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In Focus
14
SEPTEMBER 2009 / THE CPA JOURNAL
Reverse Mortgages and the Alternatives Weighing Solutions for Potential Borrowers
By James Hopson, Patricia D. Hopson, and Stephen Del Vecchio
T
he reverse mortgage is a relative newcomer to the mortgage industry. As companies increasingly promote this instrument in an effort to unlock the $3 trillion to $5 trillion of equity seniors have invested in their primary residences, financial advisors may find individuals inquiring about the advantages and disadvantage of reverse mortgages for themselves or their relatives. The focus below
is on the disadvantages of, and alternatives to, reverse mortgages. For a detailed discussion of the U.S. Department of Housing and Urban Development (HUD) Federal Housing Administration (FHA) insured Home Equity Conversion Mortgages (HECM), see “Financial Planner’s Guide to the FHA Insured Home Conversion Mortgage” by Douglas Skarr, in the Journal of Financial Planning, May 2008. In addition to HUD’s FHA HECM reverse mortgages, other popular options include proprietary reverse mortgages offered by banks or mortgage companies. Advisors should be aware that as of December 31, 2008, the Fannie Mae Home Keeper mortgage is no longer available.
SEPTEMBER 2009 / THE CPA JOURNAL
15
The Basics Reverse mortgages are marketed as a way for older individuals to borrow against the equity in their primary residence without having to make monthly payments. Caution should be exercised, because they are not magical solutions for cashstrapped seniors, and HUD reports that more than half of HECM borrowers terminate the loan within seven years. The early terminations make these loans extremely expensive, especially when the cost is amortized. The interest expense over seven years suggests that there are other, more cost-effective alternatives.
Reverse mortgages are in essence first-lien loans against the equity that senior borrowers have in their principal residence, which brokers market as tax-free loans.
The first question many ask about reverse mortgages is: “Why were reverse mortgage loans developed?” Fannie Mae claimed reverse mortgages supported its mission “to increase the affordability of housing for low-moderate and middleincome Americans, work with various government, local, and social agencies, and our lender partners, to assist older homeowners to remain in their homes and obtain needed cash” (www.fanniemae.com/global/ pdf/homebuyers/moneyfromhome.pdf). These reverse mortgage loans, however, are so complex and costly that the law requires borrowers to seek free mortgage counseling from a HUD-approved counselor before FHA’s HECM loans can be made. Fannie Mae’s guide to understand-
16
ing reverse mortgages states: “Federal law provides you a three-day ‘right of rescission,’ that is, the option to cancel the contract without penalty within three business days (including Saturdays).” Therefore, the FHA borrower should delay using the funds for the first three business days (including Saturdays), because if there is any buyer’s remorse, the funds are available to repay the loan within this grace period. Reverse mortgages are in essence firstlien loans against the equity that senior borrowers have in their principal residence, which brokers market as tax-free loans. They allow borrowers to remain in their home while meeting their financial obligations. Brokers stress that reverse mortgages require no minimum income or credit qualifications, the money is available for any purpose, and closing costs may be financed in the mortgage. The principal and interest are deferred until the borrower dies, sells the home, or moves out for a period exceeding 12 months. The amount that can be borrowed with a reverse mortgage depends upon four factors: ■ Age, ■ Equity in the home, ■ The interest rate, and ■ The value of the home (which is capped at 95% of the median home price in the geographic area in which the borrower’s home is located, and the maximum lending limit varies by county and previously ranged from $200,160 to $362,790). The Housing and Economic Recovery Act of 2008 increased the maximum home value to $625,500, increasing the maximum loan value to $417,000, which allows more homeowners living in high-cost areas to qualify for reverse mortgages. The Housing and Economic Recovery Act of 2008 also instituted a new program called HECM for Purchase, effective January 1, 2009. This program allows seniors to purchase a new primary residence and obtain a reverse mortgage in one transaction, thus eliminating a second closing. This program will also enable seniors to downsize their homes or move to a different geographical location to be closer to friends or family members. The following HUD example illustrates the relationship of the youngest borrower’s age to the amount that is available:
Based on a loan with an interest rate of approximately 9%, and a home qualifying for $100,000, a 65-year-old individual could borrow up to 22% of the home’s value; a 75-year-old individual could borrow up to 41% of the home's value; and, an 85-year-old individual could borrow up to 58% of the home's value. The percentages do not include closing costs because these charges can vary (www.hud.gov/offices/hsg/sfh/ hecm/hecmabou.cfm). The borrower can select from five HUD payment options but consideration should be given to remaining life expectancy. How many more years will people of a certain age live? Exhibit 1 presents the median remaining life expectancy for males and females aged 65 through 90. This means that about half the females now aged 65, for example, will live for at least another 18.4 years—to age 83.4. As outlined on the HUD website at www. hud.gov/offices/hsg/sfh/hecm/rmtopten.cfm, the five HUD payment options clients can choose from are as follows: ■ Tenure. Equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence. ■ Term. Equal monthly payments for a fixed period of months selected. ■ Line of credit. Unscheduled payments or installments, at times and in amounts of borrower’s choosing until the line of credit is exhausted. ■ Modified tenure. Combination of line of credit with monthly payments, for as long as the borrower remains in the home. ■ Modified term. Combination of line of credit with monthly payments, for a fixed period of months selected by the borrower. No repayment of the HECM is required until the home is no longer the borrower’s principal residence. When the loan is due, the individual or his estate will owe the lesser of the loan balance or the market value of the property. As with most reverse mortgages, the loan is generally repaid through the sale of the property. If repayment of the mortgage is triggered due to the death of the borrower, the estate has 360 days to repay the loan. The sale of the property is not required if the estate or heirs have or can borrow sufficient funds to repay the loan. Any sales proceeds in excess of the amount owed the lender SEPTEMBER 2009 / THE CPA JOURNAL
belong to the individual or his estate. Senior borrowers are charged an insurance premium up-front, equal to 2% of the maximum claim amount that may be borrowed, as well as a .5% annual premium. The insurance provides that borrowers will receive all payments due to them as long as they live in their home. It also ensures that the lender will receive full repayment of the loan balance, even if it is greater than the value of the property.
