Reverse Mortgages

Depending upon who one talks to, reverse mortgages are either a way to unlock equity in a retiree’s house or an even worse idea than the worst annuity. Financial planners are rarely ambivalent about reverse mortgages. They have their supporters and their detractors.

What is a Reverse Mortgage and How Does It Work?

As the name implies, a reverse mortgage is a loan that uses the equity in a house as collateral. Instead of paying the lender every month, the lender pays you. The first reverse mortgage was issued in 1961 by a small S&L in Maine. Several other lenders soon copied the new loan creating their own versions. In 1987, Congress passed the Housing and Community Development Act. This Act created the Home Equity Conversion Mortgage (HECM) reverse mortgage product. HECM’s standardized the product’s terms and conditions. The Federal Housing Administration began to provide federal guarantees, though in small numbers.

Recent industry statistics show that roughly 90 percent of all reverse mortgages are HECM’s. Sales of HECM’s have consistently fallen below forecasted levels. Reverse mortgages represent roughly 1% of all mortgages outstanding. Expectations for baby boomer interest in the product are high going forward. Nearly half lack sufficient liquid assets to sustain themselves in retirement.

To qualify for a reverse mortgage, one must meet the following requirements:

• The youngest owner of the home must be at least 62 years old.
• The home must be paid off or nearly paid off. There must be substantial equity in the house to make the process worthwhile.
• The borrower(s) must live in the house. If they move out, the loan may be declared in default.
• The borrower must agree to maintain the home including taxes, repairs, insurance, utilities, maintenance, etc. for as long as the loan is outstanding.

Obtaining a reverse mortgage has a few more steps than obtaining a conventional mortgage.

• HECM borrowers must complete a financial assessment. Based on the borrower’s income and credit history, some of the loan proceeds may be withheld to pay for property taxes and insurance.
• The borrower must select a payout option. HECM adjustable rate reverse mortgages offer five payout options.

• Tenure – A monthly payment made as long as at least one borrower is alive and living in the house.
• Term – A monthly payment made for a set number of years.
• A line of Credit – Unscheduled payments accessible on demand.
• Modified Tenure – A combination line of credit and tenure program
• Modified Term – A combination line of credit and term program

HECM fixed rate mortgages only offered a lump sum disbursement alternative. The FHA discontinued a fixed rate option in June 2013.

The loan amount is a function of three key factors:

• Age of the youngest borrower
• Value of the home, subject to appraisal and the FHA HECM mortgage ceiling of $636,150.
• Interest rates

The loan amount will be a percentage of the maximum loan amount for which you qualify. If the borrowers are young (in their 60’s) with a 20+ year life expectancy, the lender must account for the interest that will compound over the life of the loan. If the outstanding amount grows to more than the value of the house, the lender has no recourse. They will lose money on the transaction. To minimize this occurrence, lenders discount the amount of money they will lend based on borrowers’ age(s) and interest rates.

When a homeowner takes a reverse mortgage, he/she will encounter the following:

• The interest rate applied to the loan will be greater than a comparable standard mortgage.
• The loan origination fees will be higher than those charged for a conventional mortgage.
• Interest charged on the reverse mortgage is not tax deductible until paid.
• If the homeowner has an existing mortgage, the new lender may require that it be paid off.
• Major banks do not offer reverse mortgages. Most reverse mortgages are originated by non-depository financial institutions.
• Mandatory counseling by an independent third party. Studies conducted several years ago showed that the typical reverse mortgage borrower had an incomplete understanding of the loan terms. The Dept. of Housing and Urban Development changed the loan requirements to include third-party counseling.

Target Market

A person/couple is a good candidate for a reverse mortgage when:

• They do not plan to relocate
• They have sufficient funds from other sources to maintain the home.
• They want access to the equity either as an income supplement or as an emergency fund.

The Pros

• Borrowers do not need to make monthly payments
• The money can be used for any purpose
• The money can be used to pay off any existing mortgage
• Funds can help improve monthly income
• Funds received from the loan should not affect a borrower’s Social Security or Medicare benefits.

The cons – and why so many financial planners are not keen on reverse mortgages

• Closing costs and interest costs can be high
• The borrower is not relieved of the responsibility of paying for home ownership costs
• The reverse mortgage can complicate a desire to keep the home in the family or pass along the value of the home as an inheritance.
• Despite counseling, the Consumer Finance Protection Bureau maintains that many borrowers still do not understand these mortgages.
• Borrowers who take a lump sum are most likely to find themselves in financial difficulties later in life. (The rules have been changed to limit the amount of money that can be withdrawn on a line of credit in the first year.)
• Spouses not named on a HECM loan cannot stay in the house after the death of the spouse named on the loan.
• The HECM delinquency rate is substantially higher than for standard mortgages. Given that one need not make any payments, it means too many borrowers cannot afford to maintain the house.
• It is often a better deal to sell the house and buy something smaller or more conducive to a retirement lifestyle.