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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Little Income, Lots of Equity; and the Pros, Cons of HELOCs

by Jack M. Guttentag

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Posted on Tuesday, February 24, 2009, 12:00AM

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

"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 three payments. I don't want to destroy my credit, and have been borrowing from family to stay current. Is there anything else I can do?"

Assuming she wants to remain in the house, a reverse mortgage is the best solution to this problem. A reverse mortgage would allow her to convert the existing mortgage with its accompanying payment obligation into a reverse mortgage with no required monthly payments.

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

In a similar case some years ago, I recommended that the borrower do a cash-out refinance, investing the cash in a mutual fund and drawing it from the fund monthly to make the mortgage payment. That would work in this case also. For example, if she 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 borrower's income -- it is not "affordable." Because of the abuses committed during the housing bubble, when many homes were sold to people who couldn‘t afford them, underwriting affordability rules have become extremely rigid.

No allowance is made for the situation where 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 way to deal with the problem is for the lender to simply drop the payment to a level that is affordable to the borrower, adding the unpaid interest to the balance for a specified number of years. Because the borrower has so much equity in the house, 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.

Should You Take Out a HELOC?

Among those who have benefited unexpectedly from the financial crisis are homeowners with HELOCs (home equity lines of credit). HELOC 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 HELOC who wrote me recently had a margin of minus .75 percent, which made her rate 2.5 percent. Her first mortgage had a rate of 6.5 percent, and her HELOC 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. The reason is that she did not expect to pay off the loan for 15 years, and over that long of a period, the risk from the HELOC is too high.

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

Furthermore, HELOCs offer borrowers no protections against rising market rates. On conventional ARMs (adjustable-rate mortgages), the rate does not change until a specified rate-adjustment date, and it is subject to a rate-adjustment cap and a maximum increase over the initial rate. On a HELOC, 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, which are very high.

I did some simulations using one of the calculators on my Web site (9ai) to see how long it would take a borrower who refinanced from a 6.5 FRM (fixed-rate mortgage) to a 2.5 percent HELOC to lose all the benefit of the refinance from a rising prime rate. Assuming the prime rate rose by 1 percent 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 2 percent a year, which is still quite modest, break-even becomes 3.5 years.

If the spread between the first mortgage rate and the HELOC rate is 4 percent, and the borrower expects to be out within five years, I think a refinance into the HELOC is a good gamble. If the rate spread is only 2 percent, I would not do it unless I planned to be out within three years.

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145 Comments

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  • Yahoo! Finance User - Tuesday, March 3, 2009, 12:34PM ET  Report Abuse

    • Overall: 5/5

    in spite of the off the wall comments of others, I think this is good, sound financial advice on a matter that could get people into considerable trouble otherwise when we start to see the treasury bill "bubble" burst.

  • Yahoo! Finance User - Monday, March 2, 2009, 10:19PM ET  Report Abuse

    • Overall: 1/5

    i've figured out a way to make money. since the market is killing everyone, why not take from the gov't by filing fraudulent income tax returns. hahaahahaha

  • Fuk - Monday, March 2, 2009, 9:02PM ET  Report Abuse

    • Overall: 1/5

    your old and bald....who cares anymore jack?....the mortgage game is over

  • John - Monday, March 2, 2009, 7:23PM ET  Report Abuse

    • Overall: 1/5

    Jack Guttentag.... Ive heard of this guy before. He tried to get me to "cash out" when he was a mortgage broker at Countrywide. I think he helped me with my groceries last month at Ralphs... Wow Im glag to see he's doing good writing articles on Yahoo... Good for him

  • Irving - Monday, March 2, 2009, 7:02PM ET  Report Abuse

    • Overall: 1/5

    This guy is so out of touch. Invest in a Mutual Fund? Get a heloc? Yeah, right. Jack, welcome to planet Earth where people have lost their retirement in mutual funds and don't have a prayer of getting an heloc now. Why would Yahoo put this tripe on a finance board? Not only is it bad advice, it is stupidly put.

  • Yahoo! Finance User - Monday, March 2, 2009, 6:25PM ET  Report Abuse

    • Overall: 1/5

    If you think DJIA 6,763 is bad, JUST WAIT UNTIL 1Q09 Earnings come out!!!!!!!! SAVE YOURSELVES AND HOLD GOLD AND CASH and hope!!! even another Stimulus or Bailout or Tax cut or Rate cut won't save you now.... may Obama bless us all, amen.

