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PERSONAL FINANCIAL PLANNING

Properly assessing the reverse mortgage option

Know the costs, benefits, and alternatives for this retirement funding tool.

By Nicholas C. Lynch, Ph.D. and Charles R. Pryor, Ph.D.
July 2012

Reverse mortgagesThe recent recession left no age group untouched, but baby boomers were hit especially hard. High unemployment and an uncertain stock market have caused older Americans to realize that their retirement funds might not support their desired lifestyle. Many seniors are facing foreclosure, while others are unable to meet their basic needs, such as paying medical, energy, and other daily living expenses. A reverse mortgage can enable homeowners who are at least 62 years old and have sufficient equity in their homes to receive enough cash to live more comfortably throughout retirement.

A reverse mortgage is a loan against home equity that requires no repayment until the home is sold or the last surviving borrower dies or no longer occupies it as a principal residence. At that point, the home may have to be sold to repay the loan. The loan amount is designed to be no more than the home's value. But if sale proceeds are insufficient to repay the mortgage, the borrower's estate is not liable for the difference.

Reverse mortgages have been criticized for having high fees, as well as for forcing borrowers to remain in the home for an extended period and preventing borrowers' heirs from obtaining a valuable estate asset, the home. For these reasons, reverse mortgages have been looked upon by many CPAs and financial advisers as a last resort. However, recent changes to reverse mortgage instruments are making them more attractive for qualifying individuals.

This article takes an in-depth look at reverse mortgages, highlighting recent changes and discussing the advantages, disadvantages, and alternatives. The article focuses on reverse mortgage instruments insured by the U.S. Department of Housing and Urban Development (HUD), through the Federal Housing Administration (FHA) and its Home Equity Conversion Mortgage (HECM) program. HECMs are the lowest-cost reverse mortgage products on the market and make up about 90% of current reverse mortgages. All CPA financial advisers should be aware of the options and be ready to discuss whether these instruments are viable choices to help qualifying clients remain in their homes while obtaining necessary cash.

Must Be a First Mortgage

An HECM must be a first mortgage. However, reverse mortgage proceeds may be used to pay off an existing mortgage on the primary residence. The loan can be taken in a variety of payment options: a lump sum, fixed monthly payments for life or a fixed term, a line of credit, or some combination. Borrowers never have to make principal or interest payments during their lifetime. The loan can be repaid at any time, but as long as the homeowner does not move or vacate the primary residence for longer than 12 months (for any reason, including going into a nursing home), allow the property to deteriorate, or default on property taxes or hazard insurance, the loan does not have to be repaid until all of the homeowners are deceased. At that time, the principal and accrued interest is paid back by the homeowner's estate. There are no income, credit, or employment qualifications to obtain a reverse mortgage. As long as the loan is insured by the FHA, the payback amount cannot exceed the value of the home at the time the loan is due. However, after the home is sold, if the sale proceeds are insufficient to repay the loan, the FHA covers the shortfall. Proceeds in excess of the loan balance revert to the estate. If the heirs of the estate want to keep the residence in the family, they may pay off the mortgage with other funds.

The loan principal is limited by a formula based on:

  • The youngest homeowner's age (must be 62 or older);
  • The lesser of the appraised value of the property, the sale price of the property, or the national maximum loan limit established under Section 305(a)(2) of the Federal Home Loan Mortgage Corporation Act, P.L. 91-351, for a one-family residence; and
  • The current expected interest rate.


Qualifying property includes single-family or up to four-unit homes in which the homeowner occupies one unit, HUD-approved condominiums, mobile homes, and manufactured homes that meet FHA property standards and flood requirements. Although there is no limit on the value of a qualifying home, there is a national HECM loan limit of $625,500. The older the borrower, the lower the interest rate, and the higher the qualifying value of the home (capped at $625,500), the greater the payout.

Associated Fees

The traditional FHA reverse mortgage product, called the HECM Standard, has been criticized as having high fees. These include origination fees, servicing fees, closing costs, and mortgage insurance premiums. Borrowers may either finance the fees or pay them upfront. Closing costs commonly include an appraisal, title search and insurance, surveys, inspections, recording fees, mortgage taxes, and credit checks. Origination fees are generally assessed at up to $2,500 if the home's qualifying value is less than $125,000, or 2% of the first $200,000 of the home's value plus 1% of the amount over $200,000. HECM origination fees are capped at $6,000.

Servicing fees are commonly charged for actions such as sending account statements, disbursing loan proceeds, and ensuring that the borrower keeps up with loan requirements, such as paying property taxes and insurance. The monthly fee is no more than $30 for loans with annually adjusted rates and $35 for monthly adjusted rates. At loan origination, HECM lenders deduct the total projected servicing fees from the available funds. Each month, the monthly servicing fee is added to the outstanding loan balance.