Disadvantages of Reverse Mortgages The cash that individuals generally receive from a reverse mortgage seldom exceeds 50% of their home equity, unless they are 80 years of age or older. Therefore, potential borrowers must consider if there are more advantageous solutions to their cash flow problem that in the long run would better benefit them and their heirs. An additional disadvantage to these complex and often confusing mortgage agreements is the front-end and back-end costs (which can easily surpass 10% of a home’s equity) and the interest rate charged on reverse mortgages. Interest costs are added to the principal loan balance each month, as well as any of the following the borrower wishes to finance instead of paying up-front: ■ Application fees or origination fees (which as part of the Housing and Economic Recovery Act of 2008 now are 2% for up to $200,000 of the home’s value, plus 1% for the amount that exceeds $200,000, up to a maximum of $6,000. Origination fees, however, vary among different lenders, so it is best to compare prices), ■ Closing costs, which usually vary from $2,000 to $3,000, but can be higher in some areas of the country (which can include title search and insurance, appraisals, surveys, credit histories, taxes, recording fees, document preparation, endorsement fees, escrow/settlement fees, termite inspection, flood zone certification, attorney’s fees and title exam, county intangible tax, and state residential funding fee—all of which may be necessary to complete the transaction), ■ Servicing fees (for an annually adjusted interest rate, the servicing fee can be no more than $30 per month and the fee for the monthly adjusting HECM servicing fee can be no more than $35 per month), ■ Points, and SEPTEMBER 2009 / THE CPA JOURNAL
■ Initial and monthly mortgage insurance premiums—which consist of two types of charges: ■ A one-time premium at closing of 2% of the maximum claim amount, or ■ Annual premiums of 0.5% per year on the mortgage loan balance. Often included in the terms of proprietary loan agreements are shared equity and shared appreciation fees. These latter two fees can raise the cost of an already expensive loan. The shared appreciation clause gives the lender as much as 50% of the future appreciation in the home, and it has no relation to the amount of money borrowed. The third disadvantage is that the reverse mortgage is a rising-debt mortgage, the opposite of a typical decreasing debt mortgage. With a reverse mortgage, an individual’s debt increases and her home equity decreases. Example. Consider the following reverse mortgage from Fannie Mae which does not include the financing of closing costs, the financing of the initial insurance premium (2% of the maximum claim amount), the deduction of an initial set-aside amount sufficient to pay a $30 or $35 monthly servicing fee for the life of the loan, or any existing mortgage that must be paid off to qualify for a reverse mortgage. When measuring how a reverse mortgage loan balance grows over time, the following assumptions are made: ■ Monthly loan advance = $300 and ■ Compound interest rate = 1% per month. Exhibit 2 shows that after the first loan advance, the borrower’s loan balance is $300. After one month, the borrower receives another loan payout of $300 and is charged $3.00 in interest on the first advance, bringing the loan balance to $603. In the second month, the borrower receives another $300 payout and is charged $6.03 in interest on the loan balance, bringing the new loan balance to $909.03. The third month brings another $300 payout and a $9.09 interest charge on the loan balance, for a total current loan balance of $1,218.12. Over one year, the borrower’s total loan balance would be $3,843—that is, $3,600 in 12 monthly loan advances of $300 each, plus $243 in interest charges. Similarly, at the end of 10 years, the borrower’s total loan balance would be
EXHIBIT 1 Average Remaining Years of Life for Males and Females Aged 65–90 Age
Male
Female
65
14.2
18.4
66
13.6
17.7
67
13.0
17.0
68
12.5
16.3
69
11.9
15.5
70
11.4
14.8
71
10.8
14.2
72
10.3
13.5
73
9.8
12.8
74
9.4
12.2
75
8.9
11.6
76
8.5
11.0
77
8.0
10.4
78
7.6
9.8
79
7.2
9.2
80
6.8
8.7
81
6.4
8.2
82
6.1
7.7
83
5.8
7.2
84
5.4
6.8
85
5.1
6.4
86
4.9
6.0
87
4.6
5.6
88
4.3
5.3
89
4.1
5.0
90
3.9
4.7
17
