Many seniors struggle to make ends meet each month. At the same time, they often own thousands of dollars of real estate in the form of equity in their home. But unless they take action, that equity remains untouchable, unable to help them out with basic living expense. What’s worse is that mortgage payments further reduce their available cash each month to pay crucial expenses.
A Henry J. Kaiser Family Foundation report states that more than three of four seniors over the age of 65 have equity in their homes ranging from $67,700 to $325,200. One in 20 have home equity greater than $398,500, and 1% have more than $799,850.
And yet almost half of elderly Americans depend upon Social Security for at least one-half or more of their income, while one of eight depend solely on Social Security. But many of these seniors have home equity that could be converted into cash income.
If you or your parents are “house-rich” but cash-poor, it is time to consider whether a reverse mortgage on the family home is a better alternative to traditional avenues of converting home equity into a cash asset.
Traditional Methods to Convert Home Equity Into Cash
For seniors who anticipate and desire to live in their current residence for the foreseeable future, there are a few traditional ways (not including the reverse mortgage) to convert home equity into cash:
- Home Equity Loans. A home equity loan is essentially a loan extended to the homeowner secured by the lender’s receipt of a second mortgage lien on the real estate. The underlying loan may be as high as a 100% of the owner’s equity, depending upon the lender’s criteria, the credit rating of the borrower, and the negotiated repayment terms. For example, a homeowner with equity can usually borrow a lump sum equal to an amount between 80% and 100% of the equity.
- Home Equity Line of Credit. A home equity line of credit (HELOC) is a line of revolving credit in an amount up to the equity value, usually with an adjustable interest rate, so payment amounts vary from month to month. Like other personal loans, the terms of the loan and the amount of credit that may be available is subject to negotiation between borrower and lender.
- Cash Out Mortgage Refinancing. As interest rates move lower and/or their equity grows, many homeowners refinance so they can reduce the interest rate on the underlying loan and subsequently reduce their monthly payments or convert a portion of their equity into cash. For example, say a homeowner bought a new home in 2000 for $312,000. The 30-year, 6% fixed rate loan requires a monthly payment of $1,824.40. Today, the home has an appraised value of $350,000 and interest rates have fallen to 3.5%. The owner subsequently refinances the home at a 3.5% rate for 30 years with a monthly payment of $1,582.85. As a consequence of the refinancing, the homeowner pays off the initial mortgage, reduced his payment by over $240, and is able to pull out $30,000 of cash from built-up equity.
Though these methods are a means to access locked equity, they all share a host of disadvantages:
- Continued Exposure to Real Estate Declines. Since the lender has “full-recourse” to the property owner if the mortgage loan is not repaid, the homeowner is liable if the proceeds of the sale of the property are less than the outstanding mortgage. Real estate with a value less than the mortgage is considered to be “underwater,” a condition in which many homeowners found themselves following the mortgage securities crisis of 2008-2009.
- Payments Required for Term of New Mortgage. The homeowner refinancing his home in our example had made almost 14 years of the 30 years of payments. The refinancing – with a new loan – restarts the clock for another 30-year term, essentially adding 14 years of payments to the old due date. Retired seniors may lack sufficient income to comfortably make payments after retiring.
- Delinquent Mortgage Payments Trigger Foreclosure by Lender. The legal obligation to make payments to the lender exists for the loan term. Failure to make payment can result in foreclosure and sale of the property. If the mortgage is underwater, the seniors not only lose their home, but must make up the difference between sale proceeds and the outstanding mortgage loan.
What Is a Reverse Mortgage Loan?
A reverse home mortgage loan – sometimes referred to as a home equity conversion mortgage (HECM) – is FHA approved for seniors only, and is an increasingly popular method for older homeowners (age 62 and older) to convert excess home equity into a lump sum of cash, a line of credit, or an annuity-like series of regular monthly payments.
How It Works
The lender that makes the reverse mortgage has a first mortgage lien on the property, but does not receive payments on the loan as in a traditional mortgage, nor is the homeowner liable for any deficiency in value when the lender receives the real estate at the death or move of the homeowner. The beauty in this type of loan is that the borrower receives money from the lender, the amount of which is based on the amount of equity in the home along with other factors, such as age and interest rate. However, since the home is used as collateral on the loan, the lender receives the property upon the death or move of the homeowner. (That said, the homeowner or heirs can pay off the loan at any time and thereby keep the house.)
