Reverse Mortgage Primer
— The Government’s Redesigned Reverse Mortgage Program
Accessing home equity will become increasingly important in a world where retirement needs are expanding , people are living longer and face rapidly rising health care costs – and the retirement system is contracting . Social Security replacement rates are declining, and employer-funded pensions have shifted from defined benefit plans to 401(k)s in which balances are modest. Reverse mortgages offer a mechanism for tapping home equity for those who want to stay in their home.
Nearly all reverse mortgages today are government-insured Home Equity Conversion Mortgages (HECMs). The financial crisis put pressure on both the insurance program and on the borrowers. Declining home prices meant that lenders could not recoup the full amount of the loan when the houses were sold, requiring the government to make up the difference. And financially troubled borrowers withdrew much of their money at closing, leaving them with few resources to sustain homeownership, which led a number to default. In response, the government has redesigned the HECM program.
A Reverse Mortgage Primer
A reverse mortgage is a mortgage: a loan with the borrower’s home as collateral. But unlike a conventional mortgage, it is designed as a way for homeowners age 62 and over, with substantial home equity, to tap that equity as a source of funds to pay bills or health care expenses or to provide additional retirement income. Unlike conventional mortgages, borrowers are not required to make monthly payments. The loan must be repaid only when the borrower moves or dies. This is the key advantage for retirees who need more income: so long as they live in the house, a reverse mortgage does not add a claim on the income they already have.
The most widely used reverse mortgage is the HECM, which provides government-insured loans on assessed home values up to the Federal Housing Administration current limit of $625,500. Under this program, the government provides insurance (for a fee) to the borrower, against the risk that the lender can no longer make the contracted payments; and to the lender, against the risk that the loan balance will exceed the property value when sold.
Homeowners can take a HECM loan in the form of monthly payments, a lump sum, or a line of credit. A unique feature of a HECM line of credit is that it rises over time by the interest rate on the line. This feature is especially valuable to retirees who want to use their home equity as a reserve, and until recently had been the most popular HECM option.
The amount available to a homeowner depends on three factors:
Home value: the more valuable the home (up to the current cap of $625,500), the larger the available amount.
Interest rate: the lower the interest rate, the more slowly the outstanding balance will increase, so the larger the available amount as a proportion of the value of the house.
Age of borrower: the older the borrower, the less time for interest to accrue, so the larger the available amount.
In 2008, a regulatory ruling allowed lenders to offer fixed-rate mortgages on lump-sum loans. Fixed-rate HECM mortgages quickly became the norm. Such loans, with borrowers typically taking out the maximum amount available, accounted for about 70 percent of HECM originations during 2010-2012.
Taking the maximum loan amount at closing significantly increased the risk to both the borrower and the government. So did the fact that recent borrowers were younger, giving interest accruals more time to mount and requiring lenders to wait longer to be repaid. The finances of these younger borrowers were also weaker. The major reason recent borrowers gave for taking out a HECM loan was to pay off an existing mortgage. In time, the Great Recession sharply cut the incomes of a large number of eligible homeowners, especially homeowners in their early 60s who lost jobs or had their hours or wages reduced.
As a result, nearly 10 percent of HECM borrowers in 2012 were in default, having failed to pay property taxes or homeowners’ insurance premiums. The sharp fall in house prices during the Great Recession had also reduced the value of the collateral backing HECM loans. Despite government insurance to cover their losses, lenders needed to engage in collections and foreclosures, making the business much less attractive. The three largest HECM lenders – Bank of America, MetLife, and Wells Fargo – all withdrew from the market.
The HECM Redesign
To make the HECM insurance program financially viable, and to insure that HECM reverse mortgages provide retirees with a reliable source of retirement income, the government recently announced three key reforms to the HECM program.
The program now has a single maximum loan amount, based on the borrower’s age and current interest rates. The new maximum is about 10-15 percent less than in the HECM Standard. Borrowers are now charged 0.5 percent of that amount as the mortgage insurance premium at closing – much less previously for the Standard. As a result, the new program reduces the premiums the government collects and aims to make the program viable by reducing the government’s risk.
The new program limits homeowners from borrowing more than 60 percent of the maximum loan amount at closing, or in the first year after closing. Borrowers can take out more only to cover “mandatory obligations,” such as paying off an existing mortgage or making repairs required by the lender.12 Such borrowers pay a much higher up-front mortgage insurance premium – 2.5 percent of the house value backing the loan.
Beginning in January 2014, lenders will be required to assess a prospective borrower’s ability to pay property taxes and homeowner’s insurance premiums. The assessment is based on credit reports and an estimate of the homeowner’s “residual income” after paying basic expenses.
A homeowner’s finances are considered sufficient for a HECM loan if their “residual income,” depending on where they live, equals or exceeds $886 to $998 a month for a couple or $540 to $589 for an individual. If their residual income is below these benchmarks or their credit history is spotty, homeowners can still get a HECM loan if the proceeds will be large enough to cover the tax and insurance charges for the expected life of the loan and the homeowner authorizes the lender to reserve the amount needed and to pay these charges directly.
*Excerpted from THE GOVERNMENT’S REDESIGNED REVERSE MORTGAGE PROGRAM, Center for Retirement Research At Boston College, January 2014, Number 14-1, By Alicia H. Munnell and Steven A. Sass. For the complete article, see http://crr.bc.edu/wp-content/uploads/2014/01/IB_14-1.pdf