Lenders have in recent years encouraged eligible homeowners to consider a reverse mortgage. According to a 2010 article in The Wall Street Journal ("Reverse Mortgages Now Look Cheaper," by Kelly Greene and Anne Tergesen, April 17, 2010, tinyurl.com/7rz6euc), top lenders, including Genworth Financial Inc., OneWest Bank's Financial Freedom unit, and others, have either dropped or reduced origination fees, servicing fees, or both, on fixed-rate HECMs. This could save borrowers more than $10,000. Fixed-rate mortgages are available to borrowers only on lump-sum loans, where interest accrues on the entire loan amount. Adjustable-rate mortgage proceeds can be taken as a lump sum, fixed monthly payments, a line of credit, or some combination of these options. In choosing a payment option, homeowners should keep in mind that, although the loan proceeds are not counted as income, a one-time, lump-sum payment may reduce seniors' eligibility for need-based programs such as Medicaid.

The HECM Saver

The FHA has introduced a reverse mortgage product called the HECM Saver. The Saver cuts some of the biggest upfront fees associated with the traditional HECM Standard product, which can add up to 5% of a home's value to the loan principal. For example, HECM borrowers are required to carry mortgage insurance. The insurance guarantees that the borrower receives the agreed-upon loan amount and that, if the borrower or the borrower's heirs sell the home to repay the loan, the loan amount due can be no greater than the home's value. The borrower is charged both an initial mortgage insurance premium (MIP) at closing and an ongoing MIP over the life of the loan. HECM Standard borrowers incur an initial MIP of 2% of the lesser of the home's appraised value, the FHA HECM mortgage limit for the borrower's area, or the sale price. The upfront premium for the HECM Saver is 0.01%, or $20 on a $200,000 home, versus $4,000 for the HECM Standard. To protect the federal government and ultimately taxpayers from falling home values, the ongoing MIP was raised from 0.5% to 1.25% of the outstanding mortgage balance for all new HECMs beginning in October 2010.

The Saver option is designed for a homeowner who needs less cash, and therefore the maximum loan amount is significantly less than with the HECM Standard option. Prospective borrowers should contact a HUD-approved HECM counselor or FHA-approved lender for more information.

Alternatives to a Reverse Mortgage

Before choosing a reverse mortgage, qualifying individuals should assess their cash flow needs and consider available alternatives. For example, is cash needed in the short term to pay off an existing mortgage? Or is it for repairs or renovations such as painting, landscaping, or replacing the roof? Is there a longer-term recurring need for cash, such as paying monthly medical or energy bills?

Selling the Home

One alternative to a reverse mortgage is selling the primary residence. Qualifying taxpayers can exclude up to $250,000 in capital gain under Sec. 121 from the sale of a principal residence (up to $500,000 if married filing jointly). The home sale exclusion can allow taxpayers to downsize to a smaller home or a condominium to minimize upkeep costs, such as yard work.

On the other hand, reverse mortgages require seniors to remain in their homes for what can be a prolonged period. However, a product called a "reverse mortgage for purchase" allows eligible homeowners to purchase a new home using proceeds from a reverse mortgage in a single transaction. The product is designed to reduce the closing costs associated with what would otherwise be two separate transactions. The benefits of a reverse mortgage for purchase may be greatest when a homeowner downsizes.

For many homeowners, however, selling the primary residence is not a viable option. Individuals may not want to leave the home where they raised their family in exchange for one with no memories. Furthermore, the current market for home sales is significantly down, making it perhaps difficult to sell the residence or to realize a gain on it.

Home Equity Loans

Another alternative to a reverse mortgage is establishing a home equity line of credit (HELOC) or a traditional second mortgage loan. A HELOC allows the homeowner to borrow cash on an as-needed basis. A portion of the loan proceeds can be used to make minimum interest payments.

Individuals interested in a HELOC should shop around for a plan that fits their needs, as annual percentage rates and costs vary. HELOCs typically involve a variable interest rate. According to the Federal Reserve Board, most lenders charge the prime rate plus a margin, such as 2 percentage points. Variable-rate plans that are secured by a home place a ceiling on the interest rate charged, while some plans also specify a minimum rate. Some lenders allow borrowers to convert to a fixed rate during the life of the loan or convert all or a portion of the loan to a fixed-term installment loan.

The amount of a HELOC is typically set by subtracting a percentage (up to 85%) of the home's appraised value from the balance owed on the existing mortgage. Other factors typically considered by the lender include the borrower's credit history, income, debts, ability to repay the loan (principal and interest), and any other financial obligations. A reverse mortgage, on the other hand, can be taken as a line of credit and does not require any income, credit, or employment qualifications. Furthermore, a reverse mortgage line of credit cannot be frozen or arbitrarily lowered, as some banks have done with HELOCs.

Other sources of collateral, such as investments and life insurance cash values, can be used to secure a HELOC. Using a life insurance policy as collateral may enable a borrower to defer any interest payments until death, as with a reverse mortgage. Home equity plans typically require the borrower to withdraw a minimum amount or keep a minimum amount outstanding. Some plans may also require the borrower to take an initial advance when the line is set up. A reverse mortgage taken in the form of a line of credit, on the other hand, allows the borrower to withdraw cash as needed until the line is exhausted, without the limitations of most home equity plans.