For example, a reverse mortgage lender agrees to make a first mortgage lien of $150,000 on the homeowner’s house that has a current appraised value of $300,000. However, the homeowner has a previous mortgage loan in place of $100,000. Using the proceeds of the new loan ($150,000), the homeowner pays off the existing mortgage of $100,000, leaving excess proceeds of $50,000. (If the home did not have an existing mortgage, the homeowner’s proceeds would equal the entire $150,000). The homeowner can elect to receive payment in one of the following ways:
- Take the $50,000 in cash – what is called a “lump sum payment” – immediately at closing and spend or save it as desired. There are no tax consequences.
- Take the $50,000 in a series of monthly payments from the reverse mortgage lender. The payments can be based upon a fixed number of payments or an actuarial calculation for the life expectancy of the homeowner.
- Take the $50,000 in the form of a line of credit that can be drawn upon at any time by the homeowner. If the homeowner delays drawing from the line, the mortgage company will reduce the interest charged on the underlying reverse mortgage.
- Take the $50,000 in a combination of payments and a line of credit.
The homeowner is never required to make principal or interest payments on a reverse mortgage loan. These characteristics – the payment of money from a lender to the homeowner that is not taxable and does not affect Social Security or Medicare benefits – can especially benefit seniors strapped for cash.
There are several clear-cut eligibility requirements for borrowers to obtain a reverse mortgage.
- Borrowers must be age 62 or older.
- The purchased home must be the primary residence of the borrowers.
- The property must be single family or an FHA-approved condominium.
- Borrowers have to complete a HUD approved counseling session to ensure they understand the financial costs and legal requirements of the HECM.
- Borrowers must have the financial capability to pay mandatory expenses such as property taxes, homeowners insurance, and normal maintenance.
The Rate and Costs
The interest rate on mortgage loans, whether conventional or reverse, can be at a fixed or variable rate and is based upon the existing market interest rates and each mortgage company’s business decisions to differentiate itself from competitors. As a consequence, rates usually vary somewhat from lender to lender, just as rates vary for conventional mortgages.
In addition to traditional closing fees, an upfront mortgage insurance premium (MIP) is charged. The fee is equal to 0.5% if the loan-to-value ratio (LTV) is 60% or less, or 2.5% if the LTV is greater than 60%. An additional 1.5% MIP is charged each year. This provides lender protection in case the value of the home declines during the term of the reverse mortgage. It’s worth noting that conventional real estate mortgages do not usually require mortgage insurance if the down payment of the home is 20% or more.
Just as in traditional mortgages, lenders require that homeowners purchase and maintain property insurance, pay property taxes when due, and maintain the property in reasonable condition. Since reverse mortgages differ from traditional mortgages in that there is never a requirement to make payments to the mortgage lender, the loan matures (or can only be called by the lender) under specific conditions referred to as “maturity events,” such as the following:
- All borrowers have passed away.
- All borrowers have sold or converted title of the property to a third party.
- The property is no longer the principal residence of any borrower due to death or a physical or mental condition lasting longer than 12 months.
- Borrowers refuse to pay property taxes or maintain property insurance and have been given the opportunity to correct the deficiencies.
- Borrowers refuse or are unable to maintain property in good repair after a process of formal notice and adjudication.
In any such cases, the homeowner (if he or she is alive) or the estate has the option to keep the home by paying off the reverse mortgage loan. If the house is valued less than the mortgage loan at the time the loan is due, the homeowner or executor of the estate takes no action except to facilitate the foreclosure of the home by the lender. The lender then sells the property for as much as possible, applying the proceeds to the outstanding loan.
It’s important to note that if there is cash remaining after the loan repayment, the excess is returned to the estate. If the loan is greater than the sales proceeds, the loss is borne exclusively by the reverse mortgage company.
How Reverse Mortgages Differ From Traditional Mortgage Loans
There are several unusual characteristics of reverse mortgages that differ from traditional mortgages.
- The Lender’s Sole Security for a Reverse Mortgage Is the Home Property. Since the homeowner is never required to make mortgage payments, the source of repayment to the mortgage lender is the sale of the property upon the owner’s death or move from the property. By contract, the owner is allowed to remain in the property as long as he or she is living and the home is his or her principal residence.
- Homeowner’s Credit Rating or History Is Immaterial. Since the owner is not required to make payments, his or her past or present financial condition is not a factor in the underwriting nor the establishment of the credit rate extended on the mortgage.
- Loan-to-Value (LTV) Ratios Are Less Than Found in Traditional Mortgages. Traditional lenders are secured by both the market value of the property and the financial liability of the borrowers. Consequently, some lenders will loan up to 100% of the property’s market value. Reverse mortgage LTV ratios typically range between 50% and 65%.
