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A reverse mortgage is a loan available to a homeowner 62 or older who may be eligible to borrow against the equity in his or her home.
Generally with a reverse mortgage, you receive money from a lender while you stay in your home. You don't have to pay the money back for as long as you live there and keep the property in good repair, but the loan must be repaid when you die, sell your home, or move to a different primary residence.
The amount you can borrow depends on your age, your home's value, your equity in it, and current interest rates. You can access the money as a lump sum, a line of credit, or a combination of these methods.
All reverse mortgages require closing costs, much like a regular mortgage, and they can charge fixed or variable interest rates. The fees can make a reverse mortgage an expensive way to borrow.
More than 90% of reverse mortgages, officially known as home equity conversion mortgages (HECMs), are insured by the US government's Federal Housing Administration (FHA). The FHA caps the size of reverse mortgages depending on the county in which your home is located and guarantees that you will receive the full amount of your loan.
Private alternatives to HECMs, called proprietary reverse mortgages, often offer higher limits. These loans may have higher costs, however.
A financial tool that allows senior homeowners to withdraw money from the equity in their home in a lump sum,or in payments over time,in the form of a loan that is not payable until after the last spouse dies or the homeowners cease using the home full time.Because this is a loan transaction,federal truth-in-lending laws require certain disclosures to the homeowners before they enter into such a transaction.They include, among other things, the following:
• An itemization of the loan charges, appraised value of the home, and age of the youngest borrower.
• All advances to and for the benefit of the consumer, including annuity payments that the consumer will receive from an annuity that the consumer purchases as part of the reverse mortgage transaction.
• Any additional compensation to the lender, such as the right to share in the increase in value of the home.
• The assumed annual appreciation of the home at 0, 4, and 8 percent per year.
• The assumed loan period of 2 years, one based on the actuarial life expectancy of the home owner, and one based on the actuarial life expectancy times 1.4 (in case the homeowner beats the odds and lives longer than expected).
• All other normal disclosures required in any consumer lending transaction (see Regulation Z).
A mortgage loan to an elderly homeowner on which the borrower's debt rises over time, but that need not be repaid until the borrower dies, sells the house, or moves out permanently.
The “forward” mortgages that are used to purchase homes build equity—the value of the home less the mortgage balance. Borrowers pay down the balance over time, and by age 62, when they become eligible for a reverse mortgage, loan balances are either paid off or much reduced.
Reverse mortgages, in contrast, consume equity because loan balances rise over time. If there is a balance remaining on a forward mortgage at the time a reverse mortgage is taken out, it is paid off with an advance under the reverse mortgage.
Need: Most of the elderly are homeowners. For many, especially those with low incomes, homeowner equity constitutes a major part of their net worth. Most of them built that equity during their working lives, in part by paying down their mortgages.
As their incomes decline in their later years, many would like to consume their equity rather than leave it to heirs who don't need it. Without reverse mortgages, however, the only way to do that is to sell the house and live elsewhere. Reverse mortgages allow elderly homeowners to consume some or all of the equity in their homes without having to move—ever.
Suspicion: In the 1970s and early '80s, when I was actively involved in trying to develop reverse mortgage programs and bring them to the market, the need was as great as it is today. However, they were a very tough sell. I was involved in two projects that offered excellent products, but neither project survived.
The major problem was that elderly homeowners were extremely cautious and suspicious. Even when they seemed convinced, they often backed out at the last moment. Unfortunately, some programs being offered around that time did not guarantee lifetime occupancy—borrowers could be forced out of their homes if they lived too long. The complexity of reverse mortgage programs was also a deterrent.
This situation began to change in 1988 with the development of a federal program under the FHA. The borrower protections built into this program, along with the imprimatur of the federal government, paved the way toward increasing acceptance by elderly homeowners. The AARP also entered the picture as a major information source (see www.aarp.org/revmort). Complexity continues to be a problem, however, which is why the FHA requires that applicants be counseled before entering the program.
