Home Equity Conversion Mortgages (HECM) are mortgages insured by the U.S. government that were introduced in the 1987 Housing and Community Development Act. The driving force was to allow seniors who have considerable equity in their homes to supplement their incomes by withdrawing a portion of that equity. Since its inception, the Federal Housing Administration (FHA) has insured more than 1.1 million HECM loans with more than $280 billion in originations. As of December 2019, there were slightly more than 580,000 HECM loans associated with more than $156 billion remaining active. The purpose of this document is to illustrate three program risk factors and highlight one particularly key risk factor that will impact the HECM program.
The appraised value of a HECM property establishes the maximum claim amount (MCA), which is the maximum amount the FHA will insure on the property. The percentage of the MCA that the borrower qualifies for is published by the FHA and is referred to as the principal limit factor (PLF). The PLF is based on the age of the youngest borrower and the current expected interest rate (EIR). For example, let’s assume the appraised value of the home is $450,000, the youngest borrower is 72 years of age and the EIR is 3.5%. Using FHA’s PLF calculator, the PLF is 55.5%, therefore the borrower qualifies for a HECM loan of $249,750 ($450,000 x .555).
Given the reliance on the appraised value for establishing the qualified amount, it is imperative the appraised value accurately reflects the true market value of each property insured by the federal government. As reported by FHA in their annual report to Congress in 2018, loans endorsed between 2005 and 2018 had an average overvaluation of 13%. Applying these findings to the hypothetical scenario provided above, the true market value for the property would actually have been $398,230 and the appropriate associated qualifying amount would have been $221,017 ($398,230 x .555). Intuitively, given the size and potential frequency of the HECM property overvaluations, appraisal inflation has caused the Mutual Mortgage Insurance Fund (MMIF) to release substantially more funds than intended over the years. The main driver is due to the underlying collateral not being worth the amount as expected.
As homes age, repair and maintenance become important components of homeownership costs. Repair and routine maintenance are important for maintaining a home’s value and are necessary to ensure the collateral that secures a mortgage loan remains adequate.
On average, HECM borrowers have lived in their homes much longer than other owner occupants but often have fewer financial resources to spend on repair, leading to deterioration in the home. This deterioration reduces the value of the collateral that supports a HECM loan and exposes FHA to a greater risk of loss severity in the event of a claim.
Per the 2017 American Housing Survey, 35% of HECM borrowers moved into their home before 1980, compared with only 10% of all other owner occupants. In addition, HECM borrowers often have quite modest incomes: The median income of borrowers who received a HECM loan in 2018 was $26,000, as reported in Home Mortgage Disclosure Act data collected by the Consumer Financial Protection Bureau. In contrast, the overall U.S. median household income was $61,937 in 2018. Comparing HECM borrowers’ income to their own age cohorts, there was also a large disparity between the two; 84.5% of HECM borrowers had a reported income below the median income of $44,992 for households headed by a person age 65 or older, according to the 2018 American Community Survey.
Property Taxes, Insurance and Homeowners Association Fees
Nonpayment of property taxes and Homeowners Association (HOA) fees can both result in a lien with priority over the HECM, and nonpayment of homeowner’s insurance puts collateral for the loan at risk. Therefore, FHA must ensure that borrowers pay these items on time. If borrowers fail to pay them, the lender must advance funds on the borrowers’ behalf to pay these items.
In the past, FHA experienced an extremely high rate of default on taxes, HOA dues and nonpayment of insurance, causing losses to climb. Many borrowers defaulted on these items after taking a full draw of all funds available leaving no money for the payment of these ongoing expenses. In an effort to remedy this situation and best serve all borrowers with the HECM program, in 2014 FHA implemented the Financial Assessment Guidelines, requiring lenders to assess the borrower’s credit as well as their most recent 24 months’ mortgage payment history and history of paying real estate taxes, insurance and any homeowner’s association dues.
Borrowers with a history of delinquencies of these items can still get a HECM under the 2014 FHA guidelines but FHA does require lenders to hold funds in a Life Expectancy Set Aside (LESA) account to pay for the taxes and insurance but not HOA fees, from the proceeds. This is a benefit to the borrower who no longer has to budget for these items and to FHA because it may reduce HECM program losses. The downside for a borrower is there can be circumstances when a LESA makes the HECM loan no longer feasible; as the amount of the set-aside may consume a significant amount of available HECM proceeds if the amount of the taxes and insurance are high and the borrowers are relatively young. The risk to the FHA insurance fund is that the borrower might outlive the amount in the LESA account and once the funds in the LESA are depleted, the borrower is responsible for paying all property charges, and may be unable to make the payments.
London Interbank Offered Rate
The fourth key factor is the sunset of the London Interbank Offered Rate by the end of 2021. LIBOR is vital to the program because LIBOR-indexed floating-rate loans have been the majority of HECM endorsements for the last decade. According to Reverse Mortgage Daily, as of October 2018, 60% of the overall HECM market was based on the LIBOR which equaled approximately $50 billion. There have been numerous articles speculating its replacement, but this discussion focuses on the Secured Overnight Financing Rate (SOFR), which many financial analysts deem as the likely replacement index. For example, as recently as of February 2020 Fannie Mae and Freddie Mac disclosed they will stop honoring adjustable-rate mortgage loans based on the LIBOR and switch to the SOFR. In the event the FHA decides to use the SOFR as the index for HECM loans, there could be additional strain placed on the FHA’s MMIF because the SOFR has historically been lower than LIBOR.
Specifically, when comparing the one-year SOFR and LIBOR rates since the SOFR’s inception in April 2018, the average difference (LIBOR minus SOFR) in the rates has been approximately 47 basis points., Based on these figures, the new EIR would be 3.03%, the PLF would be approximately 58.8% and the overvaluation qualifying loan amount would be $234,159 for the borrower profiled in the overvaluation example. If this example is indicative of the potential impact on the EIR, the updating of the current HECM portfolio and pricing for future loans will place additional strains on the MMIF’s balance sheet.
As the document has illustrated, there are three significant factors currently impacting the program with a fourth on the horizon due to the ending of the LIBOR. The important issue is that each of these factors have contributed to a negative capital ratio of 9.22% and negative capital of $5.92 billion at the end of fiscal year 2019. As long as the HECM program is operating in the red, the FHA will need to remain focused on addressing the issues that continue to improve the viability of the insurance fund and investigate solutions that will mitigate concerns going forward. Accomplishing these tasks will enable FHA to continue protecting the availability of HECMs as an essential option for retirement financing.
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 The American Housing Survey (AHS) for the U.S. in 2017 reported the median length of ownership for all owner occupants was 13 years. CoreLogic analysis of public records found that the median length of ownership for owners that took out a HECM in 2017 was 18 years; see https://www.corelogic.com/blog/2019/12/hecm-loans-in-2018-borrower-demographics-and-ownership-tenure.aspx . AHS data for 2017 also shows that home improvement spending by homeowners aged 75 or older is less than for younger homeowners.