Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Reverse Mortgages Coming of Age

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Reverse mortgages are booming. The number of reverse mortgages issued is growing at a rapid rate (though the actual number still is fairly small), and mortgage options available are increasing. More options give older homeowners more potential benefits but also increase the potential to make mistakes.

The industry’s preferred term for reverse mortgages is Home Equity Conversion Mortgage (HECM). The growth in the last few years is almost staggering, especially considering the decline in other types of mortgages. In the last year, issuance of reverse mortgages increased 40% to 50%, and since 2005 they have increased 250% to 300%.

Part of the reason for the growth is the increasing number of homeowners in the right age group. Another reason is that the FHA increased the number of reverse mortgages it will insure; it currently insures about 90% of HECMs. Also, private lenders are more aggressively marketing the loans and creating terms that are attractive to potential borrowers, including for loans not insured by FHA. Another reason for the growth is a secondary market is developing; lenders can package and sell the loans, then use the proceeds to make new loans.

The uses of HECMs have changed. Traditionally, reverse mortgages were loans of last resort for those in their late seventies and older who needed cash for medical bills, home repairs, or other essentials. Now, HECMs also are used to pay for travel, gifts to the grandchildren, and even a second home.

In a reverse mortgage, a homeowner borrows against the home equity. The loan proceeds can be received as a lump sum payment, a line of credit to be tapped when desired, or a stream of annuity-like payments. Unlike a traditional mortgage, the borrower does not make regular repayments. Instead, when the borrower stops living in the home the lender is paid from the sale proceeds.

The fees for an HECM usually are high, about 5% or more of the home’s value in most cases. The fees can be added to the loan balance, so the homeowner does not have to come up with the cash. In addition, interest is charged. The interest rate usually is variable, but some loans now offer fixed rates. The interest compounds as long as the loan is outstanding. Since the loan is not repaid until the owner leaves the home, the lender does not know how long that will be. On loans not insured by FHA, the lender takes the risk that the loan, fees, and compounded interest exceed the value of the home when the borrower lives in the home longer than expected. On FHA loans, the government reimburses the lender for the loss.

During the loan period, the borrower is owner of the home and is responsible for maintenance, taxes, and insurance.

Because of the high fees and compounding of interest, a homeowner can borrow far less than the equity in the home. The maximum percentage of the equity that can be borrowed depends on the owner’s age, the interest rate charged, and the lender.

Here are some ways reverse mortgages are used today.

  • The traditional user is a homeowner with a paid-off home, limited income, and climbing expenses. For many years HECMs were used primarily by women in their late seventies or older who were living alone and needed money for medical expenses, home repairs, or general living expenses.
  • Another use is to restructure other debts and generate cash for new spending. An older couple might have substantial home equity, a conventional mortgage, and adequate, reliable income. They take out a reverse mortgage that pays the outstanding mortgage, a year’s property taxes, and the fees related to the loan. That frees up a significant part of the income for more travel, spoiling the grandchildren, and other opportunities they want to take advantage of during their active years.
  • A home equity line of credit can be a substitute for long-term care insurance. If long-term care expenses do not arise, the line of credit is not used. The fees related to the loan still have to be paid, but the home equity passes to the next generation. The couple has the security of knowing they have a way to pay for long-term care. In addition, they do not have to use income to pay for long-term care insurance premiums.
  • Some homeowners are using HECMs for more frivolous spending. They tap their home equity to buy recreational vehicles or second homes. Or they use the proceeds to pay for vacations or new cars. Some people use reverse mortgages to pay for gifts or education for grandchildren.

No matter the use of a home equity loan, potential borrowers need to consider the same details. Otherwise, rates and fees will be too high and the spendable portion of the home equity too small.

The loan principal insured by FHA is limited based on the median home value in an area. This made HECMs unavailable to those with expensive homes and significant home equity. In the last few years, however, some lenders have made uninsured reverse mortgages available in substantial amounts, in some cases on homes worth up to $10 million. Uninsured loans tend to have higher fees and interest rates than insured loans.

Borrowers of FHA-insured loans must meet with a free, approved counselor before agreeing to a loan. Different organizations offer the counseling around the country, and some are funded at least partly by lenders. A recent New York Times article asserted that the counseling quality is uneven. The average counseling session lasts about one hour, but some borrowers report shorter sessions. The counselors do not give advice but only try to explain the loans and their different terms.

The loan fees can be significant, and there will be several types of fees. Some borrowers do not fully understand the fees, because they are added to loan principal. Potential borrowers need to be sure they understand the fees being charged and how they are being paid. If the fees are paid from the loan or added to the loan, interest will be charged on them over the life of the loan.

The fees can range from 2% to 7% of the home’s value. They tend to be higher on FHA-insured loans than on other loans. Fees might be lower on a lump sum loan than on an annuity or line of credit loan, and they might be a lower percentage of the home’s value on more valuable homes.

As on other types of loans, lenders often will trade lower expenses for a higher interest rate.

There are interesting trade offs borrowers have to consider. FHA-insured loans generally have higher fees and lower maximum loan amounts than proprietary loans. But the FHA-insured loans also tend to have lower interest rates. The borrower has to forecast which combination of loan options is likely to leave more of the home equity for heirs or will provide the most cash during the owners’ lifetimes.

A reverse mortgage is not for someone who is planning to leave the home or its equity to heirs or charity. The home will be sold, and the proceeds will first pay the HECM lender. Any remaining equity goes to the person named in the homeowner’s will, but it should be assumed that the amount will be small.

The interest rates assessed against the loan usually are variable. Fixed rates now are available from some lenders, but the starting rate tends to be higher than for the variable rate loans.

A key provision in a variable rate loan is the index used to determine the rate. Usually the rate charged is the rate on an index plus some additional percentage. The traditional rate for reverse mortgages is known as the CMT index, which is based on treasury yields. Some loans are based on LIBOR. The LIBOR-based loans are likely to charge less interest over the life of the loan, but the lender might charge higher fees.

Reverse mortgages still are only about 1% of the total mortgage market, but they can be valuable financial management tools for older homeowners. Some of the best education materials on the loans are on the AARP web site at www.aarp.org. Before making a decision, potential borrowers need to fully understand these complicated products and contact several lenders to compare terms before agreeing to a loan.

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