A major disadvantage of a HELOC relative to a reverse mortgage is that the borrower must repay the loan at the end of a fixed period. Typically, interest is paid either partially or entirely over the life of the loan, leaving the principal balance to be repaid all at once. A borrower unable to make this one-time "balloon" payment stands to lose the home. A reverse mortgage, as mentioned earlier, need not be repaid until all homeowners are deceased. A better alternative to a HELOC for individuals in need of short-term cash for renovations or repairs is a traditional second mortgage. Cash from a second mortgage is generally received as a lump sum rather than a line of credit. Furthermore, second mortgages usually carry fixed interest rates and fixed repayment amounts.

Family Purchase and Rental or Private Reverse Mortgage

Another alternative to a reverse mortgage is for one or more of the homeowners' children to buy the home and rent it back to the parents. The children can then claim tax deductions for depreciation, real estate taxes, and maintenance costs, and they can profit from any future gain on the sale of the rental property. The purchase should be for fair market value to avoid any gift tax liability by the parents. However, if the children pay fair market value for the home, they are spending $300,000 to obtain a basis that would otherwise be established cost-free as a step up upon the parents' death.

As another option, the children can set up a private reverse mortgage for their parents using a limited partnership. Since the children personally provide the cash to fund the private reverse mortgage, it is not backed by the parents' home. Therefore, when the loan becomes due, the children do not lose the home to a lender. A private reverse mortgage may be significantly cheaper to establish than a commercial reverse mortgage. For example, it costs about $3,000 to set up a private reverse mortgage line of credit versus more than $10,000 for certain HECMs. As with an HECM, the cash can be received in a number of forms, including a lump sum or line of credit. Although a private reverse mortgage is a family loan, a child should record it legally so that other family members cannot attack the arrangement after the parents are deceased. Furthermore, children should apply the applicable federal interest rate to the loan to avoid liability for gift tax. Private reverse mortgages also carry significant risks. Since the children personally provide the cash to fund the private reverse mortgage, at least one child must have assets available to fund the arrangement. The child funding the loan could lose a source of income, leaving no means of paying the elderly parents their relied-upon cash. Furthermore, if the home value declines, selling the residence may not recover the loan amount upon the parents' death.

Other options for generating short-term cash include tapping into asset funds such as those in an IRA, 401(k), or certificate of deposit. However, today's economy has significantly depleted many individuals' retirement funds, and pulling money out of any of these sources usually is a taxable transaction. Individuals can also look to cut discretionary expenditures or sell assets before taking out a reverse mortgage.

Required Counseling

Reverse mortgages can be complicated instruments, but expert help is available. Prospective borrowers are required to meet with a certified HUD counselor before submitting a loan application. This session may be paid for either by the prospective borrower or by HUD grants. Borrowers are required to answer a series of questions to loan educators indicating that they are aware of the implications of a reverse mortgage. If they cannot answer the questions, they do not receive the counseling certificate that is required to obtain a loan. As with conventional mortgages, the federal Truth in Lending Act, P.L. 90-321, guarantees a three-day right of rescission.

Toward a Well-Informed Decision

Reverse mortgages may be used for a variety of purposes, including saving a home from foreclosure, supplementing pensions and Social Security benefits, meeting current or future medical expenses, or just maintaining a comfortable lifestyle. Practitioners should be prepared to discuss the advantages, disadvantages, and alternatives to ensure that their clients make a well-informed decision.

The best time to take out a reverse mortgage may be now, as interest rates are at all-time lows. Currently, adjustable-rate HECMs are available for around 3%, while fixed-rate HECMs are around 5%. A CPA's or financial adviser's input into the investment decision may be crucial.


EXECUTIVE SUMMARY

Although they have been criticized for high associated fees, reverse mortgages can provide cash for qualifying homeowners (62 or older) to meet immediate needs, in a lump sum, as fixed monthly payments for the lives of the owners, or as a line of credit.

The leading product, the Home Equity Conversion Mortgage (HECM), is insured by the federal government and limits the payback amount to the value of the home at the time the loan is due.

A newer version of HECMs, the HECM Saver loan, features lower upfront costs, including a lower initial mortgage insurance premium.

Alternatives to reverse mortgages should be explored by clients with their financial advisers, including a home equity loan, second mortgage, and selling the residence. The latter option might include a leaseback arrangement.

Nicholas C. Lynch (nlynch@georgiasouthern.edu) is an assistant professor of accountancy at Georgia Southern University in Statesboro, Ga. Charles R. Pryor (cr-pryor2@wiu.edu) is an assistant professor of accountancy at Western Illinois University in Macomb, Ill.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.


AICPA RESOURCES

JofA article

"Going Forward With Reverse Mortgages," July 2006, page 35

Publication

The CPA's Guide to Long-Term Care Planning (#017259)

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.

PFP Member Section and PFS credential

Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Forefield Advisor. Visit the PFP Center at aicpa.org/PFP. Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential. Information about the PFS credential is available at aicpa.org/PFS.

OTHER RESOURCES

Reverse mortgage information

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