| Going Forward With
Reverse
Mortgages The benefits and pitfalls of
borrowing against your home. by Howard
Godfrey and Edward Malmgren
| EXECUTIVE
SUMMARY |
Increased life expectancy has caused the
elderly to need more funds
after retiring, especially if they elect
early retirement. The home is often the
most valuable asset an individual owns.
Reverse mortgages allow homeowners to
continue to live in their
homes while borrowing against the
equity. A reverse mortgage may provide a
lump-sum advance, a line of credit
and/or periodic advances. Monthly
advances may be received as long as the
homeowner lives in the home. Best of
all, the homeowner never needs to make a
mortgage payment. A
lump-sum advance from a reverse
mortgage may be used to pay
off the existing first mortgage and
eliminate the monthly mortgage payment,
reducing monthly cash requirements.
Caution is required because reverse
mortgages can be
prohibitively expensive unless the
homeowner has a substantial amount of
home equity, plans to convert all or
most of the equity into retirement
funding and lives in the home and
benefits from the reverse mortgage for
the long term. A
homeowner who allows reverse mortgage
payments to increase
checking or savings balances beyond
certain limits may lose government
benefits.
Howard Godfrey,
CPA, PhD, and
Edward Malmgren,
CPA, PhD, are professors of
accounting at the University of North
Carolina, Charlotte. Their e-mail
addresses are
hgodfrey@email.uncc.edu
and
egmalmgr@email.uncc.edu
, respectively.
|
 everse
mortgages were created in 1987 by the Department
of Housing and Urban Development (HUD) to provide
greater financial security to American homeowners
age 62 and older. With the aging population in the
United States and the rapid appreciation of
residential property, the reverse mortgage
industry is destined to continue to grow. Reverse
mortgages often are thought of as the solution for
elderly citizens who need additional funds;
however, they can be a costly solution and should
be used with caution. This article
will help CPAs recognize situations where reverse
mortgages can provide much-needed supplementary
retirement incomeand equally important, when they
should be avoided.
| A total of 157 home
equity conversion mortgage loans were
made in fiscal year 1990. By 2005, the
number had skyrocketed to 43,131.
Source: Department
of Housing and Urban Development,
www.hud.gov . |
W HAT A
RE R EVERSE M ORTGAGES
A reverse
mortgage is a loan against home equity that
requires no repayment as long as the owner
continues to live in the home. An HECM (see box below) must be a first
mortgage, which means any existing mortgage debt
must be paid off first, possibly with some of the
reverse mortgage funds. This reverse mortgage
provides a line of credit, one or more lump-sum
advances and/or a series of periodic advances that
may continue until the last surviving borrower
leaves the home permanently. Reverse mortgage debt
increases over time as a result of advances to the
homeowner that increase the principal, and the
accumulation of service fees and accrued interest.
| About 90% of all
reverse mortgages are Home Equity
Conversion Mortgage (HECM) loans, which
are discussed in this article. HECM
loans were designed by HUD and are
insured by the Federal Housing
Administration (FHA). Other home-equity
loans not covered in this article may
have unique advantages, such as the
absence of the lending limits that are
applicable to federally insured loans,
and drawbacks, such as higher costs.
|
The reverse mortgage debt does not become
due until the house is sold or the homeowner(s)
move out permanently. At that time the lender
likely will receive payment of the loan balance
through the sale of the home, though in order to
keep the house in the family, the homeowner or
family members may choose to pay off the mortgage
with other funds. If the sales proceeds are
insufficient to pay off the mortgage, the
shortfall is covered by mortgage insurance, which
is required with an HECM. Sale proceeds in excess
of the debt go to the homeowner(s) or the estate.
| |
 Reverse Mortgage
Meets Needs of Elderly |
| Joe Homeowner is
85 years old and his wife Jan is
84. Their home, valued at
$300,000, is debt-free. They are
committed to living in their
home as long as possible. Their
Social Security benefits and
interest on savings have been
adequate for their living costs,
but they now need in-home
nursing care several days a week
at a cost of about $1,000 per
month. Joe and Jan do not
want to be a financial burden
to their children. They do not
qualify for a bank loan to
cover these extra costs
because they do not have extra
income to cover loan payments.
