Reverse Mortgage

A mortgage loan to an elderly homeowner on which the borrower's debt rises over time, but that need not be repaid until the borrower dies, sells the house, or moves out permanently. The 'forward' mortgages that are used to purchase homes build-equity the value of the home less the mortgage balance. Borrowers pay down the balance over time, and by age 62, when they become eligible for a reverse mortgage, loan balances are either paid off or much reduced. Reverse mortgages, in contrast, consume equity because loan balances rise over time. If there is a balance remaining on a forward mortgage at the time a reverse mortgage is taken out, it is paid off with an advance under the reverse mortgage. Need: Most of the elderly are homeowners. For many, especially those with low incomes, homeowner equity constitutes a major part of their net worth. Most of them built that equity during their working lives, in part by paying down their mortgages. As their incomes decline in their later years, many would like to consume their equity rather than leave it to heirs who don't need it. Without reverse mortgages, however, the only way to do that is to sell the house and live elsewhere. Reverse mortgages allow elderly homeowners to consume some or all of the equity in their homes without having to move ever. Safeguards: Under all the programs cited in the paragraph above, borrowers have the right to live in their house until they sell it, die, or move out permanently, regardless of how much their mortgage debt grows. If the debt comes to exceed the value of the property, the lender takes the loss, except that on the FHA program, FHA reimburses the lender for any loss out of insurance premiums paid by borrowers. In addition, loans under these programs are without recourse. This means that lenders cannot attach other assets of borrowers or their heirs in the event that the reverse mortgage debt comes to exceed the property value. Borrowers do have obligations under these programs, but they are no more than one would expect. Under the three major programs, the lender can demand repayment of the loan if the borrower fails to pay property taxes or insurance, doesn't maintain the home, changes the names on the title, takes out a second mortgage, takes in boarders, or uses the home as a business. Eligibility: To be eligible for the major programs, all owners must be 62 or older and must occupy the home as their permanent residence. There are no income or credit requirements, since borrowers don't assume any payment obligation, but all the reverse mortgage programs require counseling. Eligible properties generally include one-family units, condominiums, manufactured housing, and houses in planned unit developments. Two- to four-family units may or may not qualify. Mobile homes and co-ops are not eligible, although co-ops may soon become eligible under the FHA program. The house may have an existing mortgage, but it will have to be repaid out of the reverse mortgage proceeds. An exception would be where the existing lender is willing to subordinate his claim to that of the reverse mortgage, meaning he wouldn't get paid until the reverse mortgage is repaid. No institutional lender would be willing to do that, but some special purpose reverse mortgage programs may allow it. Debt-Based Versus Equity-Based Products: While the term 'reverse mortgage' implies a debt secured by property, it is possible to fashion instruments for the same purpose that are equity-based meaning that the investor acquires an ownership interest in the property. Investors are willing to pay more to acquire a house outright than they will on a reverse mortgage, where they only earn interest on the amounts they advance the owner. Indeed, the oldest known instrument for 'home equity conversion' was of this type. At least as far back as the 19th century, notaries in France arranged deals between homeowners and individual investors where the investor paid the owner an annuity for life. Such deals were very simple. The annuity was determined by dividing the current value of the property by the owner's life expectancy The investor took possession of the house upon the owner's death, whether that happened after a month or after 40 years. However, these deals were extremely risky to both parties. Occasionally the owner would outlive the investor. And occasionally the owner would die before the ink was dry on the contract. While investors can diversify their risk by writing many contracts, owners cannot because each owner has only one house with which to transact. Combined debt/equity arrangements are also possible, and several of these have appeared in the U.S. In these deals, the investor makes a loan and also receives either a share of the appreciation in the home's value or a share of the value at termination. The equity participation feature permits the investor to pay the owner more than in a straight debt transaction. None of the programs of this type have been successful, however. The American Homestead program during the 1980s failed because the expected rate of appreciation did not materialize and investors did not earn an adequate return. In 2000, Fannie Mae terminated an equity option in connection with its Home Keeper reverse mortgage for essentially the opposite reason. In exchange for paying up to 10% of the value of their home at the termination of the contract, owners received larger payments under Home Keeper than if they took a straight loan. With this equity option, owners who terminate early pay a lot more than those who terminate late. When a syndicated columnist wrote up the news that early terminators were paying a high cost, as if it were a scandal, Fannie Mae was embarrassed, and in 2000 it terminated the equity option. FHA's Home Equity Conversion Mortgage (HECM): The largest program by far is FHA's HECM program. In 