The New Rules of Reverse Mortgages

Federal guarantees make reverse mortgages worth a second look, but careful study is still needed.

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Reverse mortgages allow qualified borrowers to tap the equity in their home, pay off their existing mortgage balance--and all the while live in their home as long as they're able. Now, recent changes in a federal loan program may make reverse mortgages attractive to millions more senior homeowners by raising the dollar value of homes that qualify for the program and extending it to the purchase of new homes. The federal program allows consumers to pay a one-time insurance premium, which guarantees that they'll receive the stream of income they are promised when executing the reverse mortgage. With retiree nest eggs hurt by declining investments and continuing weakness in home values, backers of the program see it as an increasingly attractive way for cash-strapped seniors to remain in their homes while receiving income from the properties. However, reverse mortgages sold without the federal guarantee have created image problems for the industry in the past. Even with federal involvement, the products are still complex and carry high fees, which is why it's important for consumers to understand what they're getting. Here are some things to carefully consider when deciding if a reverse mortgage is right for you.

Federal HECM program. The Federal Housing Administration began 20 years ago to build a new, federally insured reverse-mortgage product known as the Home Equity Conversion Mortgage (HECM). HECMs are non-recourse loans, meaning borrowers and their families are never on the hook for any loan losses experienced by lenders. Such losses can easily occur when homeowners continue living in their homes for long periods after the HECM is issued. Because HECMs are federally insured, the amount of homeowners' cash-loan proceeds are guaranteed and protected from lender defaults as well as any declines in the value of their homes during the life of the reverse mortgage. If home values rise, however, the gains benefit the borrower, who continues to own the house until he either dies or moves out. At that time, if the home has positive equity, the homeowner's heirs have up to a year to pay off the loan and keep the home or sell it. If the loan is "underwater," homeowners can simply walk away with no obligations and the lender will take title to the home.

Slow HECM growth. In 1990, there were only 157 HECM loans made nationally, according to the FHA, and even in 2000, the figure had risen to fewer than 7,800. Most reverse mortgages occurred in the private market, in part because the HECM appraisal ceiling on homes it would insure was too low to have broad appeal to lenders or borrowers. Since 2003, however, the HECM numbers have been rising, reflecting growing perception of the value of an insured program and big increases in the numbers of people over the age of 62--the minimum age for qualifying homeowners. There were more than 18,000 HECM loans in 2003; That figure doubled to nearly 38,000 in 2004, and doubled again to more than 76,000 in 2006. It has since risen another 50 percent to more than 112,000 in 2008.

Over the past two years, housing prices have collapsed in many markets, and the market for uninsured reverse mortgages has largely disappeared. Several reverse-mortgage companies have been purchased by large insurance companies. Their stated plans to create high-visibility reverse mortgage products have been derailed by the financial crisis and recession. But many experts feel HECMs nonetheless are poised to become mainstream products, aided in no small measure by attractive changes recently made to the HECM program.

New federal rules. Last November, the ceiling for HECM loans increased to $417,000 from as low as $200,000 in some parts of the country. This increase enables many more homes to qualify for the program. Lender origination fees were also capped at $6,000, which helped curb overall HECM fees. (The House-passed version of President Obama's stimulus program would further raise the ceiling by 50 percent to $625,500, aligning it with some other federal housing program ceilings.) Also, effective in January, the HECM program can now be used for the purchase of new homes. This provision is expected to make the program attractive to older homeowners who want to downsize into a new home or even to move to a new retirement location. "The reason we proposed this new product is that we saw a lot of seniors taking out a loan to buy a new home and then paying it off with a HECM loan," says Meg Burns, director of FHA's Office of Single Family Program Development. "We saw no reason for them to pay two sets of fees, so this was designed to make it a single transaction. We have seen this with seniors downsizing and moving into a senior community, or with people moving closer to other family members."

Is a HECM right for you? Consumer, government and industry experts stress that HECMs are not for everyone and that consumers should be deliberate and careful in evaluating the product. AARP has extensive reverse mortgage information and supports the product when used appropriately. "It's a very personal issue," an AARP staffer says. "It depends on how you feel about your home, whether you want to leave it to your children...how long you intend to live in the house, and whether you are physically capable of living in the home." Because up-front HECM loan fees can total $20,000 or more, the loans aren't attractive for people who are planning to stay in their homes for only a few years. There's no absolute residency time rule, but it should be long enough so that the per-year impact of the fees is not too large a number. Over time, Burns expects HECM fees to decline, but it will require a more active and competitive market. "The best way to reduce the cost of this product would be to create a more efficient product," she says. "You need economies of scale, and they come from doing a lot of loans. Right now, the capacity of the actual loan originators is just not quite there."

Do you qualify? If you think a HECM loan might be worth pursuing, be aware that not everyone qualifies. The youngest homeowner in the household must be at least 62. All reverse mortgages require the homeowner to pay off any existing mortgage as part of the transaction. That means homes with large mortgages will not qualify for the program because owners won't have enough equity after paying off their existing mortgage. "We've seen about 30 to 40 percent fall-out rates for insufficient appraisals after people have called us up," says Jeff Lewis, chairman of Generation Mortgage, an Atlanta-based reverse mortgage lender (the FHA maintains a list of approved HECM lenders). "Two or three years ago, that fall-out rate might have been only 5 percent, so it's clear that a lot of people have not yet realized how much the value of their home has changed." Lewis believes HECM loans are particularly well-suited to seniors who "are relatively asset rich and cash poor," providing them an opportunity to access the value in their home at a time of falling home prices and plummeting sales. While acknowledging the weakness in housing values, "it is a lot easier to find an appraiser than a buyer," he quips.