They could sell the home, but
they would need to find
alternative housing. A reverse
mortgage may be a good way to
get the funds they need to
balance their budget.
|
|
R EVERSE M ORTGAGE L IMITS
Since the homeowner is not expected to make
payments on a reverse mortgage, no minimum income
level is needed to qualify for the loan. The
borrowers health and credit rating also are
irrelevant. The amount of debt that may be
incurred is based on the value of the home, the
age of the homeowner and expected interest rates.
An older taxpayer can qualify for larger monthly
advances and/or a larger lump-sum advance because
of the shorter life expectancy over which the loan
balance will grow (see exhibit
2 ). Lower interest rates also allow
greater borrowing because there will be less
accrued interest. The impact of age on borrowing
capacity is seen in exhibit 2
with a $250,000 home, where mortgage rates
are 6%.
| |
 Know
Your Limit |
Sample age and credit-line
limits for a $250,000 house at
6% interest.
| Age
|
Credit line
|
| 65
| $129,425
|
| 75 |
$154,538 |
| 85 |
$181,460 |
| 90
| $194,150
|
Source: AARP, HomeMade
Money, page 11.
|
|
The home value that may be used in
calculating an HECM is capped by the FHA. The
limit varies from $200,160 in areas with lower
median home values to a maximum of $362,790 in
many major metropolitan areas where home values
are higher. So a $1 million home and a $400,000
home might be eligible for exactly the same loan
amount. Of course the maximum loan would be lower
for a home worth less than $200,160. The lower
limit of $200,160 is applicable in about 80% of
the counties in the United States. HUD
cautions homeowners that they should not need to
hire a paid consultant to find a reverse mortgage
lender, because HUD provides a list of
HUD-approved lenders. But all loan applicants must
obtain HUD-approved, third-party counseling before
proceeding, because reverse mortgages are complex
and potentially costly. HUD requires the
counseling to include topics such as alternative
sources of financial assistance, other home-equity
conversion options, the financial implications of
the HECM such as rising debt-falling equity, the
possible effect of the loan on public programs
such as Medicaid and details of loan options and
payment plans. This counseling is provided free or
at a nominal cost. The HECM, which provides funds
for medical costs and other living expenses during
retirement, is not intended to be used by seniors
as a source of funds for making investments, loans
to relatives and so on.
Exhibit 3 describes some situations in
which a reverse mortgage may be a good option and
some in which it is not.
| |
 Likely
Candidates |
| Those who can get
the most from a reverse
mortgage: 
Homeowners who are much older
than the minimum age of 62.
For an older homeowner, the
life expectancy suggests there
will be fewer remaining years
for reverse mortgage advances
and less accumulated interest
and service fees. The
homeowner can receive larger
advances over a relatively
short period without
projecting a loan balance that
will exceed the value of the
home.
Homeowners with small balances
on their mortgages and those
who are debt-free can receive
larger reverse mortgage
advances.
Homeowners who are having
difficulty paying an existing
mortgage can use a reverse
mortgage to eliminate the
monthly mortgage payment.
Those who can get
little benefit from a
reverse mortgage:
Homeowners who are just above
the minimum age of 62. Because
their life expectancy suggests
there will be many remaining
years for reverse mortgage
advances, there will be more
accumulated interest and
service fees.
Homeowners with little equity
in their homes are limited to
smaller advances.