$69,702—that is, $36,000 in monthly loan advances and $33,702 in interest charges. It’s no wonder that more than half of the borrowers terminate their FHA HECM mortgages within seven years, once they realize that their home equity is gradually disappearing. Potential borrowers need to understand that, with an increasing debt loan, unless the home’s value is appreciating more than the interest rate, a loan that was initially less than half the value of the home may, over time, be equal to the value of the home. The fourth disadvantage is that these loans are limited to a choice of two variable applied interest rates: an annually adjusted rate or a monthly adjusted rate, tied to the one-year U.S. Treasury Security rate. The interest rate is usually one to three percentage points higher than the Treasury rate. The FHA HECM loans limit the increase in annually adjusted rates to no more than 5% over the life of the loan, and it cannot increase by more than 2% in any year. The monthly adjusted rate cannot increase by more than 10% over the life of the loan, but there is no limit to the amount the rate can change with each monthly adjustment, as long as it does not exceed the 10% lifetime cap. Interest rates are also two to three points higher than conventional mortgages and are generally more secure because of the excess equity the homeowner has in the home. Not only are interest charges being added to the principal each month, but, because most taxpayers file on a cash basis, the interest charges are not tax deductible until paid (generally when the loan is paid off). The fifth disadvantage is that, not only do reverse mortgages reduce the borrower’s assets and whatever estate the children
may inherit, but the payments from a reverse mortgage may adversely affect Supplemental Security Income (SSI) or Medicaid benefits, both of which are based on financial need. A borrower must still maintain the home, purchase insurance, pay real estate taxes, and pay the other expenses associated with home ownership. In addition, each year, the lender will ask the borrowers to certify by mail that the property remains their principal residence, because if it is not, the mortgage becomes
There are probably better solutions than reverse mortgages for recurring needs, and reverse mortgages are poor solutions for short-term needs.
due. This may frustrate any future desire or need to relocate. The borrowers also must advise the lender if they are going to be absent from home for more than two months. Financial advisors should take a proactive approach to advising their clients in order to help them avoid unscrupulous salespeople selling reverse mortgages. Potential borrowers should be advised
that the HUD-required counseling is free and anyone charging for this service should be avoided. Any salespeople recommending a reverse mortgage to enable investment in a product they are selling should be suspect.
Alternatives to Reverse Mortgages Before an individual decides on a loan that eats away at the equity he has built over many years, he should stop and consider why he needs the money. Is it a one-time issue or an ongoing cash flow shortage? There are probably better solutions than reverse mortgages for recurring needs, and reverse mortgages are poor solutions for short-term needs. The following options might be preferable for singleoccurrence, short-term cash needs (e.g., roof replacement or remodeling for handicapped access) and recurring monthly needs. The first option individuals should consider is selling their home instead of making expensive renovations or repairs. This option may not be emotionally satisfying, but it may be the most financially sound one. Simply maintaining a large home and yard can become overwhelming as people age. There are many smaller homes in retirement communities specifically designed with features for the elderly. Selling and renting or leasing back the residence is another alternative. People often need some time to decide whether selling their residence and moving is in their best interest. This option may provide them with not only cash to meet immediate needs but also a cushion for future contingencies. Another option for individuals to consider is tapping into funds that they initially intended to leave undisturbed. Often these
EXHIBIT 2 Fannie Mae Example Previous Month’s Loan Balance
Interest on Previous Month’s Loan Balance
0
$0
$0
$300.00
$300.00
$0
1
300.00
3.00
300.00
603.00
303.00
2
603.00
6.03
300.00
909.03
306.03
3
909.03
9.09
300.00
1218.12
309.09
After Month
Current Month’s Loan Advance
Current Loan Balance
Monthly Increase in Loan Balance
Source: www.fanniemae.com/global/pdf/homebuyers/moneyfromhome.pdf
18
SEPTEMBER 2009 / THE CPA JOURNAL
funds are not used, or have a significant balance, and withdrawing a portion of the funds will not jeopardize the client’s lifestyle. These funds may be in an IRA or 401(k) plan. They may be the cash value of a life insurance policy, an investment account, or locked up in a certificate of deposit. Instead of just borrowing from an insurance policy, one should consider other alternatives. There are secondary markets that will purchase life insurance policies and generally pay two to 10 times what the issuing company will pay, depending on age and health. The other alternative is a conventional loan from a bank or a relative, especially if it is just a short-term need and one can repay the loan over a reasonable time period. Most local banks will offer cash-out refinancing loans or a homeequity line of credit; however, these loans require monthly payments, so borrowers must consider if their