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Article Excerpt
Federal Housing Administration-insured reverse mortgages, known as Home Equity Conversion Mortgages (HECMs), did not originally have a provision for low-cost refinancing. If a borrower's house value increased faster than expected, the borrower could not tap that additional equity without terminating the first loan and originating a new HECM loan with full closing costs. We test several low-cost refinancing options using a stochastic simulation model that allows interest rates and house prices to vary in historically accurate patterns. Low-cost refinancing decreases the net value of the fund by 54% to $98.5 million, but it remains positive in 80% of the trials.
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The Federal Housing Administration (FHA) runs an insurance program for reverse mortgages called the Home Equity Conversion Mortgage (HECM) Program. Through this program, homeowners aged 62 and above can receive a loan backed by the equity in their homes. Loan payments come from the lender either as regularly scheduled monthly payments or as unscheduled line-of-credit payments by request of the borrower. Repayment occurs when the borrower leaves her home and the house is sold. The FHA insures that the lender makes payments as agreed. When the outstanding balance reaches 98% of the maximum claim amount (the lower of the FHA loan limit and the appraisal), the lender automatically assigns the loan to the FHA for subsequent payments. By ensuring loan payments and covering any excess loan amount beyond the original appraised value, the FHA has virtually eliminated the risk to either borrower or lender. The FHA takes on this risk to help senior homeowners pay for their living expenses and unexpected bills.
Given the uncertainties about loan size, repayment schedule and collateral value, it is not surprising that private lenders have relied on the FHA to provide insurance for these loans. Created in 1987 under the National Housing Act, the HECM Program had very little reverse mortgage data on which to base premiums. Premiums were set at 2% of the maximum claim amount plus an annual premium of 0.5% of the outstanding balance. The maximum claim amount is the lesser of the FHA loan limit and the appraised value at origination. Owners can borrower up to the principal limit that depends on the current interest rate and the age of the borrower. The principal limit increases as the borrower ages because there is less time and less uncertainty until repayment. Repayment and claims do not occur until the borrower leaves her home. (1) This pattern means that premium revenues come long before the claims, so the fund value is very sensitive to interest rates.
House values are initially determined with an appraisal and are assumed to grow at the long-run average. There is no adjustment for changes in property value after origination. With house prices growing at 3 to 4% and outstanding balances growing at 7 to 8%, loan balances will eventually exceed house values. Another key assumption is that loans are likely to terminate at 1.3 times the mortality rate according to the age of the owner (or younger coborrower). The premiums generated from normal or above-normal house price gains must offset the few cases of house price losses or extremely long-lived owners. While this approach ensures financial soundness for the insurance fund, it deprives the owners in rapidly appreciating housing markets from tapping the additional equity in their home. The only option is for those owners to repay the original loan and initiate a new HECM loan with all the upfront expenses. According to No Place Like Home, A Report to Congress on FHA's Home Equity Conversion Mortgage Program (U.S. Department of Housing and Urban Development [HUD] 2000, p. 28), average closing costs are $3,826 plus upfront premium charges of about $2,000 (2% on median house value of $107,000). These large transaction costs create a large hurdle that has essentially blocked refinancing of HECMs.
One way to reduce the hurdle on refinancing is to charge an upfront premium on just the increase in the maximum claim amount, which is the change in appraisal value unless limited by the local FHA loan limits (U.S. HUD 2003). Owners benefit by being able to borrow against the increased equity in their homes. Lenders benefit because they collect interest on larger loans and retain the servicing fee for a longer period. Even the FHA can benefit with larger annual premiums associated with the larger loans. However, those larger outstanding balances mean there is less excess collateral value to cover claims.