Homeowners who plan to move to
another living situation such
as a nursing home within a few
years. They may incur high
costs and receive relatively
small benefits, especially if
they select a monthly advance
option. |
|
COMPARISON
SHOPPING
The monthly adjusted
HECM provides the largest loan at the lowest
interest rate. However, the annually adjusted
HECM, with a higher initial interest rate, has
less risk, because the increase on interest rates
is capped at 5 percentage points, compared with 10
for the monthly adjusted HECM. If a borrower
allocates some (or all) of the net principal
amount to an HECM line of credit, the unused
portion of that credit will increase over time, at
a rate tied to the accruing interest rate.
Both the monthly and the annually adjusted
HECM have an initial mortgage insurance premium of
2% of the maximum claim amount (the lesser of the
value of the home or the FHA loan limit) as well
as an annual mortgage insurance premium of
one-half of one percent of the loan balance. The
origination fee is limited to the greater of
$2,000 or 2% of the maximum claim amount. The
origination fee, upfront mortgage insurance
premium and other closing costs may be financed as
part of the reverse mortgage.
Example . Joe and Jan
Homeowner have a $300,000 home, but the FHA
lending limit for their area is $200,160, which is
their maximum claim amount. They choose the
monthly adjustable HECM. (
Exhibit 4 shows how to compute the amount
of reverse mortgage funds available, loan costs
and so on.) The initial interest rate is 5.87% and
the expected future rate is 5.85%, with a cap of
15.87%. There is also a charge of 0.5% of the
mortgage balance each month for mortgage
insurance.
| |
 FHA /HUD
Monthly Adjustment Reverse
Mortgage |
|
|
The loan principal limit is $156,525.12,
which is computed with a formula that takes into
account the maximum claim amount of $200,160, a
HUD limit factor and expected future interest
rates. A set-aside is deducted for future monthly
loan processing fees, leaving an available
principal limit of $152,317.47. Joe and Jan choose
to finance the initial mortgage insurance premium
of 2% of the maximum claim amount ($4,003.20) and
the origination fee, which also is $4,003.20, as
well as other closing costs of $1,561.32. This
means that they have a loan balance of $9,567.72
before they begin receiving reverse mortgage
advances. These financed costs reduce the net
principal limit to $142,749.75. Their
first option is to receive monthly advances of
$1,187.42 for as long as either one of them lives
in the home. They also have the option of
receiving more, say $1,500 per month, for only a
fixed period.
| | The
Impact of the Deficit
Reduction Act of 2005
BY MICHAEL DAVID
SCHULMAN
O ne major unknown factor
concerning reverse mortgages
is the impact that the Deficit
Reduction Act of 2005 will
have on them. Because one of
the goals of the act is to
reduce government spending on
Medicaid, it legislates that
Medicaid be denied to
applicants with more than
$500,000 in home equity. As a
result, more and more older
adults will be required to pay
for their own health care. It
is expected that the number of
reverse mortgages will
increase as a result.
The Deficit Reduction Act
also requires the state be
named as a remainder
beneficiary in annuity
contracts, presumably to
permit states to recover their
Medicaid costs. While the
details, on a state-by-state
basis, have yet to be worked
out, it seems clear that many
planning situations that would
have been solved through the
use of an annuity contract
(whether issued by an
insurance company or a
so-called private annuity)
will need to find an
alternative income source.
Despite looking like
annuities, reverse mortgages
are a form of borrowing, so
the remainder to the state
rule referred to above does
not apply. Reverse mortgages
likely will be used in many of
these cases.
Another not yet determined
aspect of the Deficit
Reduction Act and reverse
mortgages is who gets the
money when the house is sold.
Put differently, the lender is
in a primary position on a
reverse mortgage. However,
Medicaid also can put a lien
on an older adults residence
as benefits are paid. What
will happen if Medicaid
insists on being first? Or, if
a Medicaid lien is in effect
when an adult wishes to take a
reverse mortgage, will
Medicaid take a subordinate
position to the mortgage
lender? As with any
financial product being
marketed to older adults, CPAs
must take care to protect the
client from financial fraud.
In general, it is
inappropriate to purchase a
reverse mortgageor any
investment productfrom a
door-to-door vendor.
