A reverse mortgage or home equity conversion mortgage (HECM) is a special type of home loan for older homeowners (62 years or older) that requires no monthly mortgage payments. Borrowers are still responsible for property taxes and homeowner’s insurance. Reverse mortgages allow elders to access the home equity they have built up in their homes now, and defer payment of the loan until they die, sell, or move out of the home. Because there are no required mortgage payments on a reverse mortgage, the interest is added to the loan balance each month. The rising loan balance can eventually grow to exceed the value of the home, particularly in times of declining home values or if the borrower continues to live in the home for many years. However, the borrower (or the borrower’s estate) is generally not required to repay any additional loan balance in excess of the value of the home.
Specific rules for reverse mortgage transactions vary depending on the laws of the jurisdiction. For example, in Canada, the loan balance cannot exceed the fair market value of the home by law.
One may compare a reverse mortgage with a conventional mortgage, where the homeowner makes a monthly payment to the lender, and after each payment, the homeowner’s equity increases by the amount of the principal included in the payment.
Regulators and academics have given mixed commentary on the reverse mortgage market. Some economists argue that reverse mortgages allow the elderly to smooth out their income and consumption patterns over time, and thus may provide welfare benefits. However, regulatory authorities, such as the Consumer Financial Protection Bureau, argue that reverse mortgages are “complex products and difficult for consumers to understand,” especially in light of “misleading advertising,” low-quality counseling, and “risk of fraud and other scams.” Moreover, the Bureau claims that many consumers do not use reverse mortgages for the positive, consumption-smoothing purposes advanced by economists. In Canada, the borrower must seek independent legal advice before being approved for a reverse mortgage.
The FHA-insured Home Equity Conversion Mortgage, or HECM, was signed into law on February 5, 1988 by President Ronald Reagan as part of the Housing and Community Development Act of 1987. The first HECM was given to Marjorie Mason of Fairway, Kansas, in 1989 by James B. Nutter and Company.
To qualify for the HECM reverse mortgage in the United States, borrowers generally must be at least 62 years of age and the home must be their primary residence (second homes and investment properties do not qualify).
On 25 April 2014, FHA revised the HECM age eligibility requirements to extend certain protections to spouses younger than age 62. Under the old guidelines, the reverse mortgage could only be written for the spouse who was 62 or older. If the older spouse passed away, the reverse mortgage balance became due and payable. If the surviving spouse didn’t have the ability to pay off or refinance the reverse mortgage balance, he or she was forced to either sell or give up ownership of the home. This often created a significant hardship for spouses of deceased HECM mortgagors, so FHA revised the eligibility requirements in Mortgagee Letter 2014-07. Under the new guidelines, spouses who are younger than age 62 at the time of origination retain the protections offered by the HECM program if the older spouses passes away. This means that the surviving spouse can remain living in the home without having to repay the reverse mortgage balance as long as they keep up with property taxes and homeowners insurance and maintain the home to a reasonable level.
For a reverse mortgage to be a viable financial option, existing mortgage balances usually must be low enough to be paid off with the reverse mortgage proceeds. However, borrowers do have the option of paying down their existing mortgage balance to qualify for a HECM reverse mortgage.
The HECM reverse mortgage follows the standard FHA eligibility requirements for property type, meaning most 1–4 family dwellings, FHA approved condominiums, and PUDs qualify. Manufactured homes also qualify as long as they meet FHA standards.
Before starting the loan process for an FHA/HUD-approved reverse mortgage, applicants must take an approved counseling course. The counseling is meant to protect borrowers, although the quality of counseling has been criticized by groups such as the Consumer Financial Protection Bureau.
In a 2010 survey of elderly Americans, 48% of respondents cited financial difficulties as the primary reason for obtaining a reverse mortgage and 81% stated a desire to remain in their current homes until death.
