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After Exhausting Other Options, You May Want to Consider a Reverse Mortgage

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Introduction

First, I want to make it clear that by including a section on Reverse Mortgages, I am not necessarily recommending them nor advocating that they be a part of a well-balanced investment portfolio.  My purpose is to present them in an accurate and unbiased manner, explaining how they work and their advantages and pitfalls.

I’ll leave the decision to you as to whether a reverse mortgage has a place within your retirement financial plan.  However, one point that I will make is that like any loan, a reverse mortgage has significant associated costs and should only be considered when it is absolutely required to enable you to meet your financial obligations.  It will reduce the overall value of your estate and consequently the assets that can be passed on to your heirs.

Despite these concerns (and others mentioned later), the volume of reverse mortgages being sold is significant (over 70,000 per year), and it is expected to grow as the U.S. population ages.  The U.S. senior population is expected to increase from 35 million in 2000 to 64 million in 2025, and seniors are expected to make up a larger share of the population.

Reverse Mortgage Defined

A reverse mortgage is a product that allows you to convert part of the equity in your home into cash without having to sell your home.

Like a regular mortgage, a reverse mortgage offsets some of the equity assets of your home with a liability obligation.  This liability manifests itself as a lien against your property.  The major difference between the two mortgages is that in a regular mortgage, you make monthly payments to the lender; whereas, in a reverse mortgage, the lender makes payments to you.

After each payment in a conventional mortgage, the equity increases by the amount of the principal included in the payment, and when the mortgage has been paid in full, the property is released from the mortgage.  In a reverse mortgage, the mortgage balance increases as money is paid out and interest is charged.  The lender gets the money to pay you from your home’s equity – your equity will continue to decrease as the reverse mortgage’s balance increases.

Types of Reverse Mortgages

There are three types of reverse mortgages: 

  • Single-purpose, offered by some state and local government agencies and nonprofit organizations;
  • Federally-insured, known as Home Equity Conversion Mortgages (HECMs) and backed by the U. S. Department of Housing and Urban Development (HUD)
  • Proprietary, private loans that are backed by the companies that develop them.

Single-purpose reverse mortgages are the least expensive option.  They are not available everywhere and can be used for only one purpose, which is specified by the government or nonprofit lender.  For example, the lender might stipulate that the loan is to be used only to pay for home repairs, improvements, or property taxes.  Most homeowners with low or moderate income can qualify for these loans.

HECMs and proprietary reverse mortgages are generally more expensive than traditional home loans, and the upfront costs can be high.  However, HECMs alone account for 90% of all reverse mortgages originated in the U.S.  HECM loans are widely available, have no income or medical requirements, and can be used for any purpose.

Obtaining a Reverse Mortgage (Eligibility)

To obtain a reverse mortgage, you must:

  • Be at least 62 years of age,
  • Live in and own your home (it must be your principal residence),
  • Have sufficient equity in the home to pay off any existing mortgage with the reverse mortgage,
  • Obtain court approval for the reverse mortgage prior to closing if you have a current or pending bankruptcy, and
  • For an HECM (and some proprietary reverse mortgages), receive a certificate of completion from an approved counseling course.

Qualification is based on the youngest borrower on title.  Principal residence means that you must reside at the property for six months and one day per year.

The counseling is meant to serve as a safeguard to ensure that you completely understand the reverse mortgage.  The counselor is required to explain the loan’s costs and financial implications, and possible alternatives to an HECM.  The counseling fee (around $125) can be paid from the loan proceeds, but you cannot be turned away if you can’t afford the fee.

There are no minimum income or credit requirements because no payments are required on the mortgage.  A credit report will only be used to check any federal tax liens or other items that may affect qualification.

If you have a mortgage already, a reverse mortgage will first pay off your existing mortgage and then give you the remaining proceeds.  In fact, many borrowers use a reverse mortgage for that purpose – to eliminate monthly payments on their traditional mortgage.

If a property has increased in value after a reverse mortgage is taken out, it is possible in some areas to acquire a second reverse mortgage for the increased equity in the home.  Also, a reverse mortgage may be refinanced if enough equity is present in the home, and in some cases may qualify for a streamline refinance if the interest rate is reduced.

Reverse mortgages follow FHA standards for property types, meaning most 1–2 family dwellings, FHA approved condominiums and PUD's will qualify.  Manufactured housing qualifies based on standard FHA guidelines.

Loan Size

How much you can borrow with a HECM or proprietary reverse mortgage depends on several factors, including:

  • The age of the youngest borrower on the title (the older the owner, the more money that will be received);
  • The type of reverse mortgage you select (whether the payment is taken as a line of credit, lump sum, or monthly payments);
  • The appraised value of your home (this includes any health or safety repairs that need to be made, plus the value of any existing liens on the house);
  • The principal amount of any existing mortgage(s) on the home;
  • The maximum lending limit (which varies by county, but may not exceed $625,500); and
  • Current interest rates (as determined by the U.S. Treasury 1 year T-Bill, the LIBOR index or 1 Year CMT).

