Reverse Mortgage Case Study and Pros and Cons

By Keith Cummins

Reverse Mortgage (RM) participation is growing at a remarkable rate. Last year’s total of over 37,000 was more than half of all the RM s originated in the United States since 1991 (In 1991 HUD published new regulations making RM insurance available to all FHA lenders). Over the past few years, the number of homes that have a RM has doubled each year and this trend is expected to continue through the year 2010. Since senior homeowners are becoming increasingly interested in RM s, let’s examine how the product works and then discuss its pros and cons.

Of course, everyone’s situation is unique. Just like any other product or service, after identifying individual problems and goals, then a solution can be made to satisfy each different situation. Here is just one scenario of problems and solutions.

In this example we have a homeowner, of primary residence, aged 69. We know she is eligible for the loan because she owns a home, lives there, and is of age. Her problem is she has insufficient income and would like long-term care insurance, but can not afford it. Her goal is to remain independent and live comfortably and safely in her own home. Her home is appraised at $300,000 and she has a mortgage of $49,500. The monthly principal and interest payment is $548. Given her age, home value, and interest rate structure of about 4 3/4%, the funds available from the reverse mortgage are about $152,000; all tax-free. Several products are available. This example uses the FHA/HUD Monthly Adjustable. It is the most common because it is federally insured and offers the highest amount of funds available to the borrower. It comprises over 90% of the market. Although the product is federally insured, there are no restrictions on how the money is used.

Because a RM is a non-recourse loan, any mortgages, lines of credit, or other liens against the home are required to be entirely repaid . Most often the funds from the RM itself are used. From the $152,000 available to our example homeowner, she repays her traditional mortgage of $49,500. This leaves $102,500.

$65,000 is received as a lump sum and used to purchase an annuity. She chooses one where the monthly payout is enough to pay the monthly premium needed to purchase long-term care insurance. Although the RM gives her the option to receive a monthly income that she could use to put toward the long-term care insurance, she uses the annuity instead because it gives about a 10% higher monthly payout than the monthly income from the RM. This method enables her to utilize about $7,500 of the RM elsewhere. Also, if the RM is repaid because she moves or sells her home, then the annuity will still be hers and available to fund the long-term care. The monthly income from a RM would no longer be available because the loan would be due.

$17,500 is received as a lump sum and used to re-design her home. Upgrades to the interior and modifications to the exterior are made to make her home more comfortable and accommodating. A few thousand dollars are left over from her home improvement budget and she goes on the vacation she always wanted.

$20,000 remains as a line of credit that grows. A line of credit from a RM is unique because it grows at a rate pegged to the loan balance growth rate. For example, after 10 years growing at 4 3/4 % her line of credit would give her access to over $32,000 (for simplicity, we are assuming the rate stays constant at 4 3/4%; of course, the actual rate adjusts monthly and the actual credit line would be adjusted accordingly). Compared to a traditional line of credit that is capped and loses purchasing power, her line of credit can adjust for inflation.

Our example homeowner has resolved her problem and achieved her goals with a RM. She has increased her cash flow by eliminating any monthly mortgage payment. She worries less about losing her independence and has a greater sense of security provided by the long term care insurance and growing line of credit. She has made home improvements and travelled. Overall, she has significantly increased her quality of life.

As for the pros and cons of reverse mortgages, the positives are obvious from our example. A RM is a loan that gives senior homeowners an alternative source of funds to be used however they choose and not have to be repaid for as long as they live in their home. Use of funds fall into three categories; necessity, leisure, and planning. In addition to how the funds are used, other positives are; increasing monthly cash flow, remaining in one’s own home, and possible tax reduction.

Negatives often cited are costs, maintenance, and misconceptions. The cost of a RM appears expensive when compared to a traditional loan because of the mandated mortgage insurance premium (MIP). The MIP is always 2% of the appraised home value or maximum claim limit; whichever is less. Returning to the above scenario for example, although the appraised home value is $300,000 the maximum claim limit for Baltimore County is $261,609. Therefore, the MIP is $5,232; from $261,609 X .02. This represents about 36% of the total closing costs in this example (about $14,400). 36% is a huge chunk of the total closing costs, but without it the federally insured product would not exist. Alternatively, if the home were sold at the usual commission rate of 6%, then the cost of selling the home would be at least $18,000; from $300,000 X .06.

Maintenance can also be a negative aspect of doing a RM because you are required to maintain your home as a presentable asset. For example, a leaky roof or peeling paint will have to be repaired. Funds from the RM itself are usually used for this. Repairs and inspections can postpone settlement. Also, borrowers are expected to maintain the home for the life of the loan. The borrower, of course, is responsible for maintaining their property taxes and homeowners insurance as well.

Other apparent negatives are misconceptions. Here are just a few.

The most popular one is, “I give my home to the bank.” This is not true. Just like a traditional mortgage, you maintain full control and ownership of your home. It is your name on the title, not the bank’s. As the current product became federally insured in the late 1980's, the less attractive product was eliminated. It had an equity-sharing component that probably contributed a lot to this misconception.

“I could owe more than my home is worth.” This is not true. RM s are non-recourse loans. This means there is a one-for-one relationship between the asset and the loan. In this case, the home is the only asset used to secure the loan. Therefore, repayment can never exceed the value of the home. If the value of the home were to be less than the loan balance due, then the borrower is released from any further obligation. The lender will have to make up any shortfall from the federal insurance.

“My heirs will be against it”. For the most part heirs are in favor of reverse mortgages. Often, it has been the children who introduced the idea to the parents and encouraged them to spend the money while they can on themselves. If there is an inheritance issue, then a RM offers other ways to transfer the wealth.

Another negative for those who may want to pursue a RM is that the National Housing Act has mandated a limit of only 150,000 federally insured RM s. At the current, rapid growth rate of participating homes, that limit is approaching quickly.

Rm s provide senior homeowners an additional source of funds to help satisfy their retirement concerns. This is done by converting their home equity into tax free funds and entirely eliminating monthly mortgage payments. that understand the product’s mechanics and its pros and cons will be better equipped to decide if an RM is right for them.