In 1999, a sample of homeowners who had taken FHA reverse mortgages was surveyed regarding their experience under the program. The survey found that about 80% were either “very satisfied” or “satisfied,” and only about 15% were “very dissatisfied” or “dissatisfied.”
In early 2003, reverse mortgages were being written at a rate of about 1,500 a month, which was an all-time high. Yet the volume remained small relative to the size of the potential market. About 95% of the new loans were FHA-insured. Other reverse mortgage programs were available from Fannie Mae and from Financial Freedom Senior Funding Corporation, a subsidiary of Lehman Brothers Bank, FSB. In addition, some limited special purpose programs were available from some states and cities.
Safeguards: Under all the programs cited in the paragraph above, borrowers have the right to live in their house until they sell it, die, or move out permanently, regardless of how much their mortgage debt grows. If the debt comes to exceed the value of the property, the lender takes the loss, except that on the FHA program, FHA reimburses the lender for any loss out of insurance premiums paid by borrowers.
In addition, loans under these programs are without recourse. This means that lenders cannot attach other assets of borrowers or their heirs in the event that the reverse mortgage debt comes to exceed the property value.
Borrowers do have obligations under these programs, but they are no more than one would expect. Under the three major programs, the lender can demand repayment of the loan if the borrower fails to pay property taxes or insurance, doesn't maintain the home, changes the names on the title, takes out a second mortgage, takes in boarders, or uses the home as a business.
Eligibility: To be eligible for the major programs, all owners must be 62 or older and must occupy the home as their permanent residence. There are no income or credit requirements, since borrowers don't assume any payment obligation, but all the reverse mortgage programs require counseling.
Eligible properties generally include one-family units, condominiums, manufactured housing, and houses in planned unit developments. Two- to four-family units may or may not qualify. Mobile homes and co-ops are not eligible, although co-ops may soon become eligible under the FHA program.
The house may have an existing mortgage, but it will have to be repaid out of the reverse mortgage proceeds. An exception would be where the existing lender is willing to subordinate his claim to that of the reverse mortgage, meaning he wouldn't get paid until the reverse mortgage is repaid. No institutional lender would be willing to do that, but some special purpose reverse mortgage programs may allow it.
Debt-Based Versus Equity-Based Products: While the term “reverse mortgage” implies a debt secured by property, it is possible to fashion instruments for the same purpose that are equity-based—meaning that the investor acquires an ownership interest in the property. Investors are willing to pay more to acquire a house outright than they will on a reverse mortgage, where they only earn interest on the amounts they advance the owner.
Indeed, the oldest known instrument for “home equity conversion” was of this type. At least as far back as the 19th century, notaries in France arranged deals between homeowners and individual investors where the investor paid the owner an annuity for life. Such deals were very simple. The annuity was determined by dividing the current value of the property by the owner's life expectancy. The investor took possession of the house upon the owner's death, whether that happened after a month or after 40 years.
However, these deals were extremely risky to both parties. Occasionally the owner would outlive the investor. And occasionally the owner would die before the ink was dry on the contract. While investors can diversify their risk by writing many contracts, owners cannot because each owner has only one house with which to transact.
Combined debt/equity arrangements are also possible, and several of these have appeared in the U.S. In these deals, the investor makes a loan and also receives either a share of the appreciation in
the home's value or a share of the value at termination. The equity participation feature permits the investor to pay the owner more than in a straight debt transaction.
None of the programs of this type have been successful, however. The American Homestead program during the 1980s failed because the expected rate of appreciation did not materialize and investors did not earn an adequate return. In 2000, Fannie Mae terminated an equity option in connection with its Home Keeper reverse mortgage for essentially the opposite reason.
In exchange for paying up to 10% of the value of their home at the termination of the contract, owners received larger payments under Home Keeper than if they took a straight loan. With this equity option, owners who terminate early pay a lot more than those who terminate late. When a syndicated columnist wrote up the news that early terminators were paying a high cost, as if it were a scandal, Fannie Mae was embarrassed, and in 2000 it terminated the equity option.