On March 2, 2015, FHA implemented new guidelines that require reverse mortgage applicants to undergo a financial assessment. Though HECM borrowers are not required to make monthly mortgage payments, FHA wants to make sure they have the financial ability and willingness to keep up with property taxes and homeowner’s insurance (and any other applicable property charges). Financial assessment involves evaluating two main areas:
- Residual income – Borrowers must have a certain amount of residual income left over after covering monthly expenses.
- Satisfactory credit – All housing and installment debt payments must have been made on time in the last 12 months and there are no more than two 30-day late mortgage or installment payments in the previous 24 months. There is no major derogatory credit on revolving accounts in the last 12 months.
If residual income or credit does not meet FHA guidelines, the lender can possibly make up for it by documenting extenuating circumstances that led to the financial hardship. If no extenuating circumstances can be documented, the borrower may not qualify at all or the lender may require a large amount of the principal limit (if available) to be carved out into a Life Expectancy Set Aside (LESA) for the payment of property charges (property taxes, homeowners insurance, etc.).
The HECM reverse mortgage offers fixed and adjustable interest rates. The fixed-rate program comes with the security of an interest rate that does not change for the life of the reverse mortgage, but the interest rate is usually higher at the start of the loan than a comparable adjustable-rate HECM. Adjustable-rate reverse mortgages typically have interest rates that can change on a monthly or yearly basis within certain limits.
Applicants for a HECM reverse mortgage will likely notice that there are two different interest rates disclosed on their loan documents: the initial interest rate, or IIR, and the expected interest rate, or EIR.
Initial Interest Rate (IIR)
The initial interest rate, or IIR, is the actual note rate at which interest accrues on the outstanding loan balance on an annual basis. For fixed-rate reverse mortgages, the IIR can never change. For adjustable-rate reverse mortgages, the IIR can change with program limits up to a lifetime interest rate cap.
Expected Interest Rate (EIR)
The expected interest rate, or EIR, is used mainly for calculation purposes to determine how much a reverse mortgage borrower qualifies for based on the value of the home (up to the maximum lending limit of $625,500) and age of the youngest borrower. The EIR is often different from the actual note rate, or IIR. The EIR does not determine the amount of interest that accrues on the loan balance (the IIR does that).
Amount of Proceeds Available
The total pool of money that a borrower can receive from a HECM reverse mortgage is called the principal limit (PL), which is calculated based on the maximum claim amount (MCA), the age of the youngest borrower, the expected interest rate (EIR), and a table to PL factors published by HUD. Similar to loan-to-value (LTV) in the forward mortgage world, the principal limit is essentially the percentage of the value of the home that can be lent under the FHA HECM guidelines. Most PLs are typically in the range of 50% to 60% of the MCA, but they can sometimes be higher or lower. The table below gives examples of principal limits for various ages and EIRs and a property value of $250,000.
|Borrower’s Age at Origination||Expected Interest Rate (EIR)||Principal Limit Factor (as of Aug. 4, 2014)||Initial Principal Limit Based on MCA of $250,000|
The principal limit tends to increase with age and decrease as the EIR rises. In other words, older borrowers tend to qualify for more money than younger borrowers, but the total amount of money available under the HECM program tends to decrease for all ages as interest rates rise.
Closing costs, existing mortgage balances, other liens, and any property taxes or homeowners insurance due are typically paid out of the initial principal limit. Any additional proceeds available can be distributed to the borrower in several ways, which will be detailed next.
Options for Distribution of Proceeds
- Lump sum in cash at settlement
- Monthly payment (loan advance) for a set number of years (term) or life (tenure)
- Line of credit (similar to a home equity line of credit)
- Some combination of the above
Note that the adjustable-rate HECM offers all of the above payment options, but the fixed-rate HECM only offers lump sum.
The line of credit option accrues growth, meaning that whatever is available and unused on the line of credit will automatically grow larger at a compounding rate. This means that borrowers who opt for a HECM line of credit can potentially gain access to more cash over time than what they initially qualified for at origination.
The line of credit growth rate is determined by adding 1.25% to the initial interest rate (IIR), which means the line of credit will grow faster if the interest rate on the loan increases.