Consumer safeguards. Consumers are required to complete a consulting session before getting a HECM loan, and there is an FHA list of approved counseling agencies. The agencies may charge a fee that equals their cost for the session, up to a maximum of $125. This fee can be added to the loan's closing costs, but you should make sure you're not paying it needlessly. FHA rules say that financially strapped homeowners must still be offered the counseling, even if they can't pay for it. "Consumers need to think through their future, and the counseling session is a good place to do that," says Peter H. Bell, president of the National Reverse Mortgage Lenders Association (NRMLA) in Washington. "Any loan officer who is doing the right thing will talk to the prospective client about the importance of discussing this with family members," he adds, "but there are a lot of seniors who don't want to discuss their financial affairs with their family members, for any number of reasons."

Age affects loan terms. The major factors affecting HECM loans are the age of the borrower, the value of the home, the borrower's equity in the home, the interest rate of the loan, and the manner in which the borrower wants to receive the proceeds of the loan. The process is confusing, in large part because it does, in fact, work like a typical mortgage in reverse. Let's begin with the fact that the proceeds of HECM loans are tied to the ages of the borrowers, with older borrowers receiving higher percentages of their homes' value. A 62-year old HECM applicant, for example, can be expected to stay in his home for more years than a 72-year-old applicant. Accordingly, the projected interest expense applied to his loan will be for a longer period, and this expense will be paid to the lender out of the remaining equity in his home. Lenders thus offer smaller shares of a home's equity to younger borrowers. "Your net proceeds on a reverse mortgage are about 85 percent of your age times the value of your house," says Lewis. ReverseVision, a reverse-mortgage software company, created a public version of its loan illustration tool at U.S. News' request. Make sure you look carefully at the details of loan fees, current loan interest rates, and the choices of how loan proceeds may be used.

Understanding HECM fees. The fees on a HECM loan consist of an origination fee to the lender, the insurance premium paid to the FHA and the closing costs (which are similar to a regular mortgage.) The amount of the loan proceeds available to borrowers is further reduced by setting aside the expected monthly servicing costs of the loan during its projected lifetime. No one knows how long that will be, of course, and any unspent service fees would be included in the borrower's remaining equity. For a 70-year-old borrower whose home is appraised at $400,000, Lewis says the HECM loan illustration offered by Generation Mortgage that uses current interest rates would support gross proceeds of $275,600 (or 68.9 percent of appraised value). Up-front fees would total $16,212: $6,000 for origination, $8,000 for FHA insurance, and $2,212 in closing costs. Loan proceeds would be reduced by a servicing set-aside of $5,193, resulting in net proceeds to the borrower of $254,195.

While the fees may seem steep, advocates make two points in their defense. The first is that traditional mortgages often embed fees in the form of higher interest rates and thus understate the true cost of the fees. "The problem is that under the HECM program the fees are more transparent" then in a conventional mortgage, says Burns. "Regular mortgage lenders can reflect fees in higher interest rates, but you can't do that with HECMs." In addition, Lewis says, the FHA insurance premium is actually a bargain and enables HECM payout percentages that are much higher than in uninsured reverse mortgages. "We believe the economic value of that fee is worth much more" than the premium amount," he says. In fact, Lewis maintains that the HECM program is a terrific subsidy to older homeowners. "The government set up this program when people's life expectancies were lower and when the outlook for home price appreciation was much more optimistic," he says.

Lewis laughs at the notion that large fees are making for big paydays in his industry. "This is not a 'quick buck' product; there are not a lot of reverse mortgage salesmen driving around in Ferraris," he says. "There's almost a missionary kind of fervor that people have who interact with clients in this industry. It's really corny, perhaps, but this is a long-term sale to a client who needs a lot of hand-holding."

Loan proceeds are yours to spend. HECM loan proceeds can be taken as a lump sum, fixed installments, or in other ways the borrower might prefer. While fixed-rate loans are in vogue these days with regular mortgages, they are nearly twice as high as current variable rates available on HECM loans, and experts agree the variable-rate product is preferable today. It produces a higher percentage of loan proceeds to appraised value, and borrowers are protected from a spike in rates by the insurance guarantee and the non-recourse feature of the loan. Users of fixed-rate loans are also required to take the entire amount of loan proceeds in a lump sum, while the variable-rate product permits more flexible uses of the funds.

AARP urges borrowers to draw down only the funds they need, and Lewis strongly agrees, noting that the remaining proceeds should be used as an available line of credit that actually will rise in value over time. That's because the HECM loan levies the interest rate on the amount drawn down. If money isn't used, Lewis says, then the projected borrowing cost for those funds is credited to the borrower's remaining equity in the home. For example, if a HECM loan had a 5 percent interest rate and the borrower's net proceeds were $200,000, the lender would charge $10,000 a year in interest expense. This amount would be added to the outstanding amount of the loan, and it would effectively be funded by the remaining equity value of the home. If the borrower used half of that $200,000 but did not draw down the other $100,000, for example, than $5,000 in interest expense would be avoided, and this amount effectively would be added back to the available line of credit that the borrower could use.

Experts unanimously caution consumers against viewing a reverse mortgage as an investment, but FHA's Burns notes that the money is the borrower's to use as they wish. Criticizing the HECM program for poor investment choices, she notes, is akin to blaming an ATM for dispensing money that is spent unwisely. Not that people don't try. "We did have a woman who came into one of our offices who had used a HECM to get a face lift," Burns recalls. "She was very unhappy with her face life and wanted us to help her get the loan cancelled. She apparently even took off her wig to show them the poor quality of the face lift."