Ginny… will retire shortly and still owe $67,000 at 6 percent on my mortgage, which I have not been able to refinance because I can’t document enough income … the mortgage still has 10 years to go, and the payment is $744. My house is worth $250,000 and I have savings of $300,000, which earn about 2 percent taxable income. Should I pay off the mortgage, let things ride, or is there another option?” Chloe C, Santa Fe, NM
Chloe…You actually have three options:
1. Let things ride.
2. Pay off the balance out of savings.
3. Pay off the balance with a HECM reverse mortgage. (HECM stands for home equity conversion mortgage.)
And you might have a fourth option at some point, as I’ll indicate below.
Option 2, liquidating $67,000 of assets to pay off the mortgage balance, is clearly better than option 1 because the mortgage is costing you substantially more than you are earning on your savings. If you keep the mortgage in force and pay the $744 from your savings, in 10 years at 2 percent you will be left with $267,638.
If you pay off the mortgage now, in 10 years your savings will be $284,539. The earnings rate on your savings would have to rise above 6 percent within the next few years, which is not very likely, to change the conclusion that paying off the mortgage now is better than retaining it.
Option 3 is to pay off the mortgage with an adjustable-rate HECM reverse mortgage, taking the balance of your HECM borrowing power as a credit line. On Nov. 15, 2012, you could have obtained a HECM ARM at 2.46 percent, plus the FHA mortgage insurance premium of 1.25 percent. You will also incur upfront charges of about $10,000 that are added to your HECM loan balance.
Under option 3, your mortgage debt rises over time, but unlike your current mortgage debt, which must be repaid on schedule, HECM mortgage debt need not be repaid so long as you live in the house. In addition, you have a credit line that grows over time and can be drawn on to increase your spendable funds.
Your debt and credit line increase at the same rate. Assuming continuation of the current interest rate, your initial debt of $77,000 will reach $111,500 after 10 years, while your initial credit line of $82,250 will grow to $119,100. While interest rates on ARMs will probably rise at some point during the next 10 years, the impact on your debt and your unused credit line will be the same. If you don’t draw on the line during that period, it will be larger than your debt no matter what happens to interest rates.
The bottom line is that option 3 gives you more spendable funds than options 1 or 2, but leaves you with a smaller estate if you stay in the house until you die, or with less proceeds from sale of the house if you move out permanently. If you attach a higher priority to leaving a debt-free house to your estate than to having more spendable funds, forget the HECM and pay off the mortgage by liquidating financial assets.
The fourth option is to pay off your current balance with a fixed-rate HECM, currently available at 4 percent plus 1.25 percent for mortgage insurance, and take the balance of your borrowing power as a credit line with an adjustable-rate HECM. This option freezes the rate applied to your debt but allows the rate applied to your credit line to increase over time as market rates increase.
Unfortunately, option 4 is not available at this time. Under existing rules, HECM borrowers who select a fixed rate must borrow the maximum amount available to them; they cannot limit the fixed rate to the amount needed to repay their existing mortgage. In your case, after paying off your existing mortgage, you would be obliged to take another $87,250 in cash, paying 6 percent on it in order to invest it at 2 percent. I don’t recommend that.
I can’t think of a valid rationale for this rule, and hopefully FHA will be fixing it soon.