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A Mortgage Muddle for Homeowners With Lots of Equity but Little Income

By Jack Guttentag
Saturday, March 7, 2009

A common problem among older homeowners is that they no longer have the income to service their mortgage and don't have a good way to convert the substantial equity in their house into cash flow. The case below is typical.

Q: I am a 67-year-old widow with a mortgage of $414,000 on a house valued at $1.25 million. I can no longer afford the mortgage payment and property taxes, but the lender will not discuss modifying my loan contract until I am behind by three payments. I don't want to destroy my credit, so I have been borrowing from family to stay current. Is there anything else I can do?

A: Assuming that you want to remain in the house, a reverse mortgage is the best solution. It would allow you to convert the existing mortgage with its accompanying payment obligation into a loan back to a bank, in which you receive the money.

Unfortunately, the loan limit on the Federal Housing Administration's Home Equity Conversion Mortgage is not high enough to help you, and the private programs with higher loan limits have essentially shut down because of the financial crisis.

In a similar case some years ago, I recommended that the borrower do a cash-out refinance, invest the cash in a mutual fund and draw cash out monthly to make the mortgage payment. That would work in this case, too.

For example, if you borrowed $800,000, the cash of $386,000 would cover the payment for at least seven years.

The trouble is that this loan would not meet current underwriting rules because the payment is too high relative to the your income -- it is not "affordable." Because of the abuses committed during the housing bubble, when many houses were sold to people who couldn't afford them, underwriting affordability rules have become extremely rigid.

No allowance is made for a situation in which the borrower is already in the house and can't afford the payment, and the purpose of the refinance is to allow her to remain in the house for years longer. Applying an affordability rule in this situation is ridiculous.

Still another possible solution is for the lender to simply drop the payment to a level that is affordable, adding the unpaid interest to the balance, for a specified number of years. Because you have so much equity, the risk of loss to the lender is negligible.

The trouble with this is that it constitutes a modification of the loan contract, and in all probability it will not be considered until the borrower is in default.

In sum, the elderly borrower with little income but a lot of equity is poorly served by our housing finance system.

Take a Chance With a Credit Line?

Among those who have benefited unexpectedly from the financial crisis are those with home equity lines of credit. Credit line rates are based on the prime rate, plus or minus a margin. The prime rate is currently 3.25 percent, the lowest it has been since 1955.

A reader with a line of credit who wrote me recently had a margin of minus 0.75 percent, which made her rate 2.5 percent. Her first mortgage had a rate of 6.5 percent, and her credit-line lender offered to increase her line by enough to pay off the first mortgage. The prospect of converting a 6.5 percent loan into a 2.5 percent loan was indeed enticing.

Nonetheless, I advised against it. That's because she did not expect to pay off the loan for 15 years, and over that long a time, the risk is too high.

The prime rate is extremely volatile. In 1980, it jumped from 13.5 percent to 21.5 percent in two months. This was an unusual episode, but unusual episodes are becoming common these days.

Furthermore, home equity credit lines offer borrowers no protections against rising market rates. On conventional adjustable-rate mortgages, the rate does not change until a specified rate adjustment date, and it is subject to a rate adjustment cap and to a maximum increase over the initial rate. On a credit line, in contrast, the rate changes whenever the prime rate changes, there are no adjustment caps, and the only maximum rates are those set by the states, and they are very high.

I did some simulations using one of the calculators on my Web site to see how long it would take a borrower who refinanced from a 6.5 percent fixed-rate mortgage to a 2.5 percent credit line to lose all the benefit of the refinance from a rising prime rate. Assuming the prime rate rose by 1 percentage point a year starting in six months, break-even occurs in about 7.5 years. The borrower who stays longer than that is a loser. If the prime rate rises by two percentage points a year, which is still quite modest, break-even becomes 3.5 years.

If the spread between the first mortgage rate and the credit line rate is four percentage points, and the borrower expects to be out within five years, I think a refinance into the home equity credit line is a good gamble.

If the rate spread is only two percentage points, I would not do it unless I planned to be out within three years.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

© 2009 Jack Guttentag; Distributed by Inman News Features

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