Available Payment Amounts: The amounts available on a reverse mortgage depend on the value of the house, age of the youngest coborrower, interest rate, upfront costs, servicing fee, method of payment, and whether there is an equity option. The tables on the next page apply to the FHA's Home Equity Conversion Mortgage program, which provides the largest payments for the property values of $100,000 and $200,000 assumed in the table, but not necessarily for larger values that exceed FHA loan limits. Upfront costs are assumed to be $2,000 plus 2% of the house value, while the servicing fee is $30 a month. There is no equity option.
The first table shows the maximum credit line, which is the amount the borrower can withdraw immediately as a lump sum. For example, at 6%, a 75-year-old with a $100,000 house could withdraw $58,433. Note that because some costs are a fixed amount, the credit lines on a $200,000 house are more than twice as large as those on a $100,000 house.
The second table shows different combinations of credit line plus monthly payments for a 75-year-old with a $100,000 house at 6%. The largest credit line of $58,433 allows no monthly payments. If the borrower only takes a $30,000 line, however, she can also receive $253 a month for life, $295 for 15 years, $385 for 10 years, or $663 for five years.
|Interest Rate||Age of Youngest Co-Borrower|
|Property Value = $100,000|
|Property Value = $200,000|
|Credit Line||Monthly Payments|
|Tenure||15 Years||10 Years||5 Years|
Available Calculators: Jerry Wagner, an expert's expert on reverse mortgages, has developed calculators used in determining the amounts a homeowner can receive under the FHA and Fannie Mae programs. Different versions of these calculators are available at Jerry's own Web site (www.revmort.com), at the AARP's site (www.rmaarp.com), and at the site of the National Reverse Mortgage Lenders Association (www.nrmla.org), where you will also find a list of reverse mortgage lenders. Financial Freedom has its own calculator, available at www.ffsenior.com, that covers all three programs.
None of these calculators show changes in the borrower's mortgage debt and homeowner equity in the future. Lenders and loan counselors have calculators that do this, however, and they can meet borrowers' requests for such information.
Total Annual Loan Costs (TALC): Federal law requires lenders to report a single interest cost figure for all reverse mortgages. The TALC is designed to allow borrowers to compare one lender's offerings (or one type of reverse mortgage) with another, and also to illustrate how the cost of a reverse mortgage declines as the transaction ages.
The TALC is somewhat analogous to the APR required on forward mortgages, except that the TALC covers all costs and the APR does not. In addition, the TALC is calculated over two years, half of life expectancy, life expectancy, and 1.4 times life expectancy, whereas APR is calculated over the term of the loan.
Under the market conditions of early 2003, the TALC was pretty much a fifth wheel for comparison shopping, especially on the FHA program. Interest rates did not vary from one lender to another, and FHAcapped the origination fee and servicing fee. Third-party settlement costs varied with the area of the country, but were not likely to vary between lenders in the same area.
Because origination and closing costs are incurred upfront, the TALC always declines over time. A typical pattern in early 2003 for a 79-year-old taking a tenure (lifetime) payment on a HECM would be a TALC of 30% if the borrower terminated after two years, 10% over five years, 6.5% over nine years, and 5.5% over 13 years. Reverse mortgages are not a good deal for borrowers who expect to be out of their homes within a few years.
Single-Purpose Programs: Much the simplest type of reverse mortgages are those offered by some states and cities, which are either for property improvement or for the payment of property taxes. These loans require no repayment so long as the borrower lives in the house. Loans for property improvement are one-time advances, while those for payment of property taxes are annual advances.
Single-purpose programs are invariably good deals, but they usually have eligibility criteria that limit their availability. The criteria may apply to income, house value, age, area, or borrower health. There is no one comprehensive source of information on these programs, but a good place to start looking is the directory of “homes and communities organized by state” on www.hud.gov.
FHA's Home Equity Conversion Mortgage (HECM): The largest program by far is FHA's HECM program. In 2003, it accounted for about 95% of all reverse mortgages. The great strengths of this program are the security provided by the federal guarantee and the payment options available to the borrower. These options are available at the outset and also throughout the life of a transaction in that borrowers can shift from one to another.
