The reverse mortgage has changed. Is now the time to get one?
Have reverse mortgages become more attractive as a result of lower mortgage rates and rising housing prices boosting the amount of home equity homeowners have? That’s a big question for millions of seniors, especially those aged 62 and above. It once again opens up the subject of how seniors can best use their “tappable” equity – or if they should leave it untouched.
What is a reverse mortgage?
A reverse mortgage is a form of cash-out refinancing. It allows property owners 62 and older to convert real estate equity into spendable cash.
Virtually all reverse mortgages are insured through the Federal Housing Administration, or FHA. This means if the debt is not repaid by the borrower it will be repaid with FHA reserves. The government calls reverse mortgages “HECMs,” short for Home Equity Conversion Mortgage. Because the FHA program is a type of insurance, borrowers must pay insurance premiums to participate. These premiums are used to fund the FHA’s reserves.
Are reverse mortgages more useful today?
Two market trends may cause seniors to re-examine reverse mortgage options.
First, in the past decade real estate equity has grown enormously as home prices have risen. Real estate equity is generally defined as the value of a home less outstanding mortgage balances. While not all homeowners have benefited from rising prices, millions have.
- As of 2019’s third quarter, the Federal Reserve estimates that American homeowners had nearly $18.7 trillion in real estate equity.
- Much of the real estate equity is held by seniors. The latest estimate from the National Reverse Mortgage Lenders Association (NRMLA) is that seniors have $7.19 trillion in real estate wealth.
Second, mortgage rates have fallen through the floor. According to Bankate, the national average rate for fixed-rate, 30-year financing in March 2020 fell to 3.56 percent. Black Knight estimates that as many as 11.1 million homeowners may have reason to refinance these days.
How does a reverse mortgage work?
Reverse mortgages are very different from traditional mortgages.
If you borrow $100,000 at 3.4 percent fixed-rate interest for 30 years with a traditional mortgage, you will have a $443.48 monthly payment for principal and interest.
However, if you borrow $100,000 with a reverse mortgage, your required monthly payments for principal and interest are zero.
How is this possible?
With our model $100,000 mortgage, the borrower pays $443.48 each month. Of this amount $160.15 is paid toward principal in the first month to reduce the loan balance. The rest of the payment – $283.33 – is interest, or what the lender charges you for loaning you money.
In the second month the debt has been reduced to $99,839.85. The borrower owes less. The monthly payment is still $443.48 but now the interest cost has been reduced to $282.88 while the principal payment has grown to $160.60.
With a reverse mortgage the process is, well, reversed.
For purposes of illustration, we again start with a $100,000 mortgage at 3.4 percent. But, instead of making a $443.48 payment each month the borrower pays nothing. This does not mean the loan is free. Instead, the interest cost – $282.88 — is added to the mortgage debt. In the second month the debt grows to $100,282.88. Since the loan balance is a little bigger, in the second month the interest cost is a touch higher. This process continues each month until the loan ends.
Reverse mortgage pros and cons
Every form of financing has its pros and cons and that surely includes reverse mortgages. Here are some of the key issues to consider.
Reverse mortgage pros
- Boosts cash Many seniors experience a significant income reduction when they retire. Monthly mortgage payments are the biggest expense for many. A senior with sufficient home equity, however, can refinance, pay off an existing regular mortgage, and even pull cash from the property with a reverse mortgage.
- You don’t have to move. According to AARP, “between 50 and 60 percent of adults age 18-49 say they want to remain in their communities and homes as they age, while nearly 80 percent of adults age 50 and older indicate this same desire.” Rather than move, a reverse mortgage may allow seniors to age in place and be near friends and family. Also, because there are costs associated with selling, moving and re-settling the result is less equity because of the expenses involved.
- Costs may be lower. There is a cost to reverse mortgages, but it may be cheaper to get a reverse mortgage than to move. You can get a good sense of reverse mortgage expenses by using the NRMLA calculator. Alternatively, to move means expenses to sell the home, move household goods, and either buy a replacement residence or rent in a new location.
- The money you get from a reverse mortgage is not taxable. According to the IRS, “reverse mortgage payments are considered loan proceeds and not income. The lender pays you, the borrower, loan proceeds (in a lump sum, a monthly advance, a line of credit, or a combination of all three) while you continue to live in your home.” At the same time, the IRS adds that reverse mortgage interest “isn’t deductible until you actually pay it (usually when you pay off the loan in full). Tax rules, as usual, can be complicated so be sure to see a tax professional for advice.
