Despite the public's negative perception of reverse mortgages, these vehicles can sometimes be practical as long as the clients understand them.
Mention a reverse mortgage and people tend to get a sour look on their face. The high upfront costs, rapidly shrinking home equity, and early abuses are hard to deny. But sometimes the reverse mortgage is a practical solution to a client's cash flow problems, as long as they really understand what they are getting into.
A reverse mortgage is a loan that allows homeowners, age 62 and older, to receive cash payments based on the equity in their home. These balloon-type loans are typically used to provide a lump sum or a series of cash payments to borrowers that want to remain in their home.
Types of Home Equity Conversion Mortgage (HECM) Loans
There are two basic types of HECM loans, the standard loan with hefty upfront premiums, and the saver loan with lower fees but higher interest and lower borrowing limits. There are fixed-rate and adjustable loans available for both the Standard and Saver loans.
The HECM Standard Loan carries an insurance guarantee that the debt cannot exceed the value of the home and that the loan will not have to be repaid as long as the one of the borrowers occupies the home.
With the HECM Saver Loan, the upfront mortgage insurance premium, or MIP, is only .01%, but the borrowing limits are 10%-18% lower than the standard loan. The interest rates also are higher, and the origination fees tend to be higher. This loan also has the ongoing 1.25% MIP added to the interest rate.
Types of Payout
The loan payout can be tailored to the client's situation and can be altered as needed for a small fee. The basic methods for receiving payment are:
Tenure--equal monthly payments as long as at least one of the borrowers is alive and occupies the property as a principal residence
Term--equal monthly payments for a fixed period of months as specified in the contract
Line of Credit--unscheduled withdrawals with the timing and amount at the borrower's discretion until the line of credit is exhausted.
Modified Tenure--combination of line of credit and monthly payments for as long as one of the borrowers is alive and occupies the home.
Modified Term--combination of line of credit and monthly payments for a fixed period.
Amount of Payout
The payout is determined by a formula that takes the home's value, the age of the youngest owner (must be 62 or older), the type of loan, the area in which the home is located, and the interest rate to determine the percentage of the allowable home value that can be accessed. To calculate various reverse mortgage scenarios, click here.
Layers of Fees
The HECM insurance fee is actually a two-part MIP. There is a 2% fee based on the home's value (up to the $625,000 limit) which is paid upfront at closing or rolled into the loan. So for a home worth $625,000, borrowers taking out 20,000 in payments will pay the same as borrowers taking our $400,000--both pay $12,510. There is also a 1.25% ongoing MIP fee added to the interest rate.
The HECM origination fee is 2% of the value of the property (not the loan amount) up to $200,000 and 1% of the value over $200,000 with a minimum fee of $2,500 and a maximum of $6,000. Lenders often waive this fee if the lump sum option is chosen for the loan.
There is also a mandatory counseling session that each buyer must attend in person by phone. This fee can be no higher than $125. Furthermore, lenders are allowed to charge a monthly servicing fee ranging from $0 to $35. Finally, Closing costs are the same as those for a traditional mortgage. They will typically include an appraisal, title insurance, title search, and recording fees.
Use of Proceeds
Proceeds must first be used to pay off an existing mortgage, if any. After that, proceeds may be used for any purpose.
Advantages of a Reverse Mortgage
Below is a list of the benefits of reverse mortgages.
--Mortage payments are eliminated.
--The amount due with an HECM loan will never exceed the value of the property when it is sold, even if the value declines.
--If the home is worth more than the loan when it is sold, the owners or heirs keep the profit.
--The owners retain title to the home.
--The owners can never be forced to leave or sell as long as the home is maintained, taxes and insurance are paid, and one of the homeowners continues to occupy the home.
--Flexibility in method of payment. The fee to change payment plans is only $20.
--The line of credit might increase over time. The credit line grows larger over time so that the available cash increases until it is all withdrawn. For example if the credit line equals $200,000, but only $50,000 is taken out, the remaining credit is $150,000. However, the $150,000 grows at the same rate as the interest being charged on the loan plus one half of a percentage point.
--Taxable income is not affected by the reverse mortgage payments.
--If the borrower or their estate sells the home to pay off the debt, the amount due can be no greater than the value of the home, even if the loan balance exceeds the sale price.
Disadvantages and Risks
Despite the advantages, there are also some drawbacks.
--Serious family friction and resentment may occur when children are left out of the decision process. They might have counted on using the value of the home to help with their parents' care or might have expected to receive the home as an inheritance.
--The owners or heirs must pay off the loan when the property is sold.
--There's risk of rapid decline in home equity, especially with the lump-sum option or larger withdrawals in early years.
--If one of the borrowers needs more than in-home care in later years, there might be no remaining home equity to pay for ongoing care.
--A stay in a nursing home or assisted-living facility for more than a year by the sole or remaining homeowner triggers the loan balance to become due.
--Adjustable loan rates can rise up to 10% over the initial interest rate.
--The balance of the loan must be paid in full if the borrower or their estate wants to keep the property, even if the debt exceeds the value of the property (this is currently being challenged in court).
Who Might Benefit?
A number of people could find advantages of such a vehicle.
--The older the client, the more equity they can withdraw over time.
--Clients who want to preserve outside funds for emergencies or growth opportunities but need additional monthly income.
--Clients who would like to "age in place" and have homes that will continue to be safe, comfortable, low-cost, and easy to maintain regardless of health changes.
--Clients who need a lump sum to make home modifications so that they can remain in their homes as they age.
--Clients who are "house poor"--they have considerable equity, but other financial resources are limited.
--Clients who have long-term-care insurance that will cover them if they've exhausted their equity balance and still need nursing-home care.
Meet Bob and Sue
They are 78 and 74 years old with a home value of $700,000 and no mortgage. They have $170,000 in savings which they are spending down at $2,000 per month to make ends meet. They have long-term-care insurance, and their children approve of their decision. They have decided to take the modified tenure option of a standard adjustable loan to improve their current cash flow.
The amount they can have access to is based upon the allowable home value ($625,500 max), and the age of the younger client (age 74). They will take an initial $30,000 withdrawal to catch up on maintenance and add to their cash reserve for emergencies. They will also take a monthly payout for life of $2,381 which is based upon the younger life of 74. Their loan will be an adjustable-rate loan based on LIBOR plus margin. Their payment will not change at the death of the first spouse. The initial interest rate is 3.465% (2.215% LIBOR + 1.25% FHA MIP) with a lifetime interest-rate cap of 12.215%.
The costs for this loan are expected to be as follows:
$12,510 One-time FHA Mortgage Insurance Premium
+ $ 6,000 HECM Origination Fee based upon the home's value
+ $ 125 Counseling Fee
+ $ 6,200 Document Prep, Appraisal, Title Insurance, Recording Fees, Tax Stamps, and so on
= $24,835 Total upfront costs.
Weigh the options
In some cases the reverse mortgage can be a perfect solution to a client's cash flow problem or even just provide access to equity that the homeowner would rather spend than pass along to heirs. But consider some alternatives before taking the plunge. Does it make more sense to downsize to a smaller and less expensive home? If the cash is a short-term need would a home equity loan fill the bill? Can the home be refinanced with better terms? Will isolation become a problem by staying alone in the home? What happens if the surviving spouse needs nursing-home care after the HECM benefits are exhausted?
The reverse mortgage is a not a panacea and it is not cheap, but in the right circumstances, it can work.
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