Torrey Larsen’s Home Equity Retirement team at Retirement Funding Solutions recently went through the discipline of learning how to calculate the growth on a HECM loan balance, as well as the future value of a HECM line of credit. Encouraged by how illuminating the exercise was, they moved on to determine both term and tenure payments from any given net principal limit.
It wasn’t much of a leap thereafter to calculate the future value of a line of credit, and how that could be expressed as deferred term or tenure payments. In the end, they could even calculate loan balance/LOC for varying rates over the course of a loan.
Many of us fell into reverse mortgage lending and our training was hit-or-miss. For veterans who have survived this volatile business, we have become pretty darn good at explaining the benefits of the HECM. Unfortunately, we don’t always have a deep understanding of exactly how a HECM works. Several times a year I find myself in a heated battle with a loan officer, often someone who has been in the business for a long time, who insists that the HECM line of credit earns interest. This baffles me. It is so easy to compare the HECM growing credit capacity to growth in credit limits on a credit card. How could one miss this? The difference between the two is that the HECM lender has a contractual obligation, established at loan origination, to provide growing access to credit at a rate that cannot be canceled, frozen or reduced. The credit availability growth is not arbitrary, like other forms of credit. More astoundingly, it grows independently of the housing value. What a benefit! In a perfect world, our training would have started with a more developed understanding of the HECM LOC.
A more widespread misunderstanding is how a payment on the HECM loan balance increases the line of credit. In part, this is because we really don’t understand that it is the ongoing principal limit driving the loan balance and line of credit values. For simplicity, let’s assume there are no servicing fee set-asides. In the background, the principal limit is growing at the note rate +1/12 the 1.25 percent MIP. It is doing so because, inherently, the HECM is a negatively amortizing loan. Credit capacity grows every month and is expressed as loan balance, or loan balance plus remaining line of credit. The loan balance and line of credit are subsets of the principal limit. One can clearly see on our amortization schedules that (initial principal limit) – (initial loan balance) = (initial LOC). All three are compounding at the effective rate, right? Now, make a payment to reduce the loan balance, and it must show up, dollar for dollar, in the LOC column in order to maintain the equation above.
What tends to be confusing is the allocation pattern for those payments. Some call it the “waterfall” and it means that the payment is allocated first to MIP, next to servicing fees, then interest, and finally to draws on principal. This order of allocation has nothing to do with the increase in line of credit when a payment is made! In other words, these are two separate issues that we tend to conflate. Every payment against the loan balance (on adjustable loans, of course) does attach to the line of credit. But for tax purposes, the payment will not be counted as an interest payment unless the MIP/servicing fees assessed if any, components of the loan balance have been cleared. The revolving line of credit and the tax deduction applicability of the payment are two completely different issues. This is a pretty crucial distinction when talking with referral partners and discretionary clients, and one our industry needs to overcome once and for all.
Knowing more about how our HECM works has been on my mind after a recent trip to the UK, where I met with the Equity Release Council. Right away, I could see that the HECM offers unprecedented, truly ingenious flexibility: the choice of payments, no payments, partial payments, early full prepayment, deferred payments on the loan balance in addition to early draws, late draws, no draws, pause and resume draws, full draws, revolving credit draws, and term or tenure draws—all at the absolute discretion of the borrower. No special arrangements have to be made at the loan’s outset; the HECM’s versatility is built in. But what surprised me most is the benefit we enjoy due to the private/public partnership with FHA. Because of the MIP, the HECM LTV is more than twice what it is in Britain. Imagine how difficult it would be to sell a HECM that provided less than 25 percent of the home value.
Over the years, we clearly missed the boat on appealing to Middle America while we marketed vigorously to the neediest slice of homeowners. Since Financial Assessment, most of us have made the transition to a more discretionary borrower. Still, it’s pretty obvious that we need to pick up our game in order to provide accurate and complete information on how the HECM works. No one wants to be caught in a financial planner’s office, not knowing how the line of credit grows or how payments on the loan balance work. But there is something else we need to do to make sure that we live up to and benefit from our recent, more positive visibility.
