Section Review

Recent legislation has made the reverse mortgage less costly for most seniors, available for more types of property interest, and opened up a new area of financing for home purchases. This article will detail some history and be a primer of the reverse mortgage, including a summary of the recent legislative changes under the FHA Modernization Act.

The Home Equity Conversion Mortgage (“HECM”) reverse mortgage is nothing new. Reverse mortgages first came to the United States in 1961 but were not federally regulated, and were not favorable to borrowers. Congress created the HECM by passing the FHA Reverse Mortgage Legislation (Housing and Community Development Act of 1987-S. 825) on Dec. 22, 1987. For the first 10 years, the HECM was a pilot demonstration project limited to 2,500 mortgages.

Many nations have reverse mortgage programs designed to address the problems associated with a growing elderly population unable to be supported by a declining younger working population. There are reverse mortgage programs in the United Kingdom, Canada, France, India, Australia, Ireland, Spain, Japan, Germany and throughout Scandinavia.

In the United States, the public policy behind the HECM reverse mortgage is two-fold. The first is that it is less expensive for the government to insure a program that allows seniors to live in their homes for the rest of their lives than it is to pay for nursing homes.¹ The second is that the HECM program can be a source of income that baby boomers can utilize to make up for the projected shortfall in Social Security revenues beginning in 2019.² The expectation is that the HECM reverse mortgage will become a common retirement tool for baby boomers.

The HECM reverse mortgage is fairly straightforward. To qualify, a borrower must be at least age 62³ and own a home. There are no credit or income requirements. The home must be the borrowers’ principal residence. Reverse mortgages are available for single family homes, condominiums, manufactured homes, multi-family homes up to four units and, under the new regulations, cooperatives.⁴ Excluded are mobile homes, condominiums where the senior borrower’s unit consists of 25 or more percent of the condominium complex and structures that are on leased property of less than 99 years (which would exclude homes in a number of retirement communities).⁵

All HECM applicants must have counseling from a HUD approved not-for-profit agency. A lender is not allowed to steer seniors to specific counseling agencies or pay for the counseling. It is paid by the senior either at the time of the counseling or as part of the closing costs.

With a reverse mortgage, a lender makes available to a senior a percentage of their home’s value. The percentage made available is a function of the senior’s age and the HECM interest rate. The older the senior and the lower the interest rate, the greater the percentage that is made available. A 72-year-old senior will have more funds available to them than a 62-year-old senior in a house of the same value. The home value is determined by an independent HUD licensed appraiser using a comparable value method. For purposes of calculating the funds available, the house value is capped at the HUD 203(b) limit now set nationally at $417,000.

With a HECM, a senior does not make monthly payments. Instead, interest accrues on funds the senior actually uses and is paid back only from the sale proceeds of the home in three circumstances: (i) when all the borrowers have passed away; (ii) when all the borrowers have not lived in the home for 12 consecutive months (if a senior borrower returns home, then the time period for the 12 consecutive months is reset);⁶ and (iii) when the home is sold.

What is repaid from the sale of the home (or from other financing sources if the heirs wish to keep the home) are the funds the senior has actually used (which generally includes the closing costs) plus the interest that has accrued on that amount. The remaining equity goes to the borrowers or their heirs. If the amount owed is greater than the then house value, there is no deficiency. HECM reverse mortgages are non-recourse loans — there is no personal liability. In that situation, the lender will foreclose at 95 percent⁷ of the home value and forgive the deficiency.

The funds are available to a senior in three ways or a combination of those ways. The first is a lump sum where they take all the money at once to either pay off currently existing mortgages or “put it in their pocket.” Unless used to pay off a current mortgage, the lump sum is generally not the best idea since the interest will accrue on that whole amount. Interest on reverse mortgages accrues on not what is made available to the senior but on what they actually draw down.

The second is a monthly income either for as long as the senior continues to live in the home (the “tenure” plan) or for a term of years. The tenure plan makes sense for seniors who have certain budgetary requirements and know how much they need each month to make up any shortfall in their fixed income. With the tenure plan, a senior can draw down more than the home value. The term of years plan makes sense especially where the senior knows that they will be leaving their home at some set future date.

