Reverse Mortgages
Reverse mortgages have received a considerable amount of press in recent years. Once a little-used method of extracting equity from a home, they have become extremely popular—and extremely controversial. Like any financial tool, reverse mortgages can be helpful when used correctly and dangerous when used incorrectly.
What is a Reverse Mortgage?
A reverse mortgage is a special loan available to homeowners age 62 and older. It allows them to receive a cash advance (lump sum, line of credit or regular payment) in exchange for equity in their house. The borrowers can spend the loan money and retain ownership of their house. However, when the house changes hands (death or sale) or is no longer used as a primary residence, the loan must be repaid in full. The exception to this rule is that the spouses of borrowers who die will be allowed to stay in their home without the risk of foreclosure as long as they pay taxes, insurance, association fees and home maintenance costs and they are not named on the reverse mortgage as a co-borrower. The spouse must also be married to the borrower at the time of closing. While the surviving spouse will not receive payments from his or her deceased spouse’s reverse mortgage loan, the surviving spouse will also not be forced out of his or her home.
This exception is new as of August 2014, and provides significant relief to these surviving spouses, who can otherwise face an insurmountable debt after the death of their spouse. The full repayment of the reverse mortgage will now be due after the surviving spouse’s death.
The updated reverse mortgage rules also allow for a couple to receive a reverse mortgage even if one spouse is younger than age 62. However, in this case, the payout is decreased based on the younger spouse’s age. These updated rules apply only to reverse mortgages classified as HECMS, which will be described in more detail later on.
Reverse mortgages change nothing about ownership, utilities, maintenance or property taxes. No part of property management is affected. If the homeowner (or inheritor) desires to pay off the value of the reverse mortgage before selling the house, he or she is free to do so without any early repayment penalty.
Different Types
There are three types of reverse mortgages available to homeowners:
Single-purpose reverse mortgages –
These are offered by some local government groups and non-profit organizations. They are issued at low rates but are not available everywhere or to everyone. Additionally, they have restrictions in how the funds are used; as the name suggests, the money loaned out is to be used for a single purpose, such as house repairs. Single-purpose reverse mortgages often allow homeowners to use some of the house’s equity to keep the property functional.
In several states, this type of reverse mortgage takes the form of a property tax deferral.
Home Equity Conversion Mortgages (HECMs) –
Also referred to as “federally insured reverse mortgages,” these are the most popular type of reverse mortgages. HECMs are backed by the Federal Housing Administration (FHA) and the U.S. Department of Housing Urban Development (HUD). HECM rates and fees are higher than those on a single-purpose reverse mortgage, but the funds can be used for whatever the homeowner would like.
HUD requires that all homeowners applying for an HECM first receive counseling from a government-approved housing counseling agency. A counselor is required to inform potential borrowers about their options and how various fees will affect the total cost of the loan. According to the Federal Trade Commission, “Most counseling agencies charge around $125 for their services. The fee can be paid from the loan proceeds, but you cannot be turned away if you can’t afford the fee.”
Proprietary reverse mortgages –
Privately issued by a bank or some other company, these reverse mortgages do not have the government restrictions found in the other two. Typically, proprietary reverse mortgages will have the highest rates and largest fees, but, because they do not have loan size limits, they can be more useful to owners who want to extract as much as they can from valuable properties. Unlike an HECM, some proprietary mortgage lenders do not require counseling. (Individuals should always seek counsel when considering a reverse mortgage.)
Expenses and Fees
When a reverse mortgage is issued, the lender will charge various fees on the loan. The size of each fee will depend on the type of mortgage and the issuer. Borrowers must be careful to review all charges before agreeing to a reverse mortgage. Some of the most common fees include the following:
Outstanding mortgage value –
A lender will not issue a reverse mortgage unless the money loaned out will cover any existing debt on the house. This means that the more a homeowner owes on his or her house, the less money will go into his or her pocket; the owner must use the funds to pay off the outstanding mortgage first.
Origination fee –
Though low for single-purpose mortgages and limited by law to $6,000 for HECMs, the origination fee could be substantial for a proprietary loan. Origination fees should be factored in to the total when thinking about size of the requested mortgage.
Interest –
Like any other loan, a lender will charge the borrower an annual rate of interest. The interest is added to the outstanding balance of the reverse mortgage on a monthly basis.
Mortgage insurance premium (MIP) –
Required by HUD for all HECM loans, an MIP is both an upfront and an annual insurance payment a borrower must pay to guarantee access to all payments or credit. The insurance also protects homeowners (or their families) from ever having to repay more than the value of the house. An annual insurance fee is not interest; it accrues on top of standard interest rates and is added to the outstanding balance. (An HECM Saver mortgage is available to individuals looking to pay a smaller upfront MIP; however, these mortgages have smaller credit lines than standard HECMs.)
Servicing fees –
There can be a number of additional fees issued for services associated with a reverse mortgage. These fees, although typically minor, are often issued monthly and can add up over time. Fees may slip a borrower’s notice because they are automatically deducted from monthly disbursements or are added to the outstanding balance.
Mortgage Amount
The size of a reverse mortgage will depend on a number of factors calculated through lengthy equations. Some of the biggest factors include interest rates, homeowner age and market value of the house. In general, the older a homeowner, the larger percent of the house’s value will be available as credit (the bank assumes less value lost to interest for older owners).
Both single-purpose and HECM have limits on total value they are allowed to declare for a property. Proprietary mortgages do not feature any federal limits and are useful for getting a larger loan. However, since HECMs feature more protection than proprietary mortgages and have an equity limit as high as $625,500, the majority of people favor them over propriety mortgages.
Whatever the amount, the value of the reverse mortgage can be distributed to the borrower in any number of ways. The borrower can receive fixed payments for a set number of years (possibly for life) and/or be given a line of credit that can be accessed as needed. Whichever way they are disbursed, the longer a borrower is expected to have access to a loan, the smaller the maximum loan size will be.
When do Reverse Mortgages Work Well?
The advantage of a reverse mortgage is that it allows a homeowner to tap the equity of the house without having to sell it right away. This can provide much needed cash for owners while simultaneously preventing the costs and hassle of selling (like moving or renting). Reverse mortgages have become popular for retirees to use late in life simply because they allow them to use some of the money that they had locked up in the property.
What are the Dangers of Reverse Mortgages?
Unfortunately, reverse mortgages have some serious risks, and even when used correctly, are not very efficient. If relied upon too early in retirement, a reverse mortgage’s fees and interest rates can nearly destroy a homeowner’s equity—something they might badly need later. Although repayment is not an immediate impact, homeowners should never trivialize the effect a reverse mortgage can have on their future.
Problems can also occur if the paperwork is not handled prudently. In order for the surviving spouse to be able to remain living in the house, he or she must be named in the loan documents and establish legal ownership of the home within 90 days of the death of his or her spouse, so prudent legal action will be required. Though updated legislation means that HECM cannot force a surviving spouse from his or her home, no such regulation exists for proprietary reverse mortgages. In either case, it is best for both spouses to be upfront and sign off on a reverse mortgage.
Reverse mortgages can be extremely useful for providing extra money late in life, but home equity should never be considered something that needs to be used up. The decision to take a reverse mortgage should be made carefully after both mortgage counseling and a meeting with a trusted financial advisor. If you are considering a reverse mortgage or want to know how one could affect your retirement plans, contact Safe harbor Fiduciary.
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