2003, it accounted for about 95% of all reverse mortgages. The great strengths of this program are the security provided by the federal guarantee and the payment options available to the borrower. These options are available at the outset and also throughout the life of a transaction in that borrowers can shift from one to another. Options: Borrowers can choose from five payment plans. All of them require that the borrower maintain the property as his or her principal residence. Tenure: The borrower receives a fixed monthly payment for as long as he or she remains in the house. Term: The borrower receives a fixed monthly payment for a period specified by him or her. Line of Credit: The borrower may make withdrawals at times and in amounts selected by him or her, within a specified maximum draw. This includes drawing the maximum amount as a lump sum at the outset. Modified Tenure: A combination of tenure and line of credit. Modified Term: A combination of term and line of credit. Principal Limit: A critical number in each HECM is called the 'principal limit.' It is the present value of the house, given the owner's right to live there until he or she dies or voluntarily moves out. If the house is worth $100,000, for example, the principal limit might be only $64,000. $100,000 is what the owner can get if he or she gives up the house immediately. $64,000 is what he or she can get if he or she retains the right to live there for an indefinite period. The principal limit is determined by three factors: the borrower's age, which determines how long the investor is likely to have to wait to be repaid; the expected interest rate, which measures the cost of having to wait; and the property value, which affects the risk that the debt won't be fully paid when it comes due because it will exceed the property value. Tenure payments: Tenure payments in the HECM program are priced on the assumption that the borrower, whether age 62 or 92, male or female, will live to be 100! Borrowers who want payments for life and are not concerned with leaving equity to their heirs do better taking a lump sum under a credit line and using it to purchase an immediate annuity from a life insurance company. Interest Rates: Among the complexities of the HECM program is that it uses two interest rates. The rate the borrower pays is the one-year Treasury rate plus a margin. This rate determines how fast the borrower's debt rises over time. But borrowers have a choice between two variants of it. They can select between a) monthly rate adjustments, a margin over the Treasury rate of 1.5%, and a limit on rate change over the life of the loan of 10% and b) annual adjustments, a margin of 2.1%, and a limit on rate change of 5% over the life of the loan and 2% in any one year. The second rate, called the 'expected rate,' is used in calculating the credit line/payments borrowers can receive. It is the 10-year Treasury rate, plus the margin used in the rate selected by the borrower. In contrast to the first rate, which adjusts regularly, the expected rate is fixed for each borrower. If a borrower changes the payment plan, the expected rate used in calculating the new payment is the one set at the outset of the transaction. Credit Lines: Most borrowers who take reverse mortgages under HECM elect credit lines rather than term or tenure payments. In calculating credit lines, FHA assumes that properties will appreciate 4% a year between the time the reverse mortgage is taken out and the time the investor acquires the property. On the other hand, the calculation of term and tenure payments is very stingy. The calculation for term payments assumes that no one dies during the term and the calculation for tenure payments assumes the borrower will live to be 100. In addition, a credit line has more flexibility than tenure or term payments. A borrower could draw the same amounts under a credit line as under tenure or term payments, while retaining the flexibility to stop it or expand it at any time. Further, the unused portion of the HECM credit line increases every year at the same rate as the borrower pays on accumulated debt. Fannie Mae's Home Keeper Mortgage: Fannie Mae is the major investor in FHA HECMs and also has its own reverse mortgage product, called Home Keeper. It carries a higher interest rate than the HECM, but it does not have an insurance premium. Home Keeper offers a line of credit, tenure payments, and combinations of the two, but no term payments. Credit lines are fixed, rather than increasing over time as they do with the HECM. On homes with values that do not exceed the FHA loan limit, owners do better with an HECM than with a Home Keeper. But because Fannie Mae's loan limit is higher than the highest FHA limit, an owner whose house value exceeds the FHA limit may get a larger credit line under Home Keeper. This doesn't necessarily mean that Home Keeper is preferable in such a case, but it might be, depending on the preferences of the owner. Financial Freedom's Cash Account: This is a private program that offers only a line of credit and has no limit on property value. Costs are higher than on HECM or Home Keeper, but the draws will be higher on high-value properties. The break point in property value depends on the age of the borrower. An owner aged 79 will receive a larger draw on the Cash Account than on HECM or Home Keeper if her house is worth $400,000. But an owner aged 62 has to have a house worth $700,000 before she can draw more under a Cash Account. Financial Freedom also offers an equity participation feature on Cash Account that will increase the draw but use more equity. The interest rate used to calculate the credit line is reduced by 1% in exchange for the payment of 5% of property value at termination. The return on the transaction to Financial Freedom is capped at 8% above the initial interest rate.