Reverse Mortgages

The intense appreciation in the housing market coupled with the uncertainty, and in many cases, decreased returns of investment portfolios, has created a puzzle for many retirees who find themselves in the position of having more house than cash to help meet their high monthly expenses, such as property taxes, etc.  Their options include selling the home, transferring the home to their children, or using a home equity line of credit.  However, there is one other option most people have forgotten about – the reverse mortgage.

A reverse mortgage can provide the necessary cash flow and financial ease for clients who are looking to remain independent in their own home.

Previously, most reverse mortgages were not an attractive option due to the fact that the lender would receive most of the benefit, including costs, interest on the loan, and in many cases, sharing in whatever appreciation occurred during the loan period, or in the worst cases, the lender simply ended up owning the home.

Things have changed today.  The Federal Housing Authority (FHA) has eliminated many of these unsatisfactory provisions.  Reverse mortgages have come full circle to the extent they are now attractive not only to the retiree wanting to save the family home, but they can also be useful to replace income lost due to low interest rates or even provide additional income without forcing the sale of depreciated stock or paying long term capital gains.  In many cases, the excess income can now be used to provide for long term care insurance.

Many private and state government lenders should be considered in addition to the FHA sponsored Home Equity Conversion Mortgage (HECM).  It is always important to measure carefully each of the various programs available.  However, the following analysis will cover the generalities of reverse mortgage programs.

One desire most retirees have is to retain ownership of the family home.  The HECM program provides for this benefit.  In the past, the other options available to the retiree would have been the sale of a home to their child, thus relinquishing their one family asset.

The HECM program does not require loan repayment until the last surviving borrower dies, the home is sold, or the buyer permamently moves out of the home.  Thus, the risk of missing payments or defaulting on the loan and losing the house is mitigated.  In addition, HECM loans are non-recourse, and in some cases, the borrower may receive payments greater than the home’s value, although the borrower will never owe more than the home is worth.  The various options available to the borrower for drawing down cash are as follows:

  1. Lump Sum
  2. Monthly Payments
  3. Credit Line option

Further flexibility is created by the ability to combine any one of the following payment options, including the ability to opt in or out of these choices.

  1. The credit line option allows the homeowner to draw down only when needed.  In addition, the amount they are able to borrow could continue to grow over the lifetime of the loan.  The amount of the credit available continues to grow by the amount of interest charged on the loan.
  2. An alternative to the credit line is the monthly payment option.  This will provide a steady cash flow for the retiree.  There are two options available, tenure or term payments.  The more frequently used approach is the tenure payment and is somewhat similar to a lifetime annuity.  The most significant aspect is the FHA guarantees payments over the life of the surviving borrower regardless of the loan balance or home value.  This option actually will allow the borrower to receive payments in excess of the home value.  However, when the last borrower dies, the loan becomes due and the amount received must be paid back by the estate including any closing costs and interest.
    The alternative to the tenure payment is the term payment, providing a fixed payment over a specific term, i.e. 15 or 20 years.  This may not be the best solution, since a reverse mortgage is typically used to provide income for lifetime; thus, a term payment ending in 15 or 20 years would not satisfy the lifetime need.
  3. Lastly, the lump sum option is attractive since it could provide capital for large expenditures, such as remodeling.  Having said that, this type of expenditure could create a cash shortfall for the retiree in the future.  The FHA does require that all existing loans be paid down first using the reverse mortgage.  The use of the lump sum option could provide the necessary cash to do so.

Flexibility is created since the borrower may opt in or out of the withdrawal choices and has the ability to combine the different options.  As an example, one combination could be a tenure payment with a credit line.  This would permit the retiree to have a monthly cash flow and a safety net of available credit for unanticipated expenses.  Another option to consider is starting with a credit line in order to minimize the draw down of the credit.  If, over succeeding years, it is determined the retiree needs a steady stream of cash flow, then a change could be made to a tenure plan or a tenure plan coupled with a credit line.

One of the most significant drawbacks of a reverse mortgage is the relatively high financing costs, especially if you compare this to a traditional Home Equity Line of Credit (HELOC).  The difference between them is the HELOC is typically between 1% and 4% while the reverse mortgage could be as high as 6% to 12% of the amount borrowed.

A second drawback is created due to the fact the FHA stipulates an artificial limit regarding the value of the borrower’s home.  Currently, the cap on home value is $362,790 in urban areas at $200,160 in rural areas for 2006.  What this means is that many borrowers may not be able to use the full fair market value of their home in determining the amount of the loan.  If the retiree is still in need of further money, they may need to consider a private loan in order to free up the additional equity.

The final drawback is the youngest borrower must be at least 62 years old in order to qualify for an FHA program.

One has to consider whether these drawbacks are enough to rule out the use of a reverse mortgage as a planning strategy.  Relatively high costs should cause pause before proceeding; however, under the proper circumstances, a reverse mortgage will provide the necessary cash flow and flexibility to the retiree who is looking to remain financially independent in their own home.