The third option is a line of credit. Here, a senior draws down what they need when they need it. Interest will not accrue on the line of credit funds since the senior has not put that money in their pocket. Instead, the unused line of credit funds grow at a rate one half of one percent greater than the accruing rate of interest on the funds that are drawn down. The growth will be income tax free.⁸ This growth occurs regardless of the home’s value. Even if the home depreciates below the available line of credit funds, those funds are still available to the senior homeowner. For example, after Hurricane Katrina, hundreds of seniors were able to use their line of credit funds for up to 12 consecutive months after their homes were destroyed. These seniors had the full amount of their line of credit for use to get back on their feet although their homes had no value. They were also not personally liable to pay back the funds used.

One interesting aspect of the HECM credit line is that full or partial prepayment is allowed at any time. Any prepayment made will not only pay down the reverse mortgage balance but will increase the line of credit on a dollar for dollar basis.⁹ As such, some seniors use the Line of Credit as an investment tool especially in that HECM funds are not a countable asset for Mass Health or Medicaid spend down requirements.¹⁰

HECMs are not “too good to be true” because they are not free. The closing costs are significant. Besides normal closing costs, a HECM has an origination fee paid to the lender. This is now calculated at 2 percent of the first $200,000 of the home value or lending limit, whichever is less, and 1 percent thereafter. There is a cap of $6,000 and a floor of $2,500. A second cost is a HUD mortgage insurance premium (MIP) set at 2 percent, again of the home value or lending limit whichever is lower (the “maximum claim amount”) plus an additional annual premium of 0.5 percent of the loan balance. Borrowers do not directly pay the insurance premiums. Instead, lenders make the payments to FHA on behalf of the borrowers and the cost of the insurance is added to the borrower’s loan balance. That said, the closing costs on a $400,000 home can be $16,500.

The HUD mortgage insurance fund serves two purposes: (i) it protects lenders from suffering losses if the final loan balance exceeds the proceeds from the sale of a home;¹² and (ii) it continues monthly payments to the homeowner if the lender fails. All HECM lenders offer almost exactly the same terms since the federal government has removed their risk and, in exchange, the lenders strictly follow the federal regulations. As such, there is not a “no closing cost” HECM. Unlike traditional mortgages, where a lender can hide closing costs in a higher interest rate, HUD requires full disclosure. Finally, this means safety for the senior homeowners since HUD will step in for any lender who fails. The recent failure of Indy-Mac (the nation’s second largest HECM lender through its Financial Freedom division) had no impact on its reverse mortgage lending. It was business as usual for Financial Freedom all throughout the FDIC receivership.

Although a senior borrower can pay the closing costs, the vast majority do not, meaning that interest accrues on that amount. Another closing cost is a servicing fee calculated commonly at $35 per month.¹³ Interest does not accrue on the servicing fee charge calculated from the date of closing to the senior’s 100th birthday. This sum is escrowed and reduces the net amount available to the borrower. If the senior permanently leaves their home before age 100, the balance is credited.

The interest rate on a HECM is typically a variable interest rate, although a fixed rate is available. The variable program is either monthly or annual. The vast majority of seniors opt for the monthly variable rate since it makes the most amount of funds available. The annual variable rate will mean greater equity remaining at the time of the loan termination. The interest rate is based on an index, typically the one year treasury rate, plus a margin set by the lender. The fixed interest rate program is rarely seen. First, the interest rate is higher.¹⁴ Next, unlike the variable programs, there is no line of credit available with the fixed interest rate since the borrower is required to take a full lump sum at the date of closing.¹⁵ Over the life of the loan, the interest paid will very likely be greater than with the variable rate programs.

The final major change to the HECM program is that a senior can now use a HECM to purchase a home. This could be a useful vehicle for seniors who are downsizing. Previously, a senior would sell the larger home and pay full cash for the new smaller home. Now they can use the HECM purchase mortgage to finance a substantial part of the new home price, pay less cash from the sale of the larger home and have no mortgage payments.¹⁶ Expect to see real estate brokers marketing “half price” homes.

HECM reverse mortgages, like all financial tools, are specific to the individual situation of a senior homeowner. They are one of many options that a senior should consider as part of their financial planning. The FHA Modernization Bill has increased the variety of options and property counsel, financial planners, divorce attorneys, estate planners and elder law attorneys should familiarize themselves with the program so that they can best represent the interest of their senior clients.

