New Rules for Reverse Mortgages

The federal government has clamped down on reverse mortgages, issuing a new set of rules that make some loan amounts smaller, fees higher, and drawdowns less flexible.

What will the changes mean from a retirement-planning perspective? We'll get to that in a moment. But first, here are some basics on reverse mortgages.

Reverse Mortgage 101
Reverse mortgages allow seniors to turn their home equity into cash while staying in their homes. Unlike a forward mortgage, where you use income to pay down debt and increase equity, a reverse mortgage pays out the equity in your home as cash; your debt level rises and equity decreases.

The most popular loan type is the home equity conversion mortgage, which is administered, insured, and regulated by the U.S. Department of Housing and Urban Development. HECMs are different than traditional home equity lines of credit in that repayment of a reverse mortgage typically isn't due until the homeowner sells the property or dies.

New Rules
The new rules govern HECMs, and the changes followed congressional action taken over the summer to address the problem of rising loan defaults, which pose risk for the Federal Housing Administration insurance fund, which backstops the loans.

Homeowners age 62 or older can qualify for HECMs if they have sufficient equity in their property. The amounts that you can borrow are determined by a formula that takes into account the percentage of the home's value, your age, and prevailing interest rates.

As mentioned above, HECMs don't have to be paid back until you move out of your home or pass away. But defaults are possible because the loan terms require homeowners to continue paying property taxes, hazard insurance, and any required maintenance on the property.

Reverse mortgages would never be my first choice in funding retirement because it's a form of debt--and the HUD reforms make them more expensive to use. But home equity is one of the most important assets on the balance sheets of most older Americans, and many will need to tap it in retirement. In that context, the recent changes to the HECM program are a step in the right direction because they aim to make the loans safer and encourage loan usage as a long-term financial-planning tool, rather than as a disaster-recovery tool for households already facing significant financial stress.

What's more, the changes in net loan proceeds are minor. Here's a rundown of what's changed in the HECM program:

Consolidated loan types. HECMs used to come in two flavors: standard and "saver." Standard HECMs offered larger loan amounts and carried higher fees than saver loans; saver HECM loan amounts were 10% to 18% lower than standard loans, depending on the borrower's age. But fees were much lower.

Now, the two loan types have been consolidated, with fees varying depending on how much you borrow.

Higher fees. The mortgage insurance premium for larger loans (more than 60% of the available principal drawn in the first year) is now 2.5% of your home's appraised value, up from 2.0%. For loans below the 60% threshold, the fee is 0.50% up from 0.01% on the old saver loans. The fees were increased to shore up reserves of the FHA Mutual Mortgage Insurance Fund, which is used to repay lenders in situations where they can't recover the full amount at the loan's termination.

Smaller loans, drawdown limits. Limits on the size of larger loans have been reduced by about 15%. And borrowers won't be able to gain access to more than 60% of the total loan in the first 12 months. This change is aimed at discouraging large drawdowns that can leave borrowers strapped if proceeds are used up and other income sources are exhausted.

Risk assessments. Starting in January, borrowers will be required to undergo a financial assessment to make sure they have the capacity to meet their obligations and terms of the HECM. Although the loans have no payments, borrowers must keep their homeowners insurance and property taxes current. Lenders will be required to assess a borrower's income sources, including income from work, Social Security, pensions, and retirement accounts. Borrowers' credit histories also will be considered.

Riskier borrowers can be denied, or required to make a "set aside" fund out of loan proceeds to pay future property taxes, hazard insurance, and even flood insurance in areas the federal government identifies as flood zones. The amount of money set aside could reduce loan proceeds substantially because it will be based on the borrower's life expectancy.

Planning Implications
HECMs are best used as reserve backup funds, similar to a home equity line of credit. That's what the saver HECM was good for--and with a mortgage insurance premium of 0.01% of a home's appraised value, it was an inexpensive option. But the new HECM that most closely resembles the older saver HECM doesn't change the total loan amounts available in a dramatic way. In this particular case, it even yields a slightly higher loan amount, due to our hypothetical borrower's age (see the table below). "The old saver HECM was a bit stingier with older borrowers," explains Jerry Wagner of Ibis Software, which creates reverse mortgage calculation software for the National Reverse Mortgage Lenders Association, lenders, and counselors.

However, the amount available for the new loan type resembling the old standard HECM is reduced by 13%-16%, depending on the amount borrowed.

The table compares loan totals available under the old and new program. We're looking at a hypothetical 65-year-old borrower with an appraised home value of $500,000.

The NRMLA website has a calculator where you can run ballpark loan estimates for your own home.

Some planning experts have started advocating the use of HECM credit lines as a backup resource in lieu of a large cash reserve because the latter produces negative returns in the current ultralow interest-rate environment. Harold Evensky, president of Evensky & Katz Wealth Management, is co-author of a paper published last year examining how retirees can use a HECM line of credit in bear markets to avoid selling equities. The strategy extends portfolio life anywhere from 20% to 60%, depending on the scenario specifics.

"The idea is to use the line of credit instead of hitting the portfolio assets in a down market," says Shaun Pfeiffer, an associate professor at Edinboro University and one of Evensky's co-authors. "Then you pay it back once the investment portfolio recovers--so it's using the HECM as a line of credit."

The authors ran their numbers using the old saver HECM product, but Pfeiffer says the changes don't much affect their findings. They tested retirement withdrawal rates ranging from 4% to 6%.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.