  • KeithD - Monday, March 2, 2009, 3:11PM ET  Report Abuse

    • Overall: 5/5

    For all the dimwits yelling "sell the house, sell the house." HELL-O, do you follow the news at all? To sell a house you have to have BUYERS who have FINANCING, a very rare commodity right now which is why the market is crashing. You can try to sell a house for the same price as the foreclosure next door and it still may take years (as can that house next-door). In the meantime what do you do if you need money? My 84 year old mom just had to move from her home into assisted living, and we'll have to sell her house (it's completely paid off, no mortgage) to pay her bills at her new home. Right now her old home is empty, but selling it is NOT EASY and NOT IMMEDIATE. Yet she has no debt but expensive rent, i.e., negative cashflow, so qualifying for a HELOC may be pretty tough. She's got about 6 months of savings before the house has to produce some income. It could take longer than that to sell it in this market. If we just give the house away out of desperation, she could run out of money in a few years if she lives that long (and she might). I suspect even a reverse mortgage here won't provide enough income, and you can't get one anyway if you aren't living in the home, but that remains to be seen. And rents are too low, and won't produce enough income (and also require landlord insurance, a property management company, and a lot of headaches and uncertanties). In her neighborhood there are several forclosures that aren't selling either. There are TOO MANY HOUSES ON THE MARKET right now so selling is a guaranteed money losing proposition no matter how you cut it, but if all your equity is tied up in a house you can't live in you're really stuck.

  • El Viejo - Monday, March 2, 2009, 1:39PM ET  Report Abuse

    • Overall: 1/5

    what ever happened to 'living within your means' .... borrowing against your residence is insanity ... who would do such a stupid thing ???

  • Dog - Monday, March 2, 2009, 8:26AM ET  Report Abuse

    • Overall: 1/5

    I'll just MY 2-cents worth to the growing list of tirade's -- THE AUTHOR IS A BONEHEAD.

  • scarf - Monday, March 2, 2009, 12:06AM ET  Report Abuse

    • Overall: 2/5

    How dumb is this woman?

  • John - Sunday, March 1, 2009, 11:34PM ET  Report Abuse

    • Overall: 1/5

    In spite of the fact that he failed to mention 'selling the house' as an option I would have still given him 2 stars had his advice been plausible. But no national Bank is going to loan this woman $800,000 at anything close to prime, even if the house is worth 1.2MM (which is doubtful as others have commented already). If there is one please name it, as I have $1,000,000 in loans at 50% LTV that I would like to refinance, but can't find better than 5.5%, and that is from a local Bank I have dealt with for 10 years.

  • bajoverga - Sunday, March 1, 2009, 8:41PM ET  Report Abuse

    • Overall: 1/5

    Jack, you are a moron.

  • Joyce - Sunday, March 1, 2009, 7:25PM ET  Report Abuse

    • Overall: 1/5

    It's pretty bad when my 18 year old son's answer to this problem made more sense than the "Expert". Anyone who is defending Jack because they are buying into the whole"emotional history on the house" idea, isn't taking into consideration what might happen to this lady should she develop some serious medical problem in the future. Most people of her generation believed that you should never live above your means. That generation would have done what ever it takes to avoid debt in retirement. My son say she needs to sell her house and pay cash for a smaller home. Hopefully social security will pay for her most of other monthly expenses. Should she develop Alzheimer's disease, or something else that would require long term care, she will have the money left over from the sale of the other house.

  • Craig - Sunday, March 1, 2009, 5:31PM ET  Report Abuse

    • Overall: 1/5

    Sell the house!! A 67 year old should have their primary residence paid off especially if they are retired. Having such a large mortgage that late in life is very irresponsible. BTW how do you still know that the value of the place is still 1.2 million? Was that a recent valuation or was that back in 2006.

  • Shilen - Sunday, March 1, 2009, 1:58PM ET  Report Abuse

    • Overall: 1/5

    It used to be you were a looser if you took out a second mortgage, then the NAR and banks changed the name to HELOC and made it sound like it was a good idea, reality is you are still a looser. Anyone who took out a HELOC is a useless eater, they are fiscally incompotent and will be a drain on scociety. The best solution is to do away with HELOCs and close all existing ones...