The weakness of HECM is that it is complicated, which is why Congress made it mandatory that borrowers undergo a counseling session before they sign on. But as I write this, no one involved with HECM has much of an idea of how good or bad the counseling is. Wise borrowers will do the homework they need to counsel themselves.
Options: Borrowers can choose from five payment plans. All of them require that the borrower maintain the property as his or her principal residence.
• Tenure: The borrower receives a fixed monthly payment for as long as he or she remains in the house.
• Term: The borrower receives a fixed monthly payment for a period specified by him or her.
• Line of Credit: The borrower may make withdrawals at times and in amounts selected by him or her, within a specified maximum draw. This includes drawing the maximum amount as a lump sum at the outset.
• Modified Tenure: A combination of tenure and line of credit.
• Modified Term: A combination of term and line of credit.
These options are designed to meet diverse needs. A borrower who wants to repay what is left on his or her existing mortgage can do it with a line of credit. A borrower who plans to sell in five years but needs more income in the meantime can elect a term loan for five years. And so on.
Principal Limit: Acritical number in each HECM is called the “principal limit.” It is the present value of the house, given the owner's right to live there until he or she dies or voluntarily moves out.
If the house is worth $100,000, for example, the principal limit might be only $64,000. $100,000 is what the owner can get if he or she gives up the house immediately. $64,000 is what he or she can get if he or she retains the right to live there for an indefinite period.
The principal limit is determined by three factors: the borrower's age, which determines how long the investor is likely to have to wait to be repaid; the expected interest rate, which measures the cost of having to wait; and the property value, which affects the risk that the debt won't be fully paid when it comes due because it will exceed the property value.
There is an important proviso attached to the last factor, however. If the property value exceeds the FHA loan limit in the county in which the property is located, the loan limit is used in calculating the principal limit. This limit makes other reverse mortgages more attractive to seniors with higher-valued homes.
The owner cannot withdraw cash equal to the full principal limit. She can withdraw the net principal limit, which is the principal limit less the HECM settlement costs, including any required repairs and repayment of existing debt, and less a servicing fee hold-back or “set-aside” (see Costs below). The net principal limit is the maximum line of credit you can get at the outset if you exercise the credit line option; it is also used to determine tenure or term payments. For example, if the net principal limit is $60,000, you could take a credit line for that amount or you could take a credit line for $30,000 and use the remaining $30,000 to purchase tenure or term payments.
Property Value Versus FHA Loan Limits: The greater the value of the borrower's property, the larger should be the credit advances and/or monthly payments available under the program. But this is true only so long as the property value does not exceed the FHA loan limit in the county where the property is located. Borrowers receive no credit for value in excess of the loan limit, which in 2003 ranged from $154,896 to $280,749. For a borrower living in a county where the FHA limit is $190,000, the credit line and tenure or term payments are the same for a house worth $190,000 and a house worth $500,000.
This is not a major problem for borrowers who view a HECM as a stop gap measure and want to retain as much equity as possible. A borrower who takes a term payment for five years, for example, intending to sell at the end of that period, will retain the equity that FHA did not use in calculating his payment.
But borrowers who want to live in their house until they die, who are usually viewed as the major intended beneficiaries of reverse mortgage programs, are disadvantaged. The borrower with a $585,000 house must pay the same insurance premium as the borrower with the $185,000 house, but there is a substantial difference in risk of loss to FHA. A borrower in this situation might consider a reverse mortgage from Fannie Mae, which has a higher loan maximum, or from Financial Freedom, which has no maximum.
Note: FHA loan limits are raised at the beginning of every year. You can find them at https://entp.hud.gov/idapp/html/hicostlook.cfm.
