Forex Articles

The whole purpose of buying a house, aside from protection from the elements and keeping the meal worms out, is to build equity. Otherwise you might as well just rent until you die and let the landlord handle maintenance, right? But given that human life spans are finite, there comes a point at which the equity built up in a fully paid-for house begins to provide diminishing returns. Once you own your house freely and clearly, and can also admit that you're closer to the finish line than you are to the starting gun, wouldn't it make sense to draw down some of that equity and spend it somewhere else, instead of just building a bigger estate for your heirs to fight over?

The reverse mortgage is a financial tool that's become more popular as life expectancy has increased and more and more home owners have paid their obligations off. If you're familiar with the concept but not the particulars, reverse mortgages are available to people at least 62 years of age. Understandably, you can get a reverse mortgage only on your primary residence, and you can have only one primary residence. (For purposes of securing a reverse mortgage, your primary residence can be one unit of a duplex, triplex or fourplex.) Then you apply for a reverse mortgage, and theoretically, the monthly payments should start rolling in shortly thereafter while the equity in your home transfers from you to the reverse mortgagee. You can receive payments from the reverse facilitator until you die, if you so desire. (For more, see: Is a Reverse Mortgage Right for You?)

So what does this have to do with the Federal Reserve? Like all too many financial transactions in the United States, plenty. The most common type of reverse mortgage, the Home Equity Conversion Mortgage (HECM), is federally insured. Which means you can get one only through a Federal Housing Administration-approved lender and that the interest charged is subject to federally mandated norms.

HECMs dominate the industry. In 2012 there were about 550,000 reverse mortgages in effect in the United States, around half a million of them HECMs. This for a financial product that barely existed at the turn of the millennium. A borrower can choose either a fixed or a monthly adjustable interest rate on an HECM loan, either of which is going to be a function of the Fed's underlying rate, plus a margin. The particular Fed rate in question here is the 1-year constant maturity treasury (CMT) rate, which itself is the yield on the most recently quoted annual rates on T-bill, T-note, and T-bond issues of varying maturities. The 1-year CMT of interest to HECM lenders is that for either the 1-month, 1-year, or 10-year Treasury issue. (For more, see: Introduction to Treasury Securities.)

Don't think that getting a reverse mortgage necessarily means that you can get your hands on an amount equivalent to the full market value of your home, either. (Well, you can, but that's called selling your house.) Because HECMs are insured by the federal government, they come with a maximum value – much like the $250,000 deposit limit that the Federal Deposit Insurance Corporation sets for bank accounts. HECMs are insured to no more than $625,500, and even that is conditional on your age at the time of application. Furthermore, the higher the expected interest rate on your HECM, the smaller your principal limit.

As you might already know, federally set interest rates have been at historic lows for several years. So many years, in fact, that it's tempting to think of nanoscopic interest rates as a law of nature rather than a construct of mankind. But say the Fed finally does raise rates by 25 basis points or so. Then what? Well, you can be reasonably certain that both fixed and adjustable reverse mortgage rates will rise by at least as much. HECM rates typically include a premium of 100 to 200 basis points beyond the 1-year CMT. (For more, see: Picking the Right Reverse Mortgage Lender.)

As powerful as the Fed is, it has but little bearing on other major components of the HECM process; namely, closing costs. There are origination fees and possible mortgage insurance premia. Add appraisals and title insurance, and you could be looking at $20,000 in sunk costs just to start the process of getting your hands on the equity sunk in your home.

A reverse mortgage doesn't have quite the potential for danger that, say, a cash advance on a credit card does, but the two species are closely related. Generating cash flow from an asset such as a house is relatively easy when the cash comes with the string of an interest rate attached. And that sobering interest rate isn't the only condition on a reverse mortgage, either. When you obtain such a mortgage, you're committing to stay in the mortgaged home permanently. Unless for some reason you decide to move out, which means you'd be paying back the loan plus interest. And doing so while you're presumably well past your prime earning years. (For more, see: Reverse Mortgage Pitfalls.)

There are plenty of financial professionals that hesitate to recommend reverse mortgages. They instead argue that if you need cash flow, you should draw down the rest of your assets first. That's in large part because a reverse mortgage, much like a standard mortgage, entails those thousands upon thousands of dollars in closing costs. Meanwhile, if you wanted to sell stock or other securities with a value equal to the equity you'd draw down in a reverse mortgage, the transaction costs on the security sale would be far smaller. Plus, the sale of stocks and other investments isn't contingent on interest rates set by the Fed.

If you're looking to free up cash once you're past the age of 62, be cautious either way. Regardless, understand that the raising (and lowering, when possible) of interest rates by the Fed will have a profound impact on the size of the deposits your HECM lender makes in your bank account every month. (For more, see: The Reverse Mortgage: A Retirement Tool.)