Reverse Mortgages: Why the Bad Rap?
A quick Internet search of reverse mortgages will return a slew of articles and opinions, with an equal split between positive and negative information, but that hasn’t always been the case. When reverse mortgages were first made available to the retiring public, they quickly developed a less than rosy reputation among financial experts, retirement planners, and even some mortgage lenders. Their bad rap has a lot to do with misunderstanding how these vehicles work, how they were initially structured, and some important responsibilities homeowners overlooked in the process.
To understand if a reverse mortgage is right for certain retirement planning needs, it’s helpful to break down the issues adding to the negative reputation of reverse mortgages from all sources.
Poor Structuring and Default Rates
When reverse mortgages first came on the scene in 1989, the Department of Housing and Urban Development which insures the majority of these loans, had few qualification requirements for homeowners. This meant that anyone aged 62 and older could easily qualify for a new reverse mortgage so long as there was equity available. Lenders were not required to evaluate the financial capability of these borrowers to cover other expenses that are inherent to homeownership, nor their need for cash from home equity in the future.
Over the years, some homeowners ultimately defaulted on their loan because they took out too much in home equity, leaving them with little accessible funds to cover living expenses and upkeep of the home. As of 2017, the mortgage portfolio of HUD was valued at a depressing negative $7.7 billion due to these high rates of default.
However, recently, HUD provided new guidelines on reverse mortgages both for the consumer and the lender. Any reverse mortgage backed by HUD now requires all lenders to take a closer look at a homeowner’s total financial picture – not just the need for a lump sum or an income stream from a reverse mortgage in the moment. These recent changes also include an increase to the mortgage insurance premiums on reverse mortgages, from 0.5% to 2%, as well as a reduction in the amount of equity that can be drawn out through the loan. The shifts in the reverse mortgage guidance are meant to protect homeowners from getting in over their heads, and subsequently, decreasing the default rate over the next several years.
The Missed Memo on Homeowner Responsibilities
Another reason for the bad rap garnered by reverse mortgages is the missed memo on homeowner responsibilities throughout the process. Just like traditional mortgage loans, reverse mortgages still require homeowners to cover expenses including property taxes and homeowner’s insurance. The difference is that these costs are built into a forward mortgage as part of the monthly payment; reverse mortgage borrowers must pay these expenses out of pocket, like they would if they owned the home outright. Many borrowers in the early era of reverse mortgages misunderstood these requirements, and they failed to cover these costs consistently. When property taxes and homeowners insurance aren’t paid for, the lender may view the loan as in default, leading to foreclosure proceedings or, at the least, a hefty bill for the homeowner.
In addition to property taxes and insurance, homeowners with a reverse mortgage are also required to maintain the home through basic upkeep. The property remains an asset for the lender, as it does with a traditional forward mortgage, and this makes upkeep essential to retaining the value of the home. When homeowners miss these critical responsibilities, reverse mortgages seem like a bad financial move when default ultimately takes place.
Strategies to Avoid Common Issues
Reverse mortgages are not a good fit for every homeowner, but they are particularly ill-suited for those who do not recognize their role and responsibilities as part of the process. The best way to avoid the common issues leading to default that gave reverse mortgages their bad name is to understand the reach and limitations inherent to the loan fully.
First, the right mortgage lender will help with determining what is affordable and how much equity can be drawn from the home through a reverse mortgage, based on the financial picture of the homeowner. However, homeowners must be prepared to cover out-of-pocket expenses as well as have a plan for home upkeep from the start.
One of the ways to create a successful retirement income strategy with a reverse mortgage is to establish a Life Expectancy Set-Aside, or LESA. With this tool, a specific amount is withheld from the reverse mortgage proceeds and siphoned off for payment of property taxes, homeowners insurance, and flood insurance if required. Lenders determine the LESA amount based on the life expectancy of the youngest borrower, along with the average mortgage interest rate and potential increases in taxes and insurance costs. This can be an invaluable addition to a reverse mortgage for homeowners who are concerned about covering these expenses over their lifetime.
Getting a reverse mortgage is not a decision that should be taken lightly given the complexities of the loan and the financial impact it may have on the borrowers. However, when homeowners recognize what is required of them from start to finish, a reverse mortgage can be a valuable vehicle toward a financially sound retirement.