- The Older the Youngest Borrower, the Greater the Loan-to-Value Ratio for Reverse Mortgages. The actuarial life expectancy of the youngest borrower is the basis for calculating the probable term of the loan. However, the loan does not mature until the last living owner dies or moves away from the home. If the owner dies sooner than expected, the loan principal becomes due at that point; if the owner lives longer than the actuarial tables project, the loan is extended until the later death. For example, an 80-year-old woman has 9.61 years of remaining life expectancy while a 70 year-old female would be 16.33 years. In our example, the maximum loan amount for the 80 year-old would be $187,712. The older borrower on the same $300,000 property would receive more than $50,000 than the loan for the younger 70-year-old. In other words, the LTV ratio is higher for super seniors.
Downsizing and the Reverse Mortgage
Having raised their families by the time they reach retirement age, many seniors seek a smaller housing footprint with lower maintenance and less costs. Prior to the development of the HECM for Purchase Loan – also an FHA-insured loan – seniors who were downsizing and wanted to use a reverse mortgage had to endure two expensive closings: the first on a traditional mortgage to purchase the smaller home, followed by a second refinancing (and closing) using the reverse mortgage proceeds to pay off the traditional mortgage.
Realizing the HECM is an ideal vehicle to finance a new house, maximize cash proceeds to the seniors’ benefit, and eliminate house payments until death or a later move, the FHA approved the HECM for Purchase loan, thus eliminating the hassle and cost of the traditional mortgage closing. In addition to the standard eligibility requirements, it features the following mandates:
- Any difference between the purchase price of the new home and the HECM loan proceeds must be paid in cash by the borrower at closing. For example, if the home purchase price is $300,000 and the net loan amount after settlement costs is $140,000, the borrowers must have $160,000 in cash to close.
- Borrowers have to complete a HUD-approved counseling session to ensure they understand the financial costs and legal requirements of the HECM.
While a conventional mortgage on the new property might require less cash on the loan closing than the HECM, it also requires making monthly payments to the mortgage company. For example, costs to close on the $300,000 home purchase with a 80% loan-to-value would be approximately $70,000 ($60,000 down payment + $10,000 closing costs). Funding with an HECM mortgage would cost an additional $90,000 in proceeds ($160,000 – $70,000), but eliminate any future mortgage payments (estimated at $1,200 per month at current interest rates) and losses if the future market value of the house declines. Potential borrowers need to “run the numbers” to determine the best approach for their situation.
Determining Whether It’s Right for You
Seniors contemplating a reverse mortgage should recognize that it has advantages and disadvantages, depending upon their personal situation, financial condition, and estate desires.
- No mortgage loan payments are ever required while an owner is alive and lives on the property.
- Reverse mortgage loans do not have a fixed term, but come due only with the occurrence of specific defined events, such as the death of the borrowers.
- Neither the reverse mortgage borrower nor his or her estate is at financial risk if the home value falls below or is less than the mortgage loan balance at any time.
- The reverse mortgage borrower or his or her estate has an option at any time to repay the reverse mortgage loan and retain house ownership, as with other mortgage loans.
- The credit rating of the borrower is not considered in the criteria for making a reverse mortgage loan. A personal bankruptcy of a borrower will not affect the reverse mortgage status if other requirements are met.
- Excess equity can be taken in the form of a lump sum, monthly for a set term or amount, as a line of credit, or a combination of all three.
- To qualify for a reverse mortgage, the property must be the primary residence of the borrowers.
- A reverse mortgage is limited to lower loan-to-market value ratios (50% to 65%) than traditional mortgages, which can be as high as 100% of market value.
- The borrower and spouse must be age 62 or older. Reverse mortgages are not available to younger borrowers.
- Interest on the reverse mortgage is not deductible for income tax purposes until the loan is paid off.
- An upfront mortgage premium is charged – between 0.5% and 2.5%, depending on the loan-to-value ratio - as well as an annual mortgage premium of 1.5%.
- Borrowers require prior financial counseling before approval.
- Unless the heirs of the reverse mortgage elect to pay off the reverse mortgage, title of the home reverts to the lender and will be sold.
Like a stock that does not pay a dividend or a zero-coupon bond, equity in a home provides no cash to its owner; any increase in equity value is dormant until the asset is sold or the house is refinanced with a greater loan amount.What’s worse is that seniors still making mortgage payments are adding to the amount tied up as equity in their home. In many cases, those funds could better serve them in the form of available cash.
If you or your parents are age 62 and older, the HECM can be a valuable tool in helping you achieve financial security and peace of mind. Remember that the reverse mortgage is not for everyone. Be sure you understand the obligations and rights associated with a reverse mortgage before entering into an agreement.
Have you or any family members taken out a reverse mortgage?