LIBOR is the London Interbank Offered Rate.  It's similar to the fed funds rate, in that it represents the rate at which banks are willing to loan each other reserves.  It's an international standard for interest rates, often used as an index for resetting the rates of adjustable rate loans.

The CMT (Constant Maturity Treasury) index is an average yield on U.S. Treasury securities adjusted to a constant maturity of 1 year, as made available by the Federal Reserve Board. 

All of the above factors contribute to the Total Annual Lending Cost (TALC) – the single rate, including all the loan costs, as defined by the US Federal Government in Regulation Z.  The specific formulas to calculate the impact of the factors listed above can be found in Appendix 22 of the HUD Handbook 4235.1.

Reverse mortgages for homes valued over the maximum limit ($625,500) are called "Jumbo" reverse mortgages and are generally offered as proprietary reverse mortgages.  For owners of higher-valued homes, a Jumbo loan can provide a larger loan amount; however, these loans are currently uninsured by the FHA, and their fees are often higher.

Costs & Interest Rates

Origination Costs.  Exact loan origination costs depend on the particular reverse mortgage program the borrower acquires.  The HECM will have the following costs: 
  • Mortgage Insurance Premium (MIP) = 2% of the appraised value;
  • Origination fee, depending on the home's appraised value
    • Appraised value under $125,000 = $2,500
    • Appraised value over $125,000 = 2% of the first $200,000 plus 1% of the value over $200,000, with a $6,000 cap
  • Title insurance = varies by location
  • Title, attorney, and county recording fees = varies by location
  • Real estate appraisal = $300–$500
  • Survey (may be required) = $300–$500

Except for the real estate appraisal, the origination costs of a reverse mortgage can be financed with the proceeds of the loan itself.  The cost of getting a reverse mortgage from a private sector lender may exceed the costs of other types of mortgage or equity conversion loans.

Ongoing Costs.  In addition, there are costs during the life of the reverse mortgage:

  • Service charges (between $25 and $35), which are usually added monthly to the balance of the loan;
  • Annual Mortgage Insurance Premium, which is levied every year, equal to 1.25% of the mortgage balance (note that this is in addition to the MIP paid at settlement); and
  • Monthly interest charges, that are based on the particular reverse mortgage program.

Prior to 2007, all major reverse mortgage programs had adjustable interest rates.  Adjustable rate reverse mortgages are still being offered in programs that are adjusted on a monthly, semi-annual, or annual basis up to a maximum rate.  Several lenders now offer FHA HECM reverse mortgages that have fixed interest rates, but these typically limit the amount of the loan.

Borrower Obligation

Because you retain title to your home, you are responsible for property taxes, insurance, utilities, fuel, basic home maintenance, and other expenses during the loan period.  Unlike common practice in standard mortgages, funds for taxes and insurance are not paid out of an escrow fund; they are paid directly by the homeowner.  A lapse in either taxes or insurance could result in a default on the reverse mortgage.


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Proceeds from a Reverse Mortgage

Income received from a reverse mortgage may be used at the discretion of the borrower.  The money received is typically used to finance a home improvement, pay off a current mortgage, supplement retirement income, or pay for healthcare expenses.

The borrower can even invest the proceeds.  If a borrower wants interest-bearing instruments, the money can be kept with the lender (in which case the account grows by the same percentage as the interest rate of the loan), the funds can be moved to a directed account with a financial specialist, or the money can be invested and managed by the borrower.

The HECM lets you choose among several payment options. You can select: 

  • A Lump Sum, in cash, at settlement (this provides the cash immediately, but the interest fees are the highest);
  • Term Option – fixed monthly cash advances for a specific time period;
  • Tenure Option – fixed monthly cash advances for as long as you live in your home;
  • Line of Credit, similar to a home equity line of credit, that lets you draw down the loan proceeds at any time in amounts you choose until you have used up the line of credit; or
  • A combination of monthly payments and a line of credit.

The most common reverse mortgage is one in which the owner receives cash or a credit line from an existing home.  You can change your payment option any time for about $20.

Purchase of a New Residence with "HECM for Purchase"

The Housing and Economic Recovery Act of 2008 provided HECM mortgagors with the opportunity to purchase a new principal residence with HECM loan proceeds.  The so-called HECM for Purchase program applies if the borrower is able to pay the difference between the HECM and the sales price and closing costs for the new residence.  The program was designed to:

  • Allow seniors to purchase a new principal residence and obtain a reverse mortgage within a single transaction by eliminating the need for a second closing.
  • Enable senior homeowners to relocate to other geographical areas to be closer to family members or downsize to homes that better meet their physical needs (i.e., handrails, one-level properties, ramps, wider doorways, etc.).

Texas is the only state that does not allow for reverse mortgages for purchase.

