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.
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 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 income—and 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.
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WHAT ARE REVERSE MORTGAGES
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.
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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.
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REVERSE MORTGAGE LIMITS
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
borrower’s 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.
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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
One 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 adult’s 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 mortgage—or any
investment product—from 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.
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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.
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 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. Don’t
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.
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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 home’s title, changing
the home’s 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.
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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 CPA’s advice here may
be critical. After all, what’s involved is
the client’s most valuable asset, the home. 
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