What would you say if I asked you for a loan?
Before you answer let me first warn you by telling you a few facts:
- I’m not planning to make any payments on the loan for as long as I have the money.
- The interest on the loan will be added to the principal so the balance will grow every month.
- I intend to keep the loan outstanding until I either move out of my house or die. Since I don’t know when that will be, I don’t know when the loan will be paid off.
- I want to pay interest similar to what I would expect on a traditional mortgage. (As if I was making payments every month to pay down principal….)
- The loan will be a mortgage against my home. If the amount owed exceeds the value of my house, too bad. You only get what the house is sold for.
I’m pretty sure your answer to this question is:
“Are you nuts? Why would anyone in their right mind agree to a deal like that?”
Guess what, banks feel the same way you do…
They wouldn’t make a loan based on those five factors either if they have to take the risk of not receiving full payment …. and risk is the key word here because banks hate and avoid it.
Enter the FHA.
Banks can be assured that they will get paid fully no matter what happens to the value of the house.
That’s because FHA is insuring the loan.
This insurance is backed by the full faith and credit of the United State Government. This means that means the bank literally has no risk and therefore willing to make the loan.
That’s all really nice you might say…
… but isn’t the FHA insurance premium what makes a reverse mortgage so expensive?
The answer is absolutely not.
In fact – it’s just the opposite.
Let me explain:
FHA protects you from the Risk Premium
It’s important to understand how banks set interest rates on a loan.
Your mortgage interest rate is less than 5% while your credit card interest rate is north of 12%. That’s due to something called a “risk premium.”
It’s much riskier to lend you money to pay for clothing on a credit card than it is to lend against a secured asset like a house. If things get tight you’ll pay the mortgage before the credit card bill.
That risk of default is reflected in the 12%+ interest on the credit card.
Now, you should also know that there are “non FHA” loans available on the market. These are called “proprietary loans” and don’t follow the same restrictions of the FHA HECM loan.
Here’s the Difference:
Unfortunately, because of the lack of FHA insurance they usually have a much higher interest rate. Usually the interest on a proprietary loan is 3% to 4% higher than a HECM loan.
Let me show you how much not paying the FHA insurance premium and instead opting for the higher interest rate really costs:
FHA HCEM Reverse Mortgage vs. Proprietary Reverse Mortgage:
The graphs below demonstrate two scenarios.
The 1st represents a typical FHA insured HECM loan.
This is what a reverse mortgage was designed to do – maintain your equity.
The HECM was designed with the assumption that on average a home would appreciate at a rate of 4% per year. The second assumption is that the interest rate on the loan would not exceed 6%.
As you can see in the 1st graph we look at a home with the following attributes:
- A present home value of $400,000.
- 4% annual appreciation growing the value to $600,000 in 10 years.
- 6% interest rate on the HECM reverse mortgage.
- Taking $250,000 in cash out of the equity.
- Leaving a balance of $150,000 equity left in the home after extracting the loan.
In the 2nd graph we have all of the same assumptions except that since this is a proprietary loan the interest rate has climbed to 9%.
So, with a FHA reverse mortgage, after extracting $250,000 and leaving $150,000 equity in the home, 10 years later there is still about the same amount of equity left due to that relationship between and appreciation and interest rate.
On the other hand, without FHA, we see that the increased interest rate completely consumed all of the remaining equity within that same 10 years.
So in other words eliminating the FHA upfront fee cost this home owner an extra $150,000.
More importantly, it also consumed their remaining equity and left them with nothing to fall back on….
The FHA HECM is safer.
Another statement regarding the FHA HECM reverse mortgage is that “it is safer for seniors.”
We’ll talk more about that in the next installment….