Should you pay off an existing mortgage before taking a reverse mortgage?

Most seniors in the market for a HECM reverse mortgage while still carrying a traditional mortgage balance view the HECM as their way of ridding themselves of a monthly payment.

If there is an existing mortgage balance, enough cash must be drawn from the HECM to pay it off. However, some senior homeowners have enough financial assets to pay off the balance before they take the HECM, if it makes financial sense to do that.

It turns out that whether it makes sense may depend on where the homeowner goes to get the HECM.

I look at the question through the eyes of a 62-year-old woman with a house worth $400,000 that has an existing mortgage balance of $100,000. I assume that the owner wants the reverse mortgage that provides the largest possible monthly payment for as long as she lives in the house - a "tenure payment."

If she pays off the $100,000 balance before taking the HECM, the monthly payments on May 27 ranged from $970 to $1,143 based on quotes from six lenders that report HECM prices to my website. If she does not pay off the $100,000 balance beforehand, the available payments from the same lenders range from $453 to $618.

The payments are lower in the second example because the HECM is using part of the senior's borrowing power to pay off the existing $100,000 mortgage balance.

Using the highest of the monthly payment quotes, the difference between the two cases is $1,143 minus $618, or $525. Paying off the $100,000 balance before taking the HECM increased the tenure payment by $525 a month, but the borrower would lose the income she was earning on the $100,000 in assets used to pay off the home loan.

To match the $525 increase in the monthly payment, the $100,000 would have to yield a 6.3 percent return, after-tax and risk-free, which is possible but not very likely. While this leaves the $100,000 capital value intact, that is largely offset by the lower future HECM loan balance of the borrower who pays off the balance beforehand. After eight years, she will owe $86,000 less.

A cleaner comparison assumes that in the case where the $100,000 mortgage balance is paid off by the HECM, the borrower would use the $100,000 of financial assets to buy an annuity. On May 27 I priced an immediate life annuity on $100,000 for a 62-year-old man at $498, which is not that different from the $525 difference in tenure payment, considering that a life annuity can go on a little longer than a tenure payment. From a cash flow perspective, it is about a draw. That leaves the lower HECM loan balance of the borrower who pays off the balance beforehand as a net benefit of that option. That may or may not be important to the borrower, depending on her attitude toward bequests to her survivors.

There is one other potential benefit to paying off a loan balance before taking a HECM. The range of payments quoted by lenders is twice as large when the HECM pays off the balance than when the borrower pays it beforehand. $618 is a whopping 36 percent higher than $453 while $1,143 is only 18 percent higher than $970. The larger spread in the first case reflects the greater profitability of a HECM with a large initial loan balance, which provides greater pricing latitude and results in a wider range of price quotes.

The wider range of price quotes doesn't matter if the borrower can shop effectively for the highest payment. To see whether it was possible to shop individual lenders online, I checked the websites of 15 HECM lenders including the five largest. Only one of them, All Reverse, displayed tenure payments and future debt. I stopped my inquiry at 15, but if any of the lenders I missed provide this information on their websites, they can let me know and if it checks out, I will add their names to the web version of this article.

The alternative for senior homeowners is to access the database covering multiple lenders on my website, selecting the highest payment, just as I did. Borrowers who get locked into one lender are rolling the dice and will do better paying off the balance before taking the HECM.

• Contact Jack Guttentag via his website at mtgprofessor.com.

© 2017