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Reverse Mortgages—What Are the Pros, Cons, and Cautions?

 

September 2012

If you listen to the TV pitchmen, you would think that a reverse mortgage is every older homeowner’s dream. Advertising claims appear to promise a risk-free, low-cost way to get easy cash from your home without endangering your home ownership. Some even imply you won’t be increasing debt.

Such advertising is simplistic and deceptive. In actuality, a reverse mortgage is a complex product. Most important, it is a loan, a fact often glossed over in the ads. A reverse mortgage may be right in certain situations, but you need to take time to understand the options and costs as well as potential benefits and risks. Comparing loan offers and finding the best lender are also challenges.

Since the mortgage crisis began in 2007, there have been many changes in the reverse mortgage market place. Today, all but a very few loans, are federally insured Home Equity Conversion Mortgages (HECMs). This report provides a brief overview of what you need to know about HECMs in today’s market place.

What Is a Reverse Mortgage?

A reverse mortgage is a home loan that enables qualified, older homeowners to access part of the equity in their home as cash. Like a traditional “forward” mortgage, the loan is secured by the home. Title to the home remains with the homeowners. But with a reverse mortgage, repayment of the loan is deferred as long as the borrowers continue to meet several criteria, primarily:

  • Live in the home as their primary residence
  • Pay all property taxes and insurance
  • Maintain the home in good repair

Although repayment is deferred, interest on the borrowed amount continues to accrue for the life of the loan. That means that over time the loan balance increases and equity in the home decreases. The total of principal and interest must be paid back when the borrowers sell, move out, or die. Because the reverse mortgage is a “nonrecourse” loan, however, owners or heirs will owe only the loan balance whatever the value of the home.

A reverse mortgage:

  • Is a loan where the balance owed increases over time while the equity in your home decreases.
  • Is only for qualified homeowners who are 62 or older.
  • Has other costs such as Mortgage Insurance Premiums, origination fees, closing costs, and loan servicing fees.
  • Are expensive compared to other options such as traditional home equity loans.

In addition to interest, a reverse mortgage has other costs, both upfront and continuing, that affect the cash available to the borrower and the total balance of the loan. The type and terms of the reverse mortgage product selected also affect the amount homeowners may borrow and the total balance of the loan over time.

Just these few factors indicate the complexity of reverse mortgages. To help consumers better understand reverse mortgage options, costs and alternatives, the federal guidelines require potential borrowers to participate in an educational information session conducted by a HUD-approved counselor before applying for a reverse mortgage.

What Qualifications Are Required for a Reverse Mortgage?

  • The borrower or youngest co-borrower must be age 62 or older.
  • Borrowers must live in the home as a primary residence.
  • The house may be a single-family resident or have 2 to 4 units with one unit occupied by the borrower. Some HUD-approved condominiums and manufactured homes meeting FHA requirements also qualify.
  • The reverse mortgage must be the only loan on the home. Consequently, borrowers must own the home outright or be able to pay off any existing loan on the home, such as a traditional mortgage, home equity loan or home equity line of credit (HELOC), with the proceeds of the reverse mortgage.
  • Potential borrowers must receive a consumer information session from an HUD-approved counselor before applying for a reverse mortgage.
  • Borrowers must not be delinquent on any federal loan.
  • Although income and good credit are not required, lenders may verify income, assets, living expenses, credit history and payment record for property taxes and insurance.

What May a Reverse Mortgage Be Used For?

When created, reverse mortgages were intended as a “last resort” option to help older adults whose major asset was their home to access the equity in that home to supplement retirement income, meet major medical expenses or make major home repairs. The goal was to help older adults stay in their homes—to “age in place.” In addition, today, many borrowers take the whole loan up front as a loan to pay off an existing mortgage so they have no mortgage payments during retirement.

There are also special programs that allow borrowers to use an HECM loan to finance a new primary residence or refinance an existing primary residence.

How Much Can Be Borrowed in a Reverse Mortgage?

At today’s interest rates, borrowers may receive between 51% and 77% of the equity in an appraised home value up to a total home value limit of $625,000. This limit is set by government regulation and will revert to $417,000 if not extended after December 31, 2012.

The percentage of equity value that may be borrowed is determined by a complex formula based on the borrower’s age, the interest rate of the loan, and the appraised value of the home or the home value limit of $625,000, whichever is lower. Other factors that influence actual loan proceeds include upfront and monthly fees and costs that depend on whether the borrower opts 1) for a HECM Standard or Saver loan and 2) for an adjustable or fixed rate loan.

Generally speaking any of the following factors will result in a lower maximum loan.

  • Lower age at the time of application. The younger you are the less you can borrow.
  • Higher interest rate.
  • Lower appraised home value.
  • Choosing the HECM Saver loan option rather than the HECM Standard option.