Like me, you have probably enjoyed telling those who think reverse mortgages are scams that the Reverse Mortgage Stabilization Act of 2013 has bolstered consumer safeguards to unprecedented levels. The former product was subject to abuse but has evolved. These safeguards have positively impacted the MMI Fund as well, which is an important contribution to rehabilitating our image with regulators, referral partners and our increasingly sophisticated clientele. We should be basking in the perception that we have cleaned up our act. Imagine my surprise when a potential recruit at an interview confessed that his employer instructed loan officers to hide the fact that a condo needs to go through the FHA approval process until after the appraisal check had cleared!
Curious about what it is like to be a consumer, I sent an inquiry to a large lender. A package of colorful and informative materials arrived in short order. So far, so good. A couple of weeks later an ominous-sounding letter arrived implying that I was missing out if I did not call the enclosed number presently. An even more threatening missive arrived in two weeks, and then another. These came in varying envelopes that did not designate they were from the lender. Finally, the lender sent me a rather opaque email. I guess they wanted to confuse me into responding. I can tell you for sure that the first packet gave me a good feeling, but the following communications reinforced the idea that the reverse mortgage industry is heavy-handed and that it must have a hard time convincing folks if they have to resort to tactics like this.
To gain the most from the new HECM landscape, we need to be scrupulous in making sure that our actions align with the intent of the new regulations. Let’s not squander our chance to make housing wealth an accepted revenue stream in retirement planning. To my way of thinking, this includes pricing loans realistically, not as loss leaders. Some lenders are aggressively marketing $0 UPB no-cost loans as a marketing and recruiting strategy. The cover for this is that the tails will compensate downstream for today’s lost revenue. This may or may not happen, for we know the discretionary borrower is prudent and that even in the past, borrowers have not used HECM lines of credit ruthlessly. Futhermore, when we reached the first Day 366 when lines of credit could be accessed in full, there was no indication that borrowers were eager to cash in on their remaining lines of credit.
There are dangers in habituating planners to a no-cost loan. It is not likely to be a sustainable strategy, as several lenders have privately told me. There is considerable fine print to these offerings involving home values, geography, initial principal limits and margins, not to mention higher borrowing rates, especially if the LIBOR index increases. Face it: Getting caught up in the fine print never gives anyone a good feeling. Likewise for “cheapest.” The whole notion that my competitive advantage is that I am the cheapest not only undercuts the value of what I am selling, but diminishes whatever level of professionalism I am bringing to the transaction. When pricing corrections are eventually made, planners who have been sold on “cheapest” and not the benefit of your expertise and the incredible power of the HECM may desert the whole notion. This actually happened to our industry when the HECM Saver was discontinued. One of the most respected names in financial services dropped reverse mortgages immediately.
Do financial planners work for free? Not on your life. If you have something of value to provide, either in product or knowledge, why give it away? Most planners charge somewhere around 100 basis points every single year on the assets they manage. That’s real money and it is money that is no longer available to compound over time for retirement savings! And unless they are fee-only, they charge commissions on some products they recommend. Why should the lender work at a significant loss in order to get their attention?
Let’s get real here. A product with the flexibility, versatility and safeguards that the HECM provides cannot be given away. Sure, there are fees, but as Mary Beth Franklin of Investment News told one of her readers, “No insurance is free.”
This is a theme that Nobel Laureate and distinguished MIT professor Dr. Robert C. Merton repeated again and again at his keynote address at Oxford University at the JOIM-Oxford-EDHEC conference in September. Every reverse mortgage product around the world is unique because it is a non-recourse contract. For most of history, homes have become a usable asset only at death. And all over the world, most retirees own a house. In fact, nothing new needs to be created to make it an asset, but let’s not apologize that it does cost something to use. Converting it to a “fungible” asset during your life cannot happen for free. Use it while you need it and, if there is any value when you die, your heirs retain that value. Or, live as long as you need in your own beloved home and you are assured that there will be no risk for your heirs.
What contract could be better than that?