cash flow is adequate. Many state and local governments have programs to help the elderly. Among these are one-time reverse mortgage loans that do not have to be paid as long as the client remains in the home. The local housing authority, office on aging, or community action department should be able to help. These loans may be less costly than commercial reverse mortgages. Many counties have property tax deferral programs for the elderly. If a senior’s cash flow problem is an ongoing issue, reducing current expenses may be the solution. There are companies that will buy a percentage of the future appreciation in the home; however, this alternative is not optimal. Financial advisors should recommend that their clients sell the remainder interest in the home to one or more of their heirs. Thus, an individual will have the right to use the home for life and, upon death, the home belongs to the person owning the remainder interest. Although borrowing money to purchase a variable annuity is a prohibited transaction under securities regulation, it has been suggested that seniors may use the proceeds from reverse mortgages to buy a variable or fixed annuity, and, depending upon their age, they may have enough cash flow from the annuity to make the monthly mortgage payment and cover additional living expenses. Even if there are ways around the rules for borrowing to purchase an annuity, the annuity alternative may not work for younger clients because the payout is insufficient to pay off the loan. For those considering this option, the SEPTEMBER 2009 / THE CPA JOURNAL
annuity should be guaranteed pay for as long as the loan repayment period (Walter Updegrave, “Reverse Mortgages: Beware the Come-Ons,” Money, May 21, 2008).
Circumstances Where a Reverse Mortgage Might Be Advantageous If seniors can realistically expect to stay in their home for a long time and have pressing financial needs (such as a major healthcare crisis) that cannot be met by other alternatives, reverse mortgages should be considered. Many people over 62 were in the workforce until they recently lost their jobs. As the economy has worsened, unemployment has increased, the value of retirement savings has plummeted, and more seniors are utilizing reverse mortgages to avoid foreclosure on adjustable rate mortgages that they increasingly cannot pay from their current fixed income. The AARP Public Policy Institute recently published a study which revealed that over 25% of the foreclosures and loan delinquencies involve people 50 and older. With the new lower loan limit of $417,000, based on an increase home value of $625,500, more seniors will qualify and the lower origination fees will reduce the fees incurred on a reverse mortgage. If the numbers work, a reverse mortgage can be a
way to pay off an adjustable rate loan and can increase monthly cash flow. Before recommending that a client consider an expensive reverse mortgage, financial advisors should consider how long the extra money is needed. Is it a recurring need or a one-time need? Can expenses be cut? Can debts be consolidated and required monthly payments be reduced? What other alternatives are available? (The Sidebar includes other sources of information.) People often panic when they encounter a cash flow problem. The advisor’s job is to bring calm solutions to the table for their consideration. Clients should make a wellinformed decision, whether that is to utilize a reverse mortgage or explore a ❑ different option. James Hopson, JD, CPA, is a professor in the school of accountancy at the University of Central Missouri, Warrensburg, Mo. Patricia D. Hopson, CPA, is a consultant to private industry and clients of means and an adjunct professor at the University of Central Missouri. Stephen Del Vecchio, DBA, CPA, CFE, is also a professor in the school of accountancy at the University of Central Missouri.
ADDITIONAL INFORMATION AARP, “Home Made Money: A Consumer Guide to Reverse Mortgages.” Call 1-800-424-3410 to order or visit www.aarp.org/money/revmort/revmort_ basics/a2003-03-21-newloan.html. Department of Housing and Urban Development (HUD), “Home Equity Conversion Mortgage, Demonstration Handbook 4235.1,” Publications Service Center, Room B-258, 451 7th Street, SW, Washington, DC 20410. Call 1-888-466-3487; www.hud.gov/buying/rvrsmort.cfm. Fannie Mae, 3900 Wisconsin Avenue, NW, Washington, DC 20016-2892. Call 1-800-732-6643; www.fanniemae.com. Federal Trade Commission, “Facts for Consumers: Reverse Mortgages,” Office of Consumer/Business Education, 600 Pennsylvania Avenue, NW, Washington, DC 20580; www.ftc.gov/bcp/edu/pubs/consumer/homes/rea13.shtm. National Center for Home Equity Conversion, 7373 147th Street, NW, Apple Valley, MN 55124. Call 612-953-4474; www.reverse.org. National Consumer Law Center, “Tips for Consumers on Reverse Mortgages”; www.nclc.org/initiatives/seniors_initiative/tips.shtml. Administration on Aging, “Aging Internet Information Notes”; see www.aoa.gov.
