Stochastic Modeling of Federal Housing Administration Home Equity Conversion Mortgages with Low-Cost Refinancing

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. …