On 3 September 2013 HUD implemented Mortgagee Letter 2013-27, which made significant changes to the amount of proceeds that can be distributed within the first year of the loan. Because many borrowers were taking full draw lump sums (often at the encouragement of lenders) at closing and burning through the money quickly, HUD sought to protect borrowers and the viability of the HECM program by limiting the amount of proceeds that can be accessed within the first 12 months of the loan.
If the total mandatory obligations (which includes existing mortgage balances, all closing costs, delinquent federal debts, and purchase transaction costs) to be paid by the reverse mortgage are less than 60% of the principal limit, then the borrower can draw additional proceeds up to 60% of the principal limit in the first 12 months. Any remaining available proceeds can be accessed after 12 months.
If the total mandatory obligations exceed 60% of the principal limit, then the borrower can draw an additional 10% of the principal limit if available.
HECM for Purchase
The Housing and Economic Recovery Act of 2008 provided HECM mortgagors with the opportunity to purchase a new principal residence with HECM loan proceeds — the so-called HECM for Purchase program, effective January 2009. The “HECM for Purchase” applies if “the borrower is able to pay the difference between the HECM and the sales price and closing costs for the property. The program was designed to allow the elderly to purchase a new principal residence and obtain a reverse mortgage within a single transaction by eliminating the need for a second closing. Texas was the last state to allow for reverse mortgages for purchase.
Reverse mortgages are frequently criticized over the issue of closing costs, which can sometimes be expensive. The following are the most typical closing costs paid at closing to obtain a reverse mortgage:
- Counseling fee: The first step to get a reverse mortgage is to go through a counseling session with a HUD-approved counselor. The average cost of the counseling session is usually around $125, but counselors often don’t charge at all.
- Origination fee: This is charged by the lender to arrange the reverse mortgage. Origination fees can vary widely from lender to lender and can range from nothing to several thousand dollars.
- Third party fees: These fees are for third-party services hired to complete the reverse mortgage, such as appraisal, title insurance, escrow, government recording, tax stamps (where applicable), credit reports, etc.
- Initial Mortgage Insurance Premium (IMIP): This is a one-time cost paid at closing to FHA to insure the reverse mortgage and protect both lenders and borrowers. The IMIP protects lenders by making them whole if the home sells at the time of loan repayment for less than what is owed on the reverse mortgage. This protects borrowers as well because it means they will never have to pay out of other assets to settle up the reverse mortgage if they owe more than the home is worth. How the IMIP is calculated was changed in late 2013 with Mortgage Letter 2013-27. The IMIP is now charged as either 0.50% or 2.50% of the max claim amount (which usually equals the appraised value of the home up to a maximum of $625,500), depending on how much of the principal limit is utilized within the first 12 months of the loan. If the utilization is under 60% of the principal limit, the lower rate applies. If it’s above that amount, then the higher rate applies.
The vast majority of closing costs typically can be rolled into the new loan amount (except in the case of HECM for purchase, where they’re included in the down payment), so they don’t need to be paid out of pocket by the borrower. The only exceptions to this rule may be the counseling fee, appraisal, and any repairs that may need to be done to the home to make it fully compliant with the FHA guidelines before completing the reverse mortgage.
Lenders disclose estimated closing costs using several standardized documents, including the Reverse Mortgage Comparison, Loan Amortization, Total Annual Loan Cost (TALC), Closing Cost Worksheet, and the Good Faith Estimate (GFE). These documents can be used to compare loan offers from different lenders.
There are two ongoing costs that may apply to a reverse mortgage: annual mortgage insurance and servicing fees. Like IMIP, annual mortgage insurance is charged by FHA to insure the loan and accrues annually at a rate of 1.25% of the loan balance. Annual mortgage insurance does not need to be paid out of pocket by the borrower; it can be allowed to accrue onto the loan balance over time.
