House_bills

All My Thoughts On Reverse Mortgages

I’m not the right age for reverse mortgages[1]but a reader asked me for my help. Some deep-down part of me will always be a mortgage guy, so I decided to learn more about these things.[2]

The reader, named Jesse, aged 73, called to relay his experience trying to get a reverse mortgage on his house, and to ask for my advice.

He’d seen advertisements by Tom Selleckfor a company called American Advisors Groupand it seemed to fit his financial circumstances.[3]

For Jesse, his idea was to use the money he could pull out of his house to help pay for taxes and insurance in the coming years.

Although I had never paid much attention to reverse mortgages, I previously had a vaguely negative feeling about them. I’ll describe those and sure, there are reasons to be cautious.

In the course of following up on Jesse’s inquiry, I also earned a bunch of unique and kind of awesome features of reverse mortgages which I had never seen in any other loan product. My overall thought is that under the right circumstances, these could be very useful mortgages.

No Payments, Ever

The first weird thing is that a borrower can decide to never make any principal and interest payments on the loan. For life! The debt accrues interest of course but the borrower can choose to never pay on that interest or principal. The lender gets paid back eventually, when the house is either sold or the owner dies, but in the meantime the loan doesn’t require any payments. Ever. I’ve never seen that on a loan structure before.

Second, as long as the homeowner complies with the mortgage agreement – which means staying current on taxes and insurance – neither the homeowner nor the homeowner’s spouse can be evicted from the house. Ever. It’s a bank loan backed by collateral, but the bank can’t take the collateral for the life of the borrowers. This is also something I’ve never seen before.

As it turned out, Jesse couldn’t move forward with the reverse mortgage, however, because his husband Ralph is only 51, and Texas requires both spouses to be over age 62.[4]Other states have more lenient spousal rules, but Texas has its own way of doing things, as you may have heard.

I’ll describe my three previous issues with reverse mortgages, as well as my evolving views.

Complexity is the Enemy of the Good

An important worry is that as a relatively unusual loan product, consumers could be more likely to make bad choices about a thing they don’t understand very well. Even a traditional home mortgage can seem complex but it resembles other products we’re familiar with, like an automobile loan or a personal loan.

A reverse mortgage, by contrast, acts a bit like a retirement account or annuity, in that you can take money out over time as you get older. It’s also a bit like a credit card or home equity line of credit, in that it “revolves,” meaning you can take money out but also pay it back as often as you like. But it’s also different than a credit card or home equity loan, because you don’t have to pay it back with regular or even any payments (until you die). One of my guiding principles of finance is simplicity. Reverse mortgages may be a complicated form of debt for some people, and complicated is the enemy of the good.

Somewhat reducing my fear, however, is that every prospective reverse mortgage borrower must take a financial counseling course by phone, mandated by the Federal Housing Authority (FHA), which regulates reverse mortgages. Guy Stidham, owner of Mortgage of Texas and Financial LLC, a San Antonio-based mortgage broker who offers both traditional and reverse mortgages, says these courses cost about $150 and take a few weeks to schedule, which serves as a kind of “cooling off” function for prospective borrowers.[5]

Borrowing capacity

One of the more complicated topics of a reverse mortgage is how much you can borrow. Big picture, you should know two things: First, you can generally borrow much less initially with a reverse mortgage than with a traditional mortgage. Second, the amount you can borrow against your house trends upward over time, at the same rate as your mortgage’s interest rate. Let me fill in a few details on this issue.

Your initial borrowing amount is calculated according to an FHA formula by taking into account three things: The value of your house, your interest rate, and your age.

House_billsThe FHA says that the younger you are, the less you can borrow against your house. This makes sense since time will eat away at your home equity, and you are not required to make payments on a reverse mortgage. The FHA also says that the higher the interest rate, the less you can borrow. This also makes sense because a higher interest rate, compounding over time with no payments, will also eat away at your home equity.

With an online calculator you can see how much of your home value you are allowed to borrow against. If you test out the calculator, you’ll see a 70 year-old charged 4.5 percent can borrow less than 50 percent against their house. The typical range of borrowing is between 40 and 65 percent of home value, substantially less than the 80 percent standard with a traditional mortgage.

Here’s a weird quirk of reverse mortgages, however, The amount you can borrow against your house increases over time, precisely in line with the interest rate you are charged. If you’re charged 5 percent interest, your available borrowing limit increases by 5 percent per year. For reverse mortgage borrowers using this as a home equity line of credit, the annually increased borrowing capacity will seem like a cool feature. For people concerned with reverse mortgages eating up your home equity, this increased borrowing capacity may seem pernicious.

I won’t rule either way, except to say that debt in all forms is always a drug, which may be used for good or evil. The increasing borrowing limit just ups your dosage of the drug over time.

Are these high cost mortgages?

My second big worry was that reverse mortgage would be high cost products for borrowers. This fear turns out to be somewhat true, although there’s some nuance to the cost issue.

reverse_mortgageThe biggest cost of a reverse mortgage is mandatory mortgage insurance. Reverse mortgage borrowers are charged by the Federal Housing Authority (FHA) 2 percent of the appraised home value. For a $500,000 appraised home, the FHA would charge $10,000, which would be rolled into your loan balance at the time of origination. The FHA also charges 0.5 percent annually on the balance, as further insurance against losses. I think this is the biggest contributor to reverse mortgage costing more than traditional mortgages.

