, but less than an all cash purchase would entail.
Interest accrues on funds borrowed, but does not have to be paid until departure from the house. Whether there is equity in the house at ultimate sale depends on two factors: what the market value of the house is at that time and place; and what the negatively amortizing debt has risen to. If the house has appreciated in value at an average rate greater than the accruing interest and ongoing Mortgage Insurance Premium on the HECM, then the owner's equity is increasing; if not, it is decreasing. Ultimate market value is beyond the control of the homeowner (though he/she can influence it somewhat by maintenance and renovations during occupancy – but those are additional expenses); ultimate debt level depends on how the borrower has managed the HECM. The FHA insurance makes this a non-recourse loan, meaning that if the accrued debt exceeds the market value at the end of the loan, no other assets or persons are obligated to cover the shortfall.
The HECM for Purchase borrower has several decisions to make. The first is whether to select the fixed-rate or the adjustable-rate HECM. (Caveat: reverse mortgages work differently than forward mortgages. In the forward world, a rising interest rate means a higher monthly payment obligation, but in the reverse mortgage world, higher interest rates mean a debt and unused Line of Credit that is rising more rapidly. Thus the ending mortgage debt would be higher, but the residual equity question would still be determined by endpoint market value of the house.)
It is important that the prospective borrower understand how both the fixed-rate and the adjustable-rate HECM work.
The fixed-rate HECM is a closed end loan, requiring disbursement of all available funds at mortgage closing. By analogy, it is similar to a home equity loan. The interest rate is fixed for the life of the loan, and will not change. Partial repayment at any time is possible, but would be similar to prepayment on a forward mortgage – prepayments reduce the ultimate amount of interest charged, but the funds cannot be re-drawn. Prepayments fall into the liquidity trap. In the home equity borrowing market, consumers have more often voted with their feet – in favor of the adjustable rate HELOC.
In the present market, the fixed-rate HECM with an interest rate of 5.06% offers the borrower the largest net (after closing costs) amount. In addition, all HECMs are assessed an ongoing Mortgage Insurance Premium of 1.25% annually on the loan balance. Hence, the fixed-rate loan with no prepayments is negatively amortizing at an annual rate of 6.31%. If the house is located in a market that consistently sees housing appreciation greater than 6.31% per year, the homeowner's equity is increasing; otherwise it is decreasing.
The analogue to the adjustable-rate HECM is the HELOC – the Home Equity Line of Credit. Both are open-ended lines of credit, with the ability to repay the debt and later redraw the funds, thereby avoiding the liquidity trap (the HELOC only during the “Draw Period” - typically about 10 years; the HECM during the lifetime tenancy of at least one borrower).
Both HECMs charge an initial Mortgage Insurance Premium at mortgage closing. This premium is either 0.5% or 2.5% of the appraised value of the house, and is distinct from the ongoing Mortgage Insurance Premium of 1.25% per year on the loan balance, which applies to all HECM loans.
The lower rate applies to draws of 60% or less of the eligible loan amount in the first year of the mortgage; draws above 60% fall into the higher risk category and are charged the 2.5% rate. Since the only funds available on the closed-end, fixed rate HECM must be taken at closing, opting for a draw at or below the 60% threshold, while it reduces the premium by 2%, also substantially reduces the funds available to the mortgagor.
Since the balance of the funds are available on the adjustable rate HECM after the 12 month delay, the HECM for Purchase mortgagor can reduce their closing costs substantially if they so choose, albeit at the cost of needing to increase their down payment. For example, a 62 year old buyer using either the fixed or the adjustable rate HECM to purchase a primary residence could borrow a maximum gross amount of $157,200 in today's interest rate environment. After financing the 2.5% premium and the various associated closing costs of the purchase, that borrower would have an approximate net amount to apply towards the $300,000 purchase price of $144,000 – meaning that they would have to have a down payment of approximately $156,000.
The adjustable rate borrower (but not the fixed rate borrower) would have another option, one which would reduce their initial Mortgage Insurance Premium by $6000 (2% of the $300,000 value). They could opt to only borrow 60% of their eligible amount at closing, or $94,320. Therefore their down payment would be proportionally higher – closer to 71% of the purchase price. The remaining 40% borrowing limit of the HECM, $62,880, would go into their Line of Credit, and would be available 12 months after mortgage closing.
Finally, since the adjustable rate HECM offers benefits from making optional payments, by enhancing liquidity through the increasing Line of Credit and by potential tax deduction of mortgage interest and mortgage insurance premiums, the burrower should consider which lender margin to request. In contrast to the refinance HECM, lender/broker credits for closing costs are not allowed on the HECM for Purchase, but the lender's margin will influence how rapidly the debt and unused Line of Credit will rise. If the borrower could expect to make optional payments, selecting a higher margin will maximize credit line growth and interest , thus offering a higher itemizable deduction, which can also be timed to coincide with periods of higher income, when the deduction would be more valuable.