Servicing fees are less common today than in the past, but some lenders may still charge them to cover the cost of servicing the reverse mortgage over time. Servicing fees, if charged, are usually around $30 per month and can be allowed to accrue onto the loan balance (they don’t need to be paid out of pocket).
Taxes and Insurance
Unlike traditional forward mortgages, there are no escrow accounts in the reverse mortgage world. Property taxes and homeowners insurance are paid by the homeowner on their own, which is a requirement of the HECM program (along with the payment of other property charges such as HOA dues).
Life Expectancy Set Aside (LESA)
If a reverse mortgage applicant fails to meet the satisfactory credit or residual income standards required under the new financial assessment guidelines implemented by FHA on March 2, 2015, the lender may require a Life Expectancy Set Aside, or LESA. A LESA carves out a portion of the reverse mortgage benefit amount for the payment of property taxes and insurance for the borrower’s expected remaining life span. FHA implemented the LESA to reduce defaults based on the nonpayment of property taxes and insurance.
Are HECM Proceeds Taxable?
The American Bar Association guide advises that generally,
- The Internal Revenue Service does not consider loan advances to be income.
- Annuity advances may be partially taxable.
- Interest charged is not deductible until it is actually paid, that is, at the end of the loan.
- The mortgage insurance premium is deductible on the 1040 long form.
The money received from a reverse mortgage is considered a loan advance. It therefore is not taxable and does not directly affect Social Security or Medicare benefits. However, an American Bar Association guide to reverse mortgages explains that if borrowers receive Medicaid, SSI, or other public benefits, loan advances will be counted as “liquid assets” if the money is kept in an account (savings, checking, etc.) past the end of the calendar month in which it is received; the borrower could then lose eligibility for such public programs if total liquid assets (cash, generally) is then greater than those programs allow.
When the Loan Comes Due
The HECM reverse mortgage is not due and payable until the last borrower (or non-borrowing spouse) dies, sells the house, or fails to live in the home for a period greater than 12 months. The loan may also become due and payable if the borrower fails to pay property taxes, homeowners insurance, lets the condition of the home significantly deteriorate, or transfers the title of the property to a non-borrower (excluding trusts that meet HUD’s requirements).
Once the mortgage comes due, borrowers or heirs of the estate have several options to settle up the loan balance:
- Pay off or refinance the existing balance to keep the home.
- Sell the home themselves to settle up the loan balance (and keep the remaining equity).
- Allow the lender to sell the home (and the remaining equity is distributed to the borrowers or heirs).
The HECM reverse mortgage is a non-recourse loan, which means that the only asset that can be claimed to repay the loan is the home itself. If there’s not enough value in the home to settle up the loan balance, the FHA mortgage insurance fund covers the difference.
Volume of loans
Home Equity Conversion Mortgages account for 90% of all reverse mortgages originated in the U.S. As of May 2010, there were 493,815 active HECM loans. As of 2006, the number of HECM mortgages that HUD is authorized to insure under the reverse mortgage law was capped at 275,000. However, through the annual appropriations acts, Congress has temporarily extended HUD’s authority to insure HECM’s notwithstanding the statutory limits.
Program growth in recent years has been very rapid. In fiscal year 2001, 7,781 HECM loans were originated. By the fiscal year ending in September 2008, the annual volume of HECM loans topped 112,000 representing a 1,300% increase in six years. For the fiscal year ending September 2011, loan volume had contracted in the wake of the financial crisis, but remained at over 73,000 loans that were originated and insured through the HECM program.
Since the HECM program has created analysts have expected loan volume to grow further as the U.S. population ages. In 2000, the Census Bureau estimated that 34 million of the country’s 270 million residents were sixty-five years of age or older, while projecting the two totals to rise to 62 and 337 million, respectively, in 2025. In addition, The Center For Retirement Research at Boston College estimates that more than half of retirees “may be unable to maintain their standard of living in retirement.”. The low adoption rates can be partially explained by dysfunctional aspects of the reverse mortgage market, including high markups, complexity of the product, consumer distrust of reverse mortgage lenders, and lack of pricing transparency.