This paper measures the impact of low-cost refinancing on the FHA insurance fund for HECMs. The actuarial model is a stochastic simulation model in which interest rates and house prices vary according to historically accurate transition probabilities. A nonstochastic version of the actuarial model estimated fund net assets to be $54 million dropping to $25.5 million when low-cost refinancing was instituted. (2) The stochastic version estimates fund value to be $214.3 million, which decreases about 54% to $98.5 million under low-cost refinancing. In other words, under the current program rules, the present value of premiums net of claims is $214.3 million. A change in rules that allows low-cost refinancing would decrease that net asset value to $98.5 million. Fluctuations in interest rates and house prices provide more opportunities for refinancing as captured in the stochastic models. The number of refinances is much greater in the stochastic model than the nonstochastic model (15,743 vs. 4,238) with the same average interest rate, and the results do depend on the starting interest rate. Stochastic simulations starting at the long-run average interest rate cut the fund value by 64%, from $214.3 million to $77.2 million. With low-cost refinancing and interest rates starting at the long-run average, the fund value drops from $77.2 million to $18.0 million. (3) The simulations starting at the low interest rates predict the impact of refinancing under the current, favorable conditions. The simulations starting at the long-run average rates show what to expect on average. Clearly, refinancing has a big impact on the HECM fund value, but even without the current favorable interest rates, the fund still has a positive value in 62% of the trials. (4) Unless the government is highly risk averse, given the small possibility of large losses, the FHA could reduce the premium for refinancing without jeopardizing the soundness of the insurance fund.
The remainder of the paper is organized as follows. The next section presents more details of the HECM Program especially as it pertains to the actuarial model and relevant literature on reverse mortgages. The third section describes the proposed refinancing options with a focus on medium participation in the most flexible option. The stochastic aspects of the model are presented in the fourth section with a description of how the interest rate and house price paths were parameterized and generated. An analysis of results is contained in the fifth section along with sensitivity testing and an interpretation. The paper concludes with policy ramifications and recommendations for future research.
Details of the HECM Program and Actuarial Model
The typical HECM borrower is a non-Hispanic, white woman, aged 75 and living alone (U.S. HUD 2000, p. 14). About 30% of the borrowers are living with others. Spouses usually inherit the property and continue living in the home, so the age of the younger coborrower is used to estimate loan duration. The median property value at time of application was $107,000 in 1999, which is 23% higher than the median property value reported by elderly homeowners in the 1997 American Housing Survey (AHS). Based on the need for repairs, the general condition of HECM properties is relatively good. Although the building age is 41 years compared to 38 years for the median elderly homeowner, no repairs were needed in more than three-quarters of the HECM originations. For the HECM properties needing repairs, the average cost of repairs is about $666. It is worth noting that we do not have follow-up information on maintenance or house quality after origination. Our assumptions about house price appreciation have been kept conservative to allow for undermaintenance given the extreme age of many HECM borrowers (Quercia 1997).
Demand for reverse mortgage loans, in general, and HECM loans, in particular, has not been large, but it has been increasing. Our database of HECM loans collected from HUD administrative records in August 2001 has 51,992 originations since the program began in 1990. According to recent HUD records, the number of originations could reach 13,000 HECMs in 2002, and the number of HUD-approved lenders has increased from 60 to 191 during that year. The broader reverse mortgage market is probably no more than 100,000. To put this market size in perspective, however, earlier projections were that the market for reverse mortgages would number in the millions (Mayer and Simons 1994, Merrill, Finkel and Kutty 1994, Rasmussen, Megbolugbe and Morgan 1995, Rasmussen, Megbolugbe and Simmons 1996). For example, Rasmussen, Megbolugbe and Simmons estimated the potential demand for reverse mortgages in 1990 at 11.3 million households growing to 16.1 million by 2010. The current low interest rates and high house price appreciation rates make it a highly favorable time for HECMs, but the potential market has yet to be realized.
Several factors may be inhibiting demand, such as lack of publicity and the complexity of reverse mortgage financing. A bigger concern, which pertains to this study, is the high initial cost of a HECM and the subsequent inflexibility to adjust principal limits for above-average gains in house value. In 1999 the typical HECM borrower paid $1,800 in origination fees, $2,100 in mortgage insurance and $1,500 in closing costs or a total of $5,400. In some states (Maryland and South Dakota), the average closing cost alone was above $5,000. Even though these costs can be financed, they reduce the equity available to the owner. Such origination costs are reasonable if the loan is held for a long time and the amount financed is large. Borrowers are reluctant to refinance when that cuts short the original loan and forces them to incur those large transaction costs again. The FHA has limited control over most closing costs and approved an increase to $2,000 in origination fees to stimulate more lender participation. However, the FHA can reduce the upfront premium on the refinance, so the 2% only applies to the increase in maximum claim amount rather than the full maximum claim amount. By reducing the refinancing cost, the FHA can retain borrowers in the HECM Program longer and remove a barrier that may be inhibiting initial demand for HECMs.
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