Endnotes

1. See Testimony of the National Council on Aging at http://energycommerce.house.gov/reparchives/108/Hearings/04272005hearing1487/Stucki.pdf.

2. See Congressional Budget Office Report on Updated Long Term Projections for Social Security at www.cbo.gov/ftpdocs/96xx/doc9649/SSTOC.2.1.htm.

3. When there is more than one homeowner, the calculated funds are based on the age of the youngest homeowner.

4. Title can be held in a revocable trust so long as all beneficiaries are eligible borrowers and the trust instrument is amended to include certain HUD required language. Title can also be as a life estate. Property in irrevocable trusts are not eligible for a HECM.

5. Most of the regulations governing the HECM program can be found in 24 CFR 206; the HUD HECM Handbook (Rev. 4235.1) at www.hud.gov/offices/adm/hudclips/handbooks/hsgh/4235.1/index.cfm and various HUD Mortgagee Letters promulgated from time to time.

6. At the time of the loan termination, the borrowers or heirs are given a six-month period to sell the home with two automatically granted three-month extensions for a total of one year. For example, coupled with the twelve consecutive month rule, a home would not need to be sold until two years after all the borrowers have left the home.

7. The remaining 5 percent is allocated for foreclosure costs and brokerage fees.

8. All funds received from a HECM reverse mortgage are income tax free since they are not income but an advance on a loan. As such, the funds received do not affect social security benefits although they may affect Medicaid or Supplemental Security Income (SSI) which uses a formula limiting applicants to no more than $2,000 ($3,000 for a couple) in countable assets one day out of the month. If a Medicaid applicant draws $4,000 from the reverse mortgage line of credit and spends it the same calendar month, Medicaid is not affected. However, if the applicant does not spend most of the money and the amount left in their bank account exceeds $2,000 at the end of the month, the applicant will become ineligible for Medicaid.

9. A strategy for financial planners is to use mandatory distributions from tax deferred accounts to make a prepayment on a HECM reverse mortgage. This has three effects. It offsets the income tax paid on the distribution by creating a mortgage interest deduction. It pays down the HECM mortgage balance and it increases the funds available to the HECM borrower in the line of credit only now those funds are not countable assets.

10. See MGL Ch 19A § 36 and 130 CMR 520.015.

11. The amount of the closing costs is the single greatest criticism of the HECM program but the expectation is that the costs will decrease as the secondary market for HECMs develops. Currently, HECM securitization and loan pools are in their infancy. Costs should come down as the investor base grows which will be assisted with a new HECM product indexed to the LIBOR.

12. The lenders of the HECM borrowers affected by Hurricane Katrina were made whole by HUD through the mortgage insurance fund.

13. For the HECM annual variable interest rate and the HECM fixed interest rate programs, the servicing fee is typically $30 per month.

14. As of the date of this article, the HECM monthly variable interest rate was 2.45 percent based on the 1 year CMT plus 2.0 percent. Since 1989, the 1 year treasury (CMT) has varied from 0.90 percent to 8.53 percent. All variable HECM interest rates have a lifetime cap. For the monthly program, it is 10 percent above the initial interest rate. For example, a reverse mortgage beginning at 2.45 percent will never exceed 12.45 percent. The annual variable rate is also tied to the one year treasury bill but has a higher margin. The interest rate increase for the annual rate is no greater than 2 percent per year with a lifetime cap of 5 percent. The fixed HECM interest rate as of the date of this article is 5.68 percent.

15. HECM reverse mortgages have a right of rescission where a borrower can cancel the mortgage, with no financial cost, for a period up to three business days after the date of the closing.

16. Today, a 62-year-old selling a home for $600,000 and purchasing a downsized $400,000 home would pay cash (assuming they did not get a regular mortgage with attendant monthly payments) and have remaining reserves of $200,000. With the HECM purchase, they would receive $238,472 in HECM loan proceeds meaning cash disbursement of $161,528 with no monthly payments and a remaining reserve of $438,472.

Robert T. Cannon is an attorney and the principal of Equitas LLC, a virtual law firm that concentrates solely in guiding seniors and lender clients through the reverse-mortgage process. Equitas currently closes reverse mortgages in 10 states and Cannon lectures nationally on the HECM reverse mortgage.