Tenure Payments: Tenure payments in the HECM program are priced on the assumption that the borrower, whether age 62 or 92, male or female, will live to be 100! Borrowers who want payments for life and are not concerned with leaving equity to their heirs do better taking a lump sum under a credit line and using it to purchase an immediate annuity from a life insurance company. Just make sure the company is highly rated, because you are leaving the realm of federal insurance when you do this. I found immediate annuity quotes on www.immediateannuity.com, which also shows the quality ratings of each company.
You want a fixed annuity, one that pays the same guaranteed amount every month, beginning immediately. If you don't yet need the payments, you can take the credit line and sit on it—it will grow over time. Alternatively, you can wait until you need the income before taking out the credit line (see Credit Lines below).
Warning: Do not use a lump sum drawn under a reverse mortgage credit line, whether a HECM line or any other, to invest. There are no safe investments available that pay a return higher than the cost of the reverse mortgage to you. Borrowing at 6% to invest at 3% is dumb.
Interest Rates: Among the complexities of the HECM program is that it uses two interest rates. The rate the borrower pays is the oneyear Treasury rate plus a margin. This rate determines how fast the borrower's debt rises over time. But borrowers have a choice between two variants of it. They can select between a) monthly rate adjustments, a margin over the Treasury rate of 1.5%, and a limit on rate change over the life of the loan of 10% and b) annual adjustments, a margin of 2.1%, and a limit on rate change of 5% over the life of the loan and 2% in any one year. Most borrowers select a), which is what I would select.
The second rate, called the “expected rate,” is used in calculating the credit line/payments borrowers can receive. It is the 10-year Treasury rate, plus the margin used in the rate selected by the borrower. In contrast to the first rate, which adjusts regularly, the expected rate is fixed for each borrower. If a borrower changes the payment plan, the expected rate used in calculating the new payment is the one set at the outset of the transaction.
Credit Lines: Most borrowers who take reverse mortgages under HECM elect credit lines rather than term or tenure payments. In calculating credit lines, FHA assumes that properties will appreciate 4% a year between the time the reverse mortgage is taken out and the time the investor acquires the property. On the other hand, the calculation of term and tenure payments is very stingy. The calculation for term payments assumes that no one dies during the term and the calculation for tenure payments assumes the borrower will live to be 100.
In addition, a credit line has more flexibility than tenure or term payments. A borrower could draw the same amounts under a credit line as under tenure or term payments, while retaining the flexibility to stop it or expand it at any time. Further, the unused portion of the HECM credit line increases every year at the same rate as the borrower pays on accumulated debt.
A question faced by many seniors with no immediate need for funds is whether their HECM credit lines will be larger in, say, five years if they take it immediately or if they wait for five years. Waiting increases the credit line, both because the borrower will be five years older and because the house value used in calculating the line is likely to be higher.
For example, using the interest rates that prevailed in early 2003, a borrower 75 years old with a $100,000 house would have a credit line of $63,100, which if unused would grow to $74,500 after five years. If the borrower waited five years but the house did not appreciate, the credit line in five years would be $68,000, with the increase due entirely to the borrower being five years older. If the borrower waited five years and the house appreciated by 3% a year, so that in five years it was worth $115,900, the credit line in five years would be $79,600.
In general, therefore, if you don't need the money now, it is better to wait until you do. Even if the house does not appreciate, if it is currently valued well above the FHA loan limit, the annual increase in the limit will increase the line. The only situation where it is not better to wait is when the house is currently valued at less than the FHA loan limit and has no prospect of appreciation.
Note that under Fannie Mae's Home Keeper Plan, discussed below, the credit line does not increase over time at all. Hence, the
only way you can get a larger line is to delay doing the deal. In contrast, credit lines increase under the Financial Freedom plan even faster than they do under HECM, so sitting on a credit line may be a more viable strategy.
Refinancing: In many cases, borrowers who have taken out reverse mortgages under HECM in the past and still live in their
house could increase the amount they draw by refinancing. Because they are older and their house is likely to have appreciated, a recalculation of the net principal limit will provide an increased line. Even if the house has not appreciated, if its value exceeded the FHA loan limit at the outset, increases in the limit have the same effect as appreciation. In addition, interest rates may be lower than when they took out their loan.