Next, what kind of interest rate should we expect on a reverse mortgage?

Most reverse mortgages charge a variable interest rate. According to Greg Groh, a reverse mortgage originator with All Reverse Mortgage, last week the starting variable interest rate was 4.32 percent which, added to the insurance cost, would mean a borrower’s cost of 4.82 percent.

What do I think of those rates? They’re slightly higher than a traditional mortgage, but also less than the rate I’m currently charged for my home equity line of credit, on which I pay 5.49 percent, and happily so. So, the floating interest rate isn’t a big knock on reverse mortgages.

Joe DeMarkey, Strategic Business Development Leader of Reverse Mortgage Fundingestimated fixed rates now between 4.375 and 5.125 percent, in the same ballpark as a traditional 30-year mortgage. So, again, the cost of a reverse mortgage isn’t particularly from an above-market interest rate.

DeMarkey points out that 80 percent of reverse mortgages have floating interest rates rather than fixed rates. With floating rate loans, the initial interest rate often starts out reasonably low but there’s always a risk that future higher interest rates make that same debt more expensive later.

Broker commissions and origination fees

Stidham allows that a broker like him can be compensated more by the lender to sell a reverse mortgage in part because they are a less competitive product. His fee for brokering a reverse mortgage could be up to 3 times higher than with a traditional mortgage.

Finally, there’s the issue of origination fees. The maximum origination fee is capped at $6,000, and would actually be smaller for smaller loans.

Closing costs like attorney fees, title insurance, and bank appraisals are all basically the same as a traditional mortgage. Groh reports that a reverse mortgage bank appraisal cost might run slightly higher, but on the order of $550 for a reverse mortgage appraisal rather than $450 for a traditional mortgage. Not a big deal there. The main big cost difference, as I said earlier, is the FHA-charged insurance, which is pretty hefty.

Servicing Details

The servicing component of reverse mortgages is slightly different than for a traditional mortgage. Since borrowers must live in their house, does that force a sale if an elderly person moves out to a nursing facility? Yes, and no.

Borrowers may live outside of the home up to 12 continuous months, meaning even an extended hospital stay or stint in a nursing home does not trigger any change with the mortgage.

Each year a lender sends an “occupancy certificate” letter to the home which must be signed and returned, according to Cliff Auerswald of All Reverse Mortgage. If the borrower does not return that certificate, then the servicer may send someone over to do a drive-by inspection of the property.

If the borrower decided to leave the home for more than 12 months, then in fact the loan would become due. For that reason, any borrower who doesn’t plan to stay in their home “for life,” should probably look for another product rather than a reverse mortgage.

Hollowing out Equity

My third big problem with reverse mortgages was that they clashed with my traditional view of the incredible wealth building potential of home ownership– a way to automatically build up a store of wealth by making affordable monthly principal and interest payments on your house over a few decades. Because reverse mortgages drain that value over time, they made me want shout “Wait…But that’s…that’s not how it’s supposed to work!

Look, my strongest advice would be to fully pay down your home mortgage over 15 to 30 years, don’t borrow against your house, and depend solely on accumulated retirement savings plus social security to support you in your old age. There’s nothing wrong with that advice except for the fact that it sounds a bit like: “My strongest advice to you is to be rich in your old age.”

And, you know, that’s not very actionable advice by the time you actually retire.

If you can’t be rich, my second strongest recommendation would be to take out a home equity line of credit, since these are revolving lines, they allow you to flexibly borrow as needed, and act like a low-interest emergency credit card. They are awesome and we used one to renovate our kitchen and paint our house. I love my HELOC. A reverse mortgage therefore is really a third-best option, but it seems to me a pretty fine choice under many scenarios.

As my wife reminded me recently, one of my other long-standing theories of personal finance is that kids shouldn’t inherit stuff. Since we don’t intend to bequeath our house to our girls, I shouldn’t be opposed to draining the house of our home equity once we hit our 70s or 80s. At that age, the goal shouldn’t be to continuously build up assets (For what? For whom?) but rather to spend money to make our lives better.

If we planned to stay in our house, my wife and I recently agreed we’d be open to a reverse mortgage in our 70s.

[1]You have to be age 62, minimum.

[2]This post is a combination of a couple of columns I wrote for the newspaper, combined into one long post.

[3]A reverse mortgage, sometimes called a home equity conversion mortgage (aka HECM), is targeted to 62 year olds and up. Home equity, I should clarify, is the difference between the value of a house and the amount of debt on the house. That means a $300,000 house with a $100,000 mortgage has $200,000 in home equity. A reverse mortgage is a kind of home equity loan, specifically to borrow in old age without having to make payments, if you don’t want to.

[4]As an aside, Jesse wondered if discrimination from the bank was at play because he’s gay. I told him he should hope for that, as a class-action attorney could solve all his financial needs and he wouldn’t need the mortgage any more. Alas, Texas law says your spouse can’t be younger than 62 to take a reverse mortgage, whereas in other states your spouse can be younger than 62. It’s age discrimination, not LGBT discrimination. No big discrimination win for Jesse.

[5]Disclosure: I have done consulting projects for Stidham in the past.

 

 

Please see related posts:

Homeownership – Part I

Ask an Ex-Banker: HELOCs

 

 

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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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