19
14
SEPTEMBER 2009 / THE CPA JOURNAL
Reverse Mortgages and the Alternatives Weighing Solutions for Potential Borrowers
By James Hopson, Patricia D. Hopson, and Stephen Del Vecchio
T
he reverse mortgage is a relative newcomer to the mortgage industry. As companies increasingly promote this instrument in an effort to unlock the $3 trillion to $5 trillion of equity seniors have invested in their primary residences, financial advisors may find individuals inquiring about the advantages and disadvantage of reverse mortgages for themselves or their relatives. The focus below
is on the disadvantages of, and alternatives to, reverse mortgages. For a detailed discussion of the U.S. Department of Housing and Urban Development (HUD) Federal Housing Administration (FHA) insured Home Equity Conversion Mortgages (HECM), see “Financial Planner’s Guide to the FHA Insured Home Conversion Mortgage” by Douglas Skarr, in the Journal of Financial Planning, May 2008. In addition to HUD’s FHA HECM reverse mortgages, other popular options include proprietary reverse mortgages offered by banks or mortgage companies. Advisors should be aware that as of December 31, 2008, the Fannie Mae Home Keeper mortgage is no longer available.
SEPTEMBER 2009 / THE CPA JOURNAL
15
The Basics Reverse mortgages are marketed as a way for older individuals to borrow against the equity in their primary residence without having to make monthly payments. Caution should be exercised, because they are not magical solutions for cashstrapped seniors, and HUD reports that more than half of HECM borrowers terminate the loan within seven years. The early terminations make these loans extremely expensive, especially when the cost is amortized. The interest expense over seven years suggests that there are other, more cost-effective alternatives.
Reverse mortgages are in essence first-lien loans against the equity that senior borrowers have in their principal residence, which brokers market as tax-free loans.
The first question many ask about reverse mortgages is: “Why were reverse mortgage loans developed?” Fannie Mae claimed reverse mortgages supported its mission “to increase the affordability of housing for low-moderate and middleincome Americans, work with various government, local, and social agencies, and our lender partners, to assist older homeowners to remain in their homes and obtain needed cash” (www.fanniemae.com/global/ pdf/homebuyers/moneyfromhome.pdf). These reverse mortgage loans, however, are so complex and costly that the law requires borrowers to seek free mortgage counseling from a HUD-approved counselor before FHA’s HECM loans can be made. Fannie Mae’s guide to understand-
16
ing reverse mortgages states: “Federal law provides you a three-day ‘right of rescission,’ that is, the option to cancel the contract without penalty within three business days (including Saturdays).” Therefore, the FHA borrower should delay using the funds for the first three business days (including Saturdays), because if there is any buyer’s remorse, the funds are available to repay the loan within this grace period. Reverse mortgages are in essence firstlien loans against the equity that senior borrowers have in their principal residence, which brokers market as tax-free loans. They allow borrowers to remain in their home while meeting their financial obligations. Brokers stress that reverse mortgages require no minimum income or credit qualifications, the money is available for any purpose, and closing costs may be financed in the mortgage. The principal and interest are deferred until the borrower dies, sells the home, or moves out for a period exceeding 12 months. The amount that can be borrowed with a reverse mortgage depends upon four factors: ■ Age, ■ Equity in the home, ■ The interest rate, and ■ The value of the home (which is capped at 95% of the median home price in the geographic area in which the borrower’s home is located, and the maximum lending limit varies by county and previously ranged from $200,160 to $362,790). The Housing and Economic Recovery Act of 2008 increased the maximum home value to $625,500, increasing the maximum loan value to $417,000, which allows more homeowners living in high-cost areas to qualify for reverse mortgages. The Housing and Economic Recovery Act of 2008 also instituted a new program called HECM for Purchase, effective January 1, 2009. This program allows seniors to purchase a new primary residence and obtain a reverse mortgage in one transaction, thus eliminating a second closing. This program will also enable seniors to downsize their homes or move to a different geographical location to be closer to friends or family members. The following HUD example illustrates the relationship of the youngest borrower’s age to the amount that is available:
Based on a loan with an interest rate of approximately 9%, and a home qualifying for $100,000, a 65-year-old individual could borrow up to 22% of the home’s value; a 75-year-old individual could borrow up to 41% of the home's value; and, an 85-year-old individual could borrow up to 58% of the home's value. The percentages do not include closing costs because these charges can vary (www.hud.gov/offices/hsg/sfh/ hecm/hecmabou.cfm). The borrower can select from five HUD payment options but consideration should be given to remaining life expectancy. How many more years will people of a certain age live? Exhibit 1 presents the median remaining life expectancy for males and females aged 65 through 90. This means that about half the females now aged 65, for example, will live for at least another 18.4 years—to age 83.4. As outlined on the HUD website at www. hud.gov/offices/hsg/sfh/hecm/rmtopten.cfm, the five HUD payment options clients can choose from are as follows: ■ Tenure. Equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence. ■ Term. Equal monthly payments for a fixed period of months selected. ■ Line of credit. Unscheduled payments or installments, at times and in amounts of borrower’s choosing until the line of credit is exhausted. ■ Modified tenure. Combination of line of credit with monthly payments, for as long as the borrower remains in the home. ■ Modified term. Combination of line of credit with monthly payments, for a fixed period of months selected by the borrower. No repayment of the HECM is required until the home is no longer the borrower’s principal residence. When the loan is due, the individual or his estate will owe the lesser of the loan balance or the market value of the property. As with most reverse mortgages, the loan is generally repaid through the sale of the property. If repayment of the mortgage is triggered due to the death of the borrower, the estate has 360 days to repay the loan. The sale of the property is not required if the estate or heirs have or can borrow sufficient funds to repay the loan. Any sales proceeds in excess of the amount owed the lender SEPTEMBER 2009 / THE CPA JOURNAL
belong to the individual or his estate. Senior borrowers are charged an insurance premium up-front, equal to 2% of the maximum claim amount that may be borrowed, as well as a .5% annual premium. The insurance provides that borrowers will receive all payments due to them as long as they live in their home. It also ensures that the lender will receive full repayment of the loan balance, even if it is greater than the value of the property.
