Jack M. Guttentag The Mortgage Professor

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.