  • Yahoo! Finance User - Sunday, March 1, 2009, 12:09PM ET  Report Abuse

    • Overall: 1/5

    In this case, the elderly lady should just suck it up and not pay the bill for 3 months so that she can get the adjustment. Of course, one thing she needs to do is buy a reliable car before going through with this though and it would be wonderful time to do so as well with current auto market. So, buy the car, then just let the mortgage go without paying for 3 months, get the adjustment she needs. I am assuming that she want to stay there for at least 5-10 more years (otherwise, why bother with this, just sell the house, cash out the equity and move to cheaper house). HELOC idea is only good for the bank and not for this situation.

  • Yahoo! Finance User - Sunday, March 1, 2009, 11:06AM ET  Report Abuse

    • Overall: 5/5

    The HELOC advise is exactly what I was looking for i.e. 27 years left (retired at 61 years old) on a motgage for a second home that I wont live to pay off. I'll pay the mortgage off with my HELOC and hope to sell in the next three years. If not, I'll be forced to pay it off with 401k money, but 3.25% vs 5.5% minus the principal savings is relevant in today's times.

  • Tim - Sunday, March 1, 2009, 10:59AM ET  Report Abuse

    • Overall: 1/5

    The 90% of the ppl that said that Jack is a monster who is trying to prey on this poor elderly widow by encouraging her to take on additional debt and/or risk so that he can collect his fees are exactly right. Any advice other than selling the home and getting a smaller condo or townhome is malpractice and abuse. For those that say but she has an emotional attachment, that is too bad. It is a part of life. You don't get to keep things you want but can't afford simply because of emotional attachments. Sometimes you have to suck it up and do things you dont want to in order to save yourself. We have all done it. Is this woman so arrogant and self centered that she feels she does not have to do what billions before have done during tough times. If so, then I dont really care what happens to her. It's monster v. monster. If Jack has a license he should lose it. It is this kind of ignorant and self centered reasoning that got us in this mess. So when you see your 401k statement later this year, or your home drops in value another 40%, look at ppl like jack and this woman, and despise them for what they are. Filth and scum.

  • Constitutionalist - Sunday, March 1, 2009, 9:38AM ET  Report Abuse

    • Overall: 2/5

    Jack, The advice I would give the woman in your first example would be: Sell your home, take the money that's left, and either rent or buy a more affordable home in cash; invest what remains to generate enough cash flow to survive on based on all other sources of income i.e. pension, social security and existing investments.

  • Yahoo! Finance User - Saturday, February 28, 2009, 11:51PM ET  Report Abuse

    • Overall: 1/5

    First there were the drug pushers...then came the mortgage pushers....just cut to the chase and invest in crematoriums....all the old people being kept alive on 10 different drugs...well its probably worse than abortion ....just think if cheney couldnt get a pacemaker....then there wouldnt be hellaburten...reverse mortgages are predatory and should be outlawed...and so should pacemakers

  • Scott - Saturday, February 28, 2009, 8:24PM ET  Report Abuse

    • Overall: 3/5

    All you financial geniuses out there clamoring for the widow to sell her home and move to a condo have missed a couple of things -- history and emotion. Often there are a lot of memories tied up in a place, and some people still even have a sense of "home" instead of vagabond-ism. The author's advice was obviously tailored to a person who did not wish to leave her home of many years. If ya'll are such geniuses about financial advice, why don't you go out and get your own columns instead of taking ill-considered pot shots at the people who do???

  • penurius - Saturday, February 28, 2009, 5:21PM ET  Report Abuse

    • Overall: 2/5

    This woman should sell the house and buy a small one for cash. Why stay in such an expensive house by yourself? Doesn't make sense. Not only would she eliminate mortgage payments and greatly reduce taxes but also reduce heating, electricity, and maintenance. Her cash flow and standard of living would improve dramatically.

  • Ken - Saturday, February 28, 2009, 3:02PM ET  Report Abuse

    • Overall: 1/5

    I believe that even Jack Guttentag and even this nameless widow would quickly realize that by selling the house the woman becomes rich, and her "problem" is solved. There must be more to this story. My hypothesis is that the widow's house has been on the market for over a year, and there have been no offers. She has reduced the asking price to $890K, and still no buyers. Do you people have no compassion? The reality is that widows like this one are seeing their equity destroyed. There is no easy solution, and Jack concocted his convoluted answer to avoid telling her the awful truth.