Disadvantages of Reverse Mortgages The cash that individuals generally receive from a reverse mortgage seldom exceeds 50% of their home equity, unless they are 80 years of age or older. Therefore, potential borrowers must consider if there are more advantageous solutions to their cash flow problem that in the long run would better benefit them and their heirs. An additional disadvantage to these complex and often confusing mortgage agreements is the front-end and back-end costs (which can easily surpass 10% of a home’s equity) and the interest rate charged on reverse mortgages. Interest costs are added to the principal loan balance each month, as well as any of the following the borrower wishes to finance instead of paying up-front: ■ Application fees or origination fees (which as part of the Housing and Economic Recovery Act of 2008 now are 2% for up to $200,000 of the home’s value, plus 1% for the amount that exceeds $200,000, up to a maximum of $6,000. Origination fees, however, vary among different lenders, so it is best to compare prices), ■ Closing costs, which usually vary from $2,000 to $3,000, but can be higher in some areas of the country (which can include title search and insurance, appraisals, surveys, credit histories, taxes, recording fees, document preparation, endorsement fees, escrow/settlement fees, termite inspection, flood zone certification, attorney’s fees and title exam, county intangible tax, and state residential funding fee—all of which may be necessary to complete the transaction), ■ Servicing fees (for an annually adjusted interest rate, the servicing fee can be no more than $30 per month and the fee for the monthly adjusting HECM servicing fee can be no more than $35 per month), ■ Points, and SEPTEMBER 2009 / THE CPA JOURNAL
■ Initial and monthly mortgage insurance premiums—which consist of two types of charges: ■ A one-time premium at closing of 2% of the maximum claim amount, or ■ Annual premiums of 0.5% per year on the mortgage loan balance. Often included in the terms of proprietary loan agreements are shared equity and shared appreciation fees. These latter two fees can raise the cost of an already expensive loan. The shared appreciation clause gives the lender as much as 50% of the future appreciation in the home, and it has no relation to the amount of money borrowed. The third disadvantage is that the reverse mortgage is a rising-debt mortgage, the opposite of a typical decreasing debt mortgage. With a reverse mortgage, an individual’s debt increases and her home equity decreases. Example. Consider the following reverse mortgage from Fannie Mae which does not include the financing of closing costs, the financing of the initial insurance premium (2% of the maximum claim amount), the deduction of an initial set-aside amount sufficient to pay a $30 or $35 monthly servicing fee for the life of the loan, or any existing mortgage that must be paid off to qualify for a reverse mortgage. When measuring how a reverse mortgage loan balance grows over time, the following assumptions are made: ■ Monthly loan advance = $300 and ■ Compound interest rate = 1% per month. Exhibit 2 shows that after the first loan advance, the borrower’s loan balance is $300. After one month, the borrower receives another loan payout of $300 and is charged $3.00 in interest on the first advance, bringing the loan balance to $603. In the second month, the borrower receives another $300 payout and is charged $6.03 in interest on the loan balance, bringing the new loan balance to $909.03. The third month brings another $300 payout and a $9.09 interest charge on the loan balance, for a total current loan balance of $1,218.12. Over one year, the borrower’s total loan balance would be $3,843—that is, $3,600 in 12 monthly loan advances of $300 each, plus $243 in interest charges. Similarly, at the end of 10 years, the borrower’s total loan balance would be
EXHIBIT 1 Average Remaining Years of Life for Males and Females Aged 65–90 Age
Male
Female
65
14.2
18.4
66
13.6
17.7
67
13.0
17.0
68
12.5
16.3
69
11.9
15.5
70
11.4
14.8
71
10.8
14.2
72
10.3
13.5
73
9.8
12.8
74
9.4
12.2
75
8.9
11.6
76
8.5
11.0
77
8.0
10.4
78
7.6
9.8
79
7.2
9.2
80
6.8
8.7
81
6.4
8.2
82
6.1
7.7
83
5.8
7.2
84
5.4
6.8
85
5.1
6.4
86
4.9
6.0
87
4.6
5.6
88
4.3
5.3
89
4.1
5.0
90
3.9
4.7
17
