By the Numbers
Higher rates should slow HECM refinancing
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Many reverse mortgages originated in 2020 and 2021 are no longer eligible to refinance due to higher interest rates. Most reverse mortgage borrowers refinance to tap more home equity as home values appreciate. But interest rates can also play a role. When rates are low borrowers can access a larger share of their home equity immediately. But when rates increase, more equity is reserved to cover expected interest accruals. This lowers the incentive to refinance. The industry also requires lenders to only offer refinances that provide sufficient benefit to borrowers, and many loans can no longer clear those hurdles.
The FHA’s reverse mortgage program—the Home Equity Conversion Mortgage (“HECM”)—allows borrowers to turn their home’s equity into cash. The interest that borrowers owe each month is added to the loan’s principal balance so borrowers do not need to make payments. The current home value is used to set the maximum loan amount, subject to a national loan limit 50% higher than the single-family conforming loan limit. The HECM limit in 2022 is $970,800.
Borrowers can only access a fraction of the maximum loan amount, which leaves room for accrued interest to be added to the loan’s balance. This fraction is called the current principal limit. It depends on the borrower’s age and projected interest rate at origination and grows each month as the loan seasons. A younger borrower is expected to have a longer accrual period so is given a lower principal limit. The principal limit also drops if the projected accrual rate increases, for example when interest rates are rising.
The reverse mortgage industry requires that loans be at least 18 months seasoned and pass two net benefit tests to be allowed to refinance. The more important test is known as the “closing costs” test, the other test acting as a backstop when closing costs are extremely low. The closing costs test requires the amount of home equity the borrower can access after refinancing be at least five times the closing cost. If interest rates are unchanged this typically means cumulative home price appreciation must exceed 9% to pass the test. But the borrower receives less cash if interest rates are higher, and therefore needs even more HPA to be allowed to refinance.
Replicating the closing cost test shows than many loans are no longer eligible to refinance (Exhibit 1). The right-most three columns, “% Refinanceable”, show the percentage of each vintage that pass the closing cost test and were eligible to refinance at the start of the year, in June, and the difference between the two dates. In many vintages more than 50% of loans can no longer refinance. Only 3.8% of loans in the largest vintage, 2021, have sufficient home price appreciation to be eligible to refinance.
Exhibit 1. Higher interest rates will prevent many HECM refinances
The “expected rate” is the rate the FHA used to determine principal limits when the loan was originated. Borrower age is the younger borrower’s age for two-borrower loans. Closing cost HPA hurdle shows the amount of home price appreciation needed to cover a 1% closing cost and be allowed to refinance, assuming interest rates are unchanged. The interest rate HPA hurdle shows how much HPA is needed to cover lower principal limits due to higher interest rates. A loan must have more HPA than the sum of the two hurdles to be allowed to refinance. New loans are assumed to receive a 3.5% expected rate in January and a 5.0% expected rate in May, derived using a 2% margin over 10-year CMT.
Source: Ginnie Mae, Amherst Pierpont Securities
The table shows the balance, average expected rate used to determine principal limits at origination, average loan age, average borrower age, and cumulative HPA. The HPA percentage needs be high enough to pass the closing cost test, which is split into two pieces. The “Closing Cost HPA Hurdle” shows how much HPA is necessary to pass the closing cost test assuming interest rates have not changed. The “Interest Rate HPA Hurdle” section shows how much additional HPA is needed to pass the test when interest rates are higher than when a loan was originated. The cumulative HPA for a loan needs to exceed the sum of the two hurdles for a loan to allowed to refinance.
For example, the 2020 vintage on average needs 9.3% HPA to cover closing costs assuming interest rates have not moved. But at the start of the year, it needed an additional 6.7% HPA to offset higher interest rates. Because the vintage’s home values have grown 36.4%, which exceeds the sum of the two hurdles, nearly 100% of those loans were refinanceable at the start of this year. However, higher rates since the start of the year mean that only 42.9% of that vintage is still eligible to refinance in June.
The FHA used higher principal limits prior to 2018, so those vintages naturally need even more appreciation to make a refinance worthwhile. This is included in the interest rate hurdle. For example, at the start of the year the interest rate hurdle was 32.6% for the 2017 vintage compared to only 2.9% for the 2018 vintage. This is true even though both vintages were originated in similar rate environments. So higher rates should also slow prepayments in those vintages, despite a lot of accumulated home price appreciation.
Although speeds should slow because rates are higher, home prices still appear to be increasing at a record pace. Home buying activity is slowing due to higher mortgage rates. However, tight housing supply could keep home price growth strong and eventually make more HECMs refinanceable again.
Brian Landy, CFA
1 (646) 776-7795
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.