The fact that costs such as origination fees and closing fees, mortgage insurance premiums, and loan servicing fees are deducted from the loan also lowers the actual proceeds available to the borrower.

What Are the Different Types of Reverse Mortgages?

The HECM Program offers two types of reverse mortgage plans: The HECM Standard Plan and the HECM Saver Plan. The principal difference is the Standard Plan has a larger upfront fee for the Mortgage Insurance Premium (2% of home value) compared to the Saver Plan (.01% of home value), but the Standard Plan provides a larger loan. The Saver plan is intended to provide a lower cost upfront loan for borrowers who do not need as much access to their equity and who are willing to pay a slightly higher interest rate. Because other charges on both plans are similar, the effective overall cost of the Saver plan may be similar to or a little higher than the Standard plan.

Borrowers may also choose between an adjustable rate reverse mortgage and a fixed rate reverse mortgage. Before the mortgage crisis began in 2007, most reverse mortgages had adjustable rates and most borrowers took their loan as a line of credit while a minority opted for a fixed monthly disbursement. But within a short time as market offerings changed, a majority of borrowers began to select a fixed rate loan; in all fixed rate mortgages currently available, borrowers must take their loan as an upfront lump sum. The following chart, adapted from the Consumer Financial Protection Bureau’s report to Congress compares HECM loan features by rate type.

Comparison of HECM Loans by Interest Rate Type
Features of loan Adjustable Rate Fixed Rate
Available payment options All types:
  • Line of credit
  • Term—fixed monthly payment for fixed number of years
  • Tenure—fixed month payment as long as borrower lives in home
  • Modified—part line of credit plus monthly term or tenure payment
  • Lump sum
  • Lump sum only
Interest rate Averaged 2.5% in FY 2011.
Lower rate at origination but can change over the life of the loan. Increases are capped.
Averaged 5.1% in FY 2011
Higher at origination, but will not change over life of loan.
Loan structure/prepayment Open-end loan in practice: Can prepay all or some of loan at any time and re-use credit line. Closed-end loan in practice: Can prepay some or all of loan at any time, but can not re-use any of credit line.
Credit line growth Unused credit line grows over time at the same rate as the interest plus mortgage insurance premium on the loan balance No credit line growth.

What Are the Costs Associated with Reverse Mortgages?

Reverse mortgages are considered expensive loans. That’s why financial planning experts urge consumers to consider alternative options and compare costs overall. The following are major upfront and continuing costs associated with reverse mortgages. Rather than pay any of the costs upfront, borrowers typically deduct them from the loan principal which reduces the proceeds available to the borrower.

Origination fee. This fee is charged by the lender to cover the preparation of the loan paperwork and the processing of the loan. Lenders may charge a maximum of $2,500 for a home valued at $125,000 or less. For home valued over $125,000, the origination fee may be up to 2% of the home’s value to $200,000 plus 1% of the value up to the limit of $650,000. Origination fees are capped at $6,000. In today’s market place, many lenders in practice are charging much lower origination fees or waiving them.

Third-party closing costs. These costs include the appraisal, title search and insurance, surveys, inspections, recording fees, mortgage taxes, credit reports, couriers, and any other services required for closing the loan. These costs can vary by home value and by state or area within a state but typically may range from $2000 to $3000 to even higher.

Mortgage Insurance Premium (MIP). Mortgage insurance is required for HECMs. The upfront MIP due at closing for the HECM Standard Plan is 2% of the home’s appraised value. For the HECM Saver Plan, the MIP due at closing is 0.01% of the homes appraised value (both up to the FHA limit $625,000).

Monthly MIP fees for both Standard and Saver Plans are 1.25% of the current loan balance (principal and interest). Because monthly MIP fees are added to the loan balance, the interest on these compounds as it does on the principal owed.

The MIP is an important part of a HECM loan because it offers guarantees to the borrowers and their heirs and to the lenders and investors. It insures that the borrower will receive the entire loan even if the lender defaults. It also insures that the lender will be repaid even if the value of the home declines. Finally it insures that the borrower’s debt cannot be larger than the value of the home when the loan is repaid. This means that when the home is sold to pay off the debt, the amount paid to lender cannot exceed the proceeds of the sale and that the lender cannot legally seek repayment from the borrower's income, their other assets, or from their heirs.

Counseling fee. Originally the required counseling session was free or available at minimal cost. With reduced financing, expect to pay up to $125 for this session.

Servicing fee. This is a monthly fee charged by the lenders to service the loan. Servicing includes making payments to the borrower, paying insurance premiums, and acting on requests from borrower. As with traditional mortgages, the servicing fee is embedded in the interest rate. Each month, servicers receive between 30 and 144 basis points (0.30 to 1.44 percent).