$69,702—that is, $36,000 in monthly loan advances and $33,702 in interest charges. It’s no wonder that more than half of the borrowers terminate their FHA HECM mortgages within seven years, once they realize that their home equity is gradually disappearing. Potential borrowers need to understand that, with an increasing debt loan, unless the home’s value is appreciating more than the interest rate, a loan that was initially less than half the value of the home may, over time, be equal to the value of the home. The fourth disadvantage is that these loans are limited to a choice of two variable applied interest rates: an annually adjusted rate or a monthly adjusted rate, tied to the one-year U.S. Treasury Security rate. The interest rate is usually one to three percentage points higher than the Treasury rate. The FHA HECM loans limit the increase in annually adjusted rates to no more than 5% over the life of the loan, and it cannot increase by more than 2% in any year. The monthly adjusted rate cannot increase by more than 10% over the life of the loan, but there is no limit to the amount the rate can change with each monthly adjustment, as long as it does not exceed the 10% lifetime cap. Interest rates are also two to three points higher than conventional mortgages and are generally more secure because of the excess equity the homeowner has in the home. Not only are interest charges being added to the principal each month, but, because most taxpayers file on a cash basis, the interest charges are not tax deductible until paid (generally when the loan is paid off). The fifth disadvantage is that, not only do reverse mortgages reduce the borrower’s assets and whatever estate the children
may inherit, but the payments from a reverse mortgage may adversely affect Supplemental Security Income (SSI) or Medicaid benefits, both of which are based on financial need. A borrower must still maintain the home, purchase insurance, pay real estate taxes, and pay the other expenses associated with home ownership. In addition, each year, the lender will ask the borrowers to certify by mail that the property remains their principal residence, because if it is not, the mortgage becomes
There are probably better solutions than reverse mortgages for recurring needs, and reverse mortgages are poor solutions for short-term needs.
due. This may frustrate any future desire or need to relocate. The borrowers also must advise the lender if they are going to be absent from home for more than two months. Financial advisors should take a proactive approach to advising their clients in order to help them avoid unscrupulous salespeople selling reverse mortgages. Potential borrowers should be advised
that the HUD-required counseling is free and anyone charging for this service should be avoided. Any salespeople recommending a reverse mortgage to enable investment in a product they are selling should be suspect.
Alternatives to Reverse Mortgages Before an individual decides on a loan that eats away at the equity he has built over many years, he should stop and consider why he needs the money. Is it a one-time issue or an ongoing cash flow shortage? There are probably better solutions than reverse mortgages for recurring needs, and reverse mortgages are poor solutions for short-term needs. The following options might be preferable for singleoccurrence, short-term cash needs (e.g., roof replacement or remodeling for handicapped access) and recurring monthly needs. The first option individuals should consider is selling their home instead of making expensive renovations or repairs. This option may not be emotionally satisfying, but it may be the most financially sound one. Simply maintaining a large home and yard can become overwhelming as people age. There are many smaller homes in retirement communities specifically designed with features for the elderly. Selling and renting or leasing back the residence is another alternative. People often need some time to decide whether selling their residence and moving is in their best interest. This option may provide them with not only cash to meet immediate needs but also a cushion for future contingencies. Another option for individuals to consider is tapping into funds that they initially intended to leave undisturbed. Often these
EXHIBIT 2 Fannie Mae Example Previous Month’s Loan Balance
Interest on Previous Month’s Loan Balance
0
$0
$0
$300.00
$300.00
$0
1
300.00
3.00
300.00
603.00
303.00
2
603.00
6.03
300.00
909.03
306.03
3
909.03
9.09
300.00
1218.12
309.09
After Month
Current Month’s Loan Advance
Current Loan Balance
Monthly Increase in Loan Balance
Source: www.fanniemae.com/global/pdf/homebuyers/moneyfromhome.pdf
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SEPTEMBER 2009 / THE CPA JOURNAL
funds are not used, or have a significant balance, and withdrawing a portion of the funds will not jeopardize the client’s lifestyle. These funds may be in an IRA or 401(k) plan. They may be the cash value of a life insurance policy, an investment account, or locked up in a certificate of deposit. Instead of just borrowing from an insurance policy, one should consider other alternatives. There are secondary markets that will purchase life insurance policies and generally pay two to 10 times what the issuing company will pay, depending on age and health. The other alternative is a conventional loan from a bank or a relative, especially if it is just a short-term need and one can repay the loan over a reasonable time period. Most local banks will offer cash-out refinancing loans or a homeequity line of credit; however, these loans require monthly payments, so borrowers must consider if their cash flow is