Taxes & Insurance

Following are tax-related guidelines regarding reverse mortgage income: 

  • Money received from a reverse mortgage is treated as a loan advance, and loan advances are not considered to be income;
  • Therefore, money received does not directly affect Social Security or Medicare benefits;
  • Interest charged is not deductible until it is actually paid, that is, at the end of the loan; and
  • The mortgage insurance premium is deductible on the 1040 long form.

However, if borrowers receive Medicaid, SSI, or other public benefits, loan advances will be counted as "liquid assets" if the money is kept in an account (savings, checking, etc.) past the end of the calendar month in which it is received.  The borrower could then lose eligibility for these public programs if total liquid assets is greater than those programs allow.

Paying Off Your Reverse Mortgage

Remember that the bank never owns your home.  You remain the owner of your home and can stay as long as you wish.  Title to the property remains in the name of the homeowners, to be disposed of as they wish, encumbered only by the amount owing under the mortgage.

The loan must be repaid when the last surviving borrower:

  • Dies,
  • Sells the home, or
  • No longer lives in the home as a principal residence for more than 12 consecutive months.

In the HECM program, a borrower can live in a nursing home or other medical facility for up to 12 consecutive months before the loan must be repaid.

Once the mortgage comes due, the borrower or heirs of the estate have an option to:

  • Refinance the home and keep it,
  • Sell the home and cash out any remaining equity, or
  • Turn the home over to the lender.

Upon the borrower’s death, heirs are granted six months to make this decision.  After a maturity event occurs, the borrower or the estate must pay off the mortgage balance in 90 days; however, three additional 90-day extensions may be granted by the loan servicing company.

Once the property is turned over to the lender, the borrower or the heirs have no more claims to the property or equity in the property.  The lender has recourse against the property, but not against the borrower personally and not against the borrower's heirs.

A reverse mortgage lien is often recorded in a similar fashion to a home equity line of credit as the maximum lending limit.  Since this is a higher value than the amount of money actually disbursed, it is not to be confused as the payoff amount of the reverse mortgage.  The payoff is calculated based on actual disbursements plus interest owed.

Concerns Regarding Reverse Mortgages

If you’re considering a reverse mortgage, be aware that: 

  • High up-front costs make reverse mortgages expensive.  Reverse mortgages can cost $8,000 or more to enter into, as compared with other types of loans which often cost less than $5,000.

  • The interest rate on a reverse mortgage may be higher than on a conventional mortgage even though the collateral, the real property, is the same.  Also, the interest on reverse mortgages is not deductible on income tax returns until the loan is paid off in part or whole.

  • Although some reverse mortgages have fixed interest rates, most have variable rates that are tied to a financial index.  They are likely to change with market conditions.

  • Interest compounds over the life of a reverse mortgage, which means that the mortgage can quickly balloon.  Each month, interest is calculated not only on the principal amount received by the borrower but on the interest previously assessed to the loan.  Because of this compound interest, the longer a reverse mortgage is held, the more likely it is that most or all of the home equity is depleted when the loan becomes due.

  • Because reverse mortgages can use up all or some of the equity in your home, fewer assets are left for you and your heirs.  Most reverse mortgages have a “nonrecourse” clause, which prevents you or your estate from owing more than the value of your home when the loan becomes due and the home is sold.  However, if you or your heirs want to retain ownership of the home, you usually must repay the loan in full, even if the loan balance is greater than the value of the home.

  • If you don’t pay property taxes, carry homeowner’s insurance, or maintain the condition of your home, your loan may become due and payable.

  •  Reverse mortgages are confusing. Many seniors entering into reverse mortgages don't fully understand the terms and conditions associated with the loans.

Do Your Research & Shopping

If you’re considering a reverse mortgage, shop around.  Compare your options and the terms various lenders offer.  Learn as much as you can about reverse mortgages before you talk to a counselor or lender.  That can help form the questions you ask which could lead to a better deal.  Be wary of sales pitches.  Some sellers may offer you goods or services, like home improvement services, and then suggest that a reverse mortgage would be an easy way to pay for them.

Conclusion

Although, according to an AARP survey, over 90% of borrowers said that their reverse mortgage had a mostly positive effect on their lives, you need to be very cautious in obtaining a reverse mortgage.  It’s a very significant financial commitment that is frequently oversold as a panacea.  If other sources of revenue are available to you, they may better meet your retirement income needs while preserving more of your net worth.

The bottom line is that if you don’t understand the cost or features of a reverse mortgage, or if there is pressure or urgency to complete the deal, then don’t do it.  Consider seeking the advice of a family member, friend, or someone else you trust.

Remember that with most reverse mortgages, you have at least three business days after closing to cancel the deal for any reason, without penalty.  To cancel, you must notify the lender in writing.  Send your letter by certified mail, and ask for a return receipt to document when the lender received your letter.  Keep copies of your correspondence and any enclosures.  After you cancel, the lender has 20 days to return any money you’ve paid up to then for the financing.