Interest. Interest accrues on the loan each month and compounds over time. It is paid to the lenders or investors in a lump sum when the loan is repaid.

What Are the Potential Benefits?

  • A reverse mortgage can enable persons with limited income and few assets beyond the equity in their home to remain in their home and supplement their income with loan proceeds. It may also allow such persons to reduce monthly expenses such as a mortgage payment or to cover large unexpected expenses such as medical or home maintenance needs.
  • The loan advances are not taxable.
  • Unless it is a single-purpose reverse mortgage such as those available from some local or state governments to pay property tax or the like, it can be used for almost any purpose. Two regulations, however, prohibit the use of and cross-selling of loan proceeds for investment in questionable securities (such annuities or stock funds) that are riskier investments for seniors and typically pay less than the reverse mortgage loan costs.
  • There are no monthly loan payments. No payment is due until the loan is repaid because of the death of the borrower, the home is sold, or the borrower decides to pay off the loan.

What Are the Potential Risks and Drawbacks?

  • Reverse mortgages are not intended as short-term loans or short-term solutions. If you plan to sell your house and move in a few years or are trying to forestall problems paying a current mortgage, there may be other, better alternatives.
  • If you take out a reverse mortgage at an earlier age, such as in your sixties, you may not have access to equity in your home in later years when you may have a greater need for it.
  • The home is subject to foreclosure if property taxes and/or insurance is not paid or the home is not adequately maintained.
  • The interest is not deductible on income tax returns until the loan is paid off.
  • Even though most reverse mortgages don't affect your Social Security or Medicare benefits, it may affect your eligibility for certain "need based" benefits such as Medicaid.
  • There may be little or no equity remaining to leave to heirs.
  • Reverse mortgages are expensive compared to other home equity loans. Interest rates, fees and costs are generally higher than other loans.
  • Financing the closing costs, service fees, and any other costs can significantly reduce the amount of the loan available.
  • The reverse mortgage must be the only mortgage on the home, so paying off an existing mortgage with the reverse mortgage proceeds reduces the amount of loan money available for other expenses.

What Cautions Should Potential Borrowers Consider?

  • Choosing an appropriate lender to work with is important. The current market place for reverse mortgages is very fractured. Each year only about 70,000 HECMs are made but there are about 2000 entities with approval to originate loans. In 2011 and 2012, the three largest originators of HECMS (two national banks and one large insurance company) withdrew from the reverse mortgage market. As of June 2012, no depository institutions (which are subject to banking regulations) were making HECM loans. Although mortgage brokers and other sources of HECMs are subject to federal law and to regulation by the Consumer Financial Protection Bureau, CFPB regulations are still in the making. So educating yourself thoroughly about reverse mortgages and the questions to ask may help you choose the right lender. One tip: Never pay any one such as an “estate planner” to help you find a reverse mortgage lender. HUD provides qualifies lender information for free.
  • The required consumer information session can be very useful to potential reverse mortgage borrowers. But several studies show that not all counseling sessions and counselors provide sessions with adequate length and information.

What Are Some Alternatives to a Reverse Mortgage?

Before choosing a reverse mortgage, consumers should consider other options for which they may qualify and which may help them meet financial goals at lower overall cost. Some of these alternative products include:

  • A traditional home equity line of credit (HELOC)
  • Refinancing a traditional mortgage to lower monthly payments
  • Selling the home and downsizing to a smaller home that can be bought outright with the equity realized by the sale or financed with a smaller mortgage and reduced mortgage payments
  • Applying for specialized products and programs offered at the state and local level that meet the consumer’s specific need, such as deferring property tax
  • Applying for federal, state, or local programs that may provide financial assistance to seniors

Educating Yourself—It’s the First Step

If you are considering a reverse mortgage, the most important thing you can do is take the time to acquire a thorough understanding of reverse mortgages and how they work. Learn what questions you need to ask (of counselors and lenders) to get the information you need to make a decision that’s right for you and your family. The following resources will give you a good start.

For More Information

Reverse Mortgages for Seniors is the information website from the U.S. Department of Housing and Urban Development (HUD). It offers basic information and links to HUD-approved Housing Counselors and HUD-approved HECM lenders.

Reverse Mortgages: Report to Congress from the Consumer Financial Protection Bureau presents the most up-to-date information (as of June 28, 2012) and a thorough examination of both reverse mortgage products and marketplace circumstances and considerations. It’s a big report, but it’s clear and worth the effort to check out.

Reverse Mortgage Loans: Borrowing Against Your Home is a classic report from AARP that contains 2010 updates.

Loan of Last Resort: Is a reverse mortgage for you? is a set of 3 videos that look at what you need to know about reverse mortgages.


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