adequate. Many state and local governments have programs to help the elderly. Among these are one-time reverse mortgage loans that do not have to be paid as long as the client remains in the home. The local housing authority, office on aging, or community action department should be able to help. These loans may be less costly than commercial reverse mortgages. Many counties have property tax deferral programs for the elderly. If a senior’s cash flow problem is an ongoing issue, reducing current expenses may be the solution. There are companies that will buy a percentage of the future appreciation in the home; however, this alternative is not optimal. Financial advisors should recommend that their clients sell the remainder interest in the home to one or more of their heirs. Thus, an individual will have the right to use the home for life and, upon death, the home belongs to the person owning the remainder interest. Although borrowing money to purchase a variable annuity is a prohibited transaction under securities regulation, it has been suggested that seniors may use the proceeds from reverse mortgages to buy a variable or fixed annuity, and, depending upon their age, they may have enough cash flow from the annuity to make the monthly mortgage payment and cover additional living expenses. Even if there are ways around the rules for borrowing to purchase an annuity, the annuity alternative may not work for younger clients because the payout is insufficient to pay off the loan. For those considering this option, the SEPTEMBER 2009 / THE CPA JOURNAL
annuity should be guaranteed pay for as long as the loan repayment period (Walter Updegrave, “Reverse Mortgages: Beware the Come-Ons,” Money, May 21, 2008).
Circumstances Where a Reverse Mortgage Might Be Advantageous If seniors can realistically expect to stay in their home for a long time and have pressing financial needs (such as a major healthcare crisis) that cannot be met by other alternatives, reverse mortgages should be considered. Many people over 62 were in the workforce until they recently lost their jobs. As the economy has worsened, unemployment has increased, the value of retirement savings has plummeted, and more seniors are utilizing reverse mortgages to avoid foreclosure on adjustable rate mortgages that they increasingly cannot pay from their current fixed income. The AARP Public Policy Institute recently published a study which revealed that over 25% of the foreclosures and loan delinquencies involve people 50 and older. With the new lower loan limit of $417,000, based on an increase home value of $625,500, more seniors will qualify and the lower origination fees will reduce the fees incurred on a reverse mortgage. If the numbers work, a reverse mortgage can be a
way to pay off an adjustable rate loan and can increase monthly cash flow. Before recommending that a client consider an expensive reverse mortgage, financial advisors should consider how long the extra money is needed. Is it a recurring need or a one-time need? Can expenses be cut? Can debts be consolidated and required monthly payments be reduced? What other alternatives are available? (The Sidebar includes other sources of information.) People often panic when they encounter a cash flow problem. The advisor’s job is to bring calm solutions to the table for their consideration. Clients should make a wellinformed decision, whether that is to utilize a reverse mortgage or explore a ❑ different option. James Hopson, JD, CPA, is a professor in the school of accountancy at the University of Central Missouri, Warrensburg, Mo. Patricia D. Hopson, CPA, is a consultant to private industry and clients of means and an adjunct professor at the University of Central Missouri. Stephen Del Vecchio, DBA, CPA, CFE, is also a professor in the school of accountancy at the University of Central Missouri.
ADDITIONAL INFORMATION AARP, “Home Made Money: A Consumer Guide to Reverse Mortgages.” Call 1-800-424-3410 to order or visit www.aarp.org/money/revmort/revmort_ basics/a2003-03-21-newloan.html. Department of Housing and Urban Development (HUD), “Home Equity Conversion Mortgage, Demonstration Handbook 4235.1,” Publications Service Center, Room B-258, 451 7th Street, SW, Washington, DC 20410. Call 1-888-466-3487; www.hud.gov/buying/rvrsmort.cfm. Fannie Mae, 3900 Wisconsin Avenue, NW, Washington, DC 20016-2892. Call 1-800-732-6643; www.fanniemae.com. Federal Trade Commission, “Facts for Consumers: Reverse Mortgages,” Office of Consumer/Business Education, 600 Pennsylvania Avenue, NW, Washington, DC 20580; www.ftc.gov/bcp/edu/pubs/consumer/homes/rea13.shtm. National Center for Home Equity Conversion, 7373 147th Street, NW, Apple Valley, MN 55124. Call 612-953-4474; www.reverse.org. National Consumer Law Center, “Tips for Consumers on Reverse Mortgages”; www.nclc.org/initiatives/seniors_initiative/tips.shtml. Administration on Aging, “Aging Internet Information Notes”; see www.aoa.gov.
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