Refinancing does require a new set of settlement costs, including a new insurance premium. At this writing, the market was waiting for HUD to issue new regulations implementing legislation passed by Congress whereby mortgage insurance would be charged only on the increment to property value above that on the first loan. Implementation of that rule should encourage more borrowers to refinance.
Costs: HECMs and other reverse mortgage programs involve upfront costs, which can generally be financed. FHA allows lenders to charge an origination fee of $2,000 or 2% of the house value, whichever is less. FHAcharges an insurance premium of 2% of value at closing, while a monthly premium of ½% per year is included in the interest rate you pay on your loan balance. Other closing costs vary by area but run about $3,000. The calculator at www.nrmla.org shows all these costs, which are deducted from the credit line.
A servicing fee is also added to the loan balance each month. It is $30 if rate adjustments are annual and $35 if they are monthly. In addition, to ensure that there is enough money available to pay for servicing over the life of the loan, the present value of these payments is deducted from the credit line as a servicing fee “set-aside.” It is not debt, but it is deducted from the principal limit in calculating the net principal limit.
Fannie Mae's Home Keeper Mortgage: Fannie Mae is the major investor in FHA HECMs and also has its own reverse mortgage product, called Home Keeper. It carries a higher interest rate than the HECM, but it does not have an insurance premium. Home Keeper offers a line of credit, tenure payments, and combinations of the two, but no term payments. Credit lines are fixed, rather than increasing over time as they do with the HECM.
On homes with values that do not exceed the FHA loan limit, owners do better with an HECM than with a Home Keeper. But because Fannie Mae's loan limit is higher than the highest FHAlimit, an owner whose house value exceeds the FHA limit may get a larger credit line under Home Keeper. This doesn't necessarily mean that Home Keeper is preferable in such a case, but it might be, depending on the preferences of the owner.
Here is an example as of early 2003. An owner age 79 has a $300,000 house in a county where the FHA loan limit is $184,666. Fannie Mae's limit is $322,700. Both mortgages are adjustable monthly.
|FHA HECM||Home Keeper|
|Initial Interest Rate||3.41%||4.77%|
|Maximum Credit Line||$120,252||$132,753|
|Credit Line in 5 Years|
(assuming no draws on line)
|Mortgage Balance at Age 95|
(assuming tenure payments)
If this owner had no heirs and wanted the largest possible monthly payment for life starting immediately, Home Keeper would be the right choice. She probably would do better taking the full credit line and purchasing an annuity from a life insurance company, rather than taking tenure payments. However, the purchased annuity would be larger under Home Keeper because the credit line is larger.
On the other hand, if the owner wanted to leave an estate and could afford to take the lower HECM payment, she might elect the HECM because of the smaller buildup of debt. She also might go that route if her immediate need for cash was small, because the unused portion of the line grows under the HECM program.
If the owner has no immediate need for funds, she should select neither program. The best option in such case is to wait because the passage of time increases the potential draw.
Financial Freedom's Cash Account: This is a private program that offers only a line of credit and has no limit on property value. Costs are higher than on HECM or Home Keeper, but the draws will be higher on high-value properties.
The break point in property value depends on the age of the borrower. An owner aged 79 will receive a larger draw on the Cash Account than on HECM or Home Keeper if her house is worth $400,000. But an owner aged 62 has to have a house worth $700,000 before she can draw more under a Cash Account.
Financial Freedom also offers an equity participation feature on Cash Account that will increase the draw but use more equity. The interest rate used to calculate the credit line is reduced by 1% in exchange for the payment of 5% of property value at termination. The return on the transaction to Financial Freedom is capped at 8% above the initial interest rate.
Lenders: Elderly homeowners interested in a reverse mortgage should select a lender who belongs to the National Reverse
Mortgage Lenders Association (NRMLA). The 120 or so members subscribe to a code of conduct that appears on www.reversemortgage.org. That site also contains a list of lenders by state and shows the reverse mortgage programs that each lender offers.