Many of these products
have extremely high fees,
closing costs and interest
rates that can trap the unwary
homeowner.
Michael David
Schulman,
CPA/PFS, is the
principal of Schulman CPA,
Central Valley, N.Y. His
e-mail address is
michael@schulmancpa.com
.
|
|
TAX
IMPLICATIONS
A reverse mortgage
may be tax-neutral. Money received from a reverse
mortgage payout is not taxable income. The
borrower continues to be liable for property
taxes, for which he or she still qualifies for a
tax deduction. A borrower with no existing
mortgage will have no interest deduction to lose,
but a borrower who refinances a standard mortgage
with a reverse mortgage will lose the annual
mortgage interest deduction. Since no interest
payments are made, cash-basis taxpayers cannot
take a current deduction for mortgage interest and
other costs that the lender pays or accrues; that
deduction potentially will be available only when
the mortgage is paid off.
|
|
Suggest a reverse mortgage only
if your client has substantial
equity in the home, plans to
borrow a large part of that
equity and plans to live in the
home for the long term.
Dont recommend a reverse
mortgage for small loans such
as minor home repairs.
Advise against getting reverse
mortgages for investments or
loans to friends or relatives.
HUD
provides information and
face-to-face or phone
counseling about HECM loans
free or at nominal cost.
|
|
LOAN ACCELERATION CLAUSES
A homeowner with an HECM is responsible
for taking care of the property that likely will
be sold in the future to pay the loan balance.
Such responsibilities include home repairs,
property taxes, and fire and storm insurance.
Failure to fulfill such responsibilities may cause
the reverse mortgage loan to become due. The
homeowner also can cause acceleration of the loan
by renting out the home to another party, adding a
new owner to the homes title, changing the homes
zoning classification or taking out new debt
against the home.
| |
 The Upside
and the Downside of a
Reverse Mortgage |
UPSIDE
Keep the home and receive
cash.
Borrowers can stay in their
homes and convert their equity
to cash without having to make
current loan payments.
Larger amounts
when older.
Older borrowers are able
to obtain a larger monthly
advance because they have a
shorter life expectancy.
DOWNSIDE
Expensive for
short-term borrowers.
Substantial
loan origination fees and
mortgage insurance premiums
are required, as well as
annual interest and service
fees. At the end of the first
year, the loan balance will
include reverse mortgage
advances received during the
year, accrued service fees,
all of the costs of getting
the loan that were financed
and accrued interest. Part II
of Exhibit 4
shows that if the loan
with a 5.87% initial interest
rate is outstanding for only
one year, the accumulated loan
costs are 63.7% of the average
loan balance; the average loan
cost will be 26.5% if the loan
is outstanding for two years.
If the borrower dies or moves
into a nursing home within a
few years, the loan will have
been a very expensive source
of funds.
Expensive for
small amounts.
HECM loan costs are
based on the home value or
loan limit, not on the amount
the homeowner wants to borrow.
If the borrower needs only a
relatively small amount (for
example, $10,000 for a new
roof), closing costs are very
large relative to the amount
of benefit received.
Risk of
losing government
benefits.
Reverse mortgage advances will
not be considered income and
will not affect Medicaid
coverage, but any resulting
unspent cash balance may be a
problem if it exceeds Medicaid
asset limits. To avoid this,
the homeowner should borrow
only enough to meet current
needs. |
|
THE BOTTOM
LINE
A reverse mortgage makes
economic sense for you or your clients only when
it will be long-term and there is substantial
equity in the home. When considering a reverse
mortgage, homeowners should evaluate their
commitment to remain in the home and their current
state of health. They also should consider whether
in-home health care will be available if needed
from family members, friends or health care
professionals. Then, they should obtain a reverse
mortgage only if it does not have the downside
features listed in exhibit 5
, above. The CPAs advice here may be
critical. After all, whats involved is the
clients most valuable asset, the home.  |
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