- No claim against heirs. Because a reverse mortgage balance will grow in size, it’s possible that reverse mortgage debt can exceed the fair market value of the property over time. However, the responsibility to repay the debt can never exceed the property’s value. That’s because a reverse mortgage is an example of “non-recourse” financing. The result is that lenders have no claims against or other assets or heirs.
- You continue to own the home. Reverse mortgages can be paid off by borrowers but typically end when individuals move, sell or pass away. In an estate situation heirs have several choices. First, they can sell the property to repay the debt and keep any equity above the loan balance. Second, they can keep the home and refinance the reverse mortgage balance if the property’s value is sufficient. Third, if the debt exceeds the value of the property heirs can settle the loan by giving title back to the lender. The lender can then file a claim for any unpaid balance with the insurer, almost always the FHA.
Reverse mortgage cons
- Reverse financing is not free. Such mortgages have costs that include lender fees, FHA insurance charges, closing costs, etc. These costs can be added to the loan balance. However, that means the borrower has more debt and less equity. The NRMLA calculator illustrates the costs reverse mortgage borrowers can face.
- Interest rates. HECMs are structured so that both adjustable-rate and fixed-rate financing options are available. However, if you want fixed-rate financing the amount of equity you can access will be smaller than a reverse mortgage with adjustable-rate interest. The NRMLA calculator shows both fixed-rate and adjustable-rate options.
- Program violations. A reverse mortgage may cause borrowers to violate asset restrictions for the Medicaid and Supplemental Security Income (SSI) programs. This is complicated stuff so be sure to speak with an attorney who specializes in elder law or a legal clinic before searching for a reverse mortgage program. If fees are a concern see if pro-bono legal help is available in your community.
- You can be foreclosed. Since reverse mortgages do not have required monthly payments for principal and interest it might seem as though foreclosure is impossible. Not so. Seniors can be foreclosed if they do not pay property taxes, maintain property insurance, fail to pay HOA bills, etc.
- Status changes. Reverse mortgages get complicated. If the borrower goes to a long-term care facility, are they still considered a resident in the home? If a borrower marries after obtaining a reverse mortgage must a spouse move out of the property if the borrower dies? For details regarding these and other questions speak with lenders, attorneys who specialize in elder law or contact a legal clinic.
HUD reverse mortgage standards have changed
HUD HECM standards have changed during the past few years. The reason? Massive program losses in the billions of dollars.
- To cut losses in 2013, HUD limited the amount that HECM borrowers can obtain from a property and also the amount of cash that borrowers can withdraw from an HECM during the first year.
- In 2014, HUD established a “residual income” requirement similar to the long-successful VA mortgage program. The residual income standard means that after basic expenses reverse-mortgage borrowers must have enough cash left over to pay monthly living costs, including property taxes and insurance.
- In 2017, HUD reduced the amount reverse borrowers can finance. AARP reported that “a 62-year-old borrower getting a reverse mortgage with a 5 percent interest rate would be able to draw 11 percent less money from a home” than under the old rules.
- The 2017 rules also changed premium costs. “The new rules,” said AARP, “require higher initial premiums in most cases but lower annual premiums in subsequent years.”
- In 2018, HUD created a new rule which allows it to require two appraisals for properties it regards as too risky. In other words, it wants to make sure that a property has sufficient value to repay a reverse loan in the case of foreclosure. The loan will be based on one of the two appraisals, whichever is lower.
- In 2019, HUD tightened financial assessment standards. Lenders are now required to review tax returns, bank accounts and similar information to assure that borrowers can pay ongoing housing costs. If the assessment is insufficient, the lender must then set aside HECM money to assure that tax and insurance bills are paid.
What has been the result of reverse mortgage changes?
First, the number of reverse mortgages insured by the FHA fell from 60,091 in fiscal year 2013 to 31,274 in fiscal year 2019.
Second, HUD has substantially reduced reserve mortgage losses. In fiscal year 2018, the HECM reserve was down $13.63 billion. By fiscal year 2019, the potential loss had been reduced to $5.92 billion. It is very possible that reserve losses might actually be wiped out in fiscal year 2020 if claims continue to fall and home prices remain at least stable.
Should you get a reverse mortgage?
Reverse mortgages are complex. They work for some homeowners but not for all. You need to consider your finances and preferences to see if an HECM is for you. If you want to know more, be certain to shop around and speak with multiple lenders. You also need to consider estate and tax planning and to get professional help with those issues.