  • D - Saturday, February 28, 2009, 11:08AM ET  Report Abuse

    • Overall: 2/5

    There are also private attorney's who are helping borrowers deal with mortgage companies on loan modifications. The company I have been working with has been getting the rates permanently reduced from 3% to 6 %. Which depending on the program and rate they had before has really improved there situation. Of course it is not a fix all given the current economic conditions, but it is helpful. Right now we have do to the best we can and keep looking until you find a better solition. The writer may want to consider selling the home and buying another home out right sound like she has enough equity. For anyone considering a 2nd mortgage, do your work and research the product. Because once you have a 2nd mortgage your property you give up the right to the homested act. Meaning the 2nd mortgage holder can come in a take the house with just one payment being missed and you cannot do anything about it. Most people don't know or even understand this but with a first mortgage there is the homested act that protects you from home loss on the first payment being missed. My advice as a mortgage broker and I am a good one - DON'T GET A SECOND YOU WILL END UP REGRETTING IT. Try finding an independant agency to represent you on the loan modification if that does not work sell the home and buy a home out right. Just because your home is worth 1.5 million does not mean you need that much house. If you are one person I am certain your daily requirements would be better suited in a smaller residence. Look at it with eyes that are not attached but as a business, dollars and cents equation and it will lead you to the correct answer.

  • pam - Saturday, February 28, 2009, 10:08AM ET  Report Abuse

    • Overall: 5/5

    EXCELLENT! I had no idea the conversion to HELOC would have those risks. Thanks for analyzing and quantifying it for me, Jack, it was very helpful to me.

  • Yahoo! Finance User - Friday, February 27, 2009, 3:34PM ET  Report Abuse

    • Overall: 1/5

    I have to agree with most of the other people that he should have suggested to the widow to sell and downsize. The fact that he didn't even present this as an option is appalling! When you're in retirement a bunch of financial jiggery-pokery to help you hold on to a house just a little longer is beyond absurd! If the widow follows his advice she has a good chance of finding herself broke and homeless at 80. Even the second half about HELOCs couldn't make up for the horrid advice in the first half!

  • Yahoo! Finance User - Friday, February 27, 2009, 11:25AM ET  Report Abuse

    • Overall: 1/5

    I agree with some of the previous comments: SELL the house; take the net $750,000; buy a house or condo for $500,000 or less and not only will there be no mortgage payment problems but she will have cash which if invested properly will give her $10,000 to $15,000 pa to supplement whatever other income she currently has. This column just continues to support the view that everyone is entitled to a million dollar home, even if they can't afford the payments. When will we ever learn. (Hey, this could be made into a song.) SELL NOW.

  • Steve - Friday, February 27, 2009, 10:34AM ET  Report Abuse

    • Overall: 1/5

    Jack - From one loan officer to another...you make my skin crawl! Did you really advise one of your customers in retirement to take out a $800k loan so she could use the cash to make more mortgage payments? Dude, as mortgage professionals we're supposed to do what's right for the customer first. I never did understand loan officers like you, always made me sick to be around them. Have you learned anything over the past couple of years?

  • Anthony - Friday, February 27, 2009, 8:35AM ET  Report Abuse

    • Overall: 1/5

    This is horrible advice. As soon as I read the woman's situation, the first thought was "sell the home". Incredibly, the "expert" doesn't even recommend that. The cash-out refi is crazy. How about this advice - sell the house, use the proceeds to purchase a smaller, more affordable home for cash (no mortgage!) and sock the other money away to help pay for future expenses. But instead, we have to read 13 paragraphs that really doesn't address her problem. And he calls himself the mortgage professor!

  • Yahoo! Finance User - Thursday, February 26, 2009, 3:53PM ET  Report Abuse

    • Overall: 1/5

    Your advice is exactly why the financial system FAILED. Does any "expert" nowadays advise someone who cannot afford a mortgage to just simply SELL the house and MOVE to an affordable place (which is practical in this particular case)? Most readers have a better mind than this Yahoo! expert. Unbelievable, that many who claim as wise have become fools in their own accord.

Showing comments 6-35 of 145<< PreviousNext >>

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