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Mark Miller: Remaking Retirement

How to Navigate the Changing Reverse-Mortgage Market

These products might appeal to cash-strapped seniors, but they're not without risks.

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If you tune into cable channels that reach older viewers, it's hard to miss the ad pitches for reverse mortgages. Among the pitchmen are older actors Fred Thompson and Robert Wagner, who explain to seniors in reassuring tones how easy it can be to tap home equity to meet their expenses. But outside the realm of TV ads, the reverse-mortgage industry isn't quite so calm these days.

The industry has been struggling to cope with a rising number of nonperforming loans and foreclosures in the wake of the housing crash. It's also adjusting to a changing loan marketplace following the departure of three very large lenders and the introduction of new products. And more changes are looming, with a temporary increase in loan limits tied to the federal stimulus law scheduled to expire this fall.

The changes have sparked questions in some quarters about the future of reverse mortgages, though advocates argue the loans are an essential tool for tough times, as many baby boomers are now approaching retirement with inadequate investment resources.

What do the changes in the reverse-mortgage market mean for borrowers? Here's a look at the recent trends--and what potential borrowers should look out for as they navigate the market

The Basics
Reverse mortgages are available only to homeowners over age 62. They allow seniors to turn their home equity into cash while staying in their homes. Unlike a forward mortgage, where you use income to pay down debt and increase equity, a reverse mortgage pays out the equity in your home as cash; your debt level rises and equity decreases.

The most popular loan type is the Home Equity Conversion Mortgage, which is administered and regulated by the U.S. Department of Housing and Urban Development. HECMs are different than traditional home equity lines of credit in two critical ways:

  • Repayment of a reverse mortgage typically isn't due until the homeowner sells the property or dies.
  • Borrowers can't be disqualified based on personal assets or income; lenders are required to accept all applicants, so long as their homes are judged to have sufficient equity to support the HECM.

Loan limits depend on the amount of equity in your home and your age--the older you are, the more cash you can get. But the limit for standard HECMs was boosted from $417,000 to $625,500 in 2009 under the federal stimulus law. The ceiling is scheduled to fall back to its previous level at the end of September, though HUD is weighing a possible extension of the higher limit. Even if loan limits do fall, the change would affect primarily borrowers in parts of the country with high home values, such as California, New York, and the District of Columbia.

HECM fees are steep and typically include:

  • An origination fee of 2% of the first $200,000 of your home's value, plus 1% on the additional value; the overall origination fee can't exceed $6,000.
  • Closing costs for appraisal, title search, insurance, and so on.
  • An upfront mortgage insurance premium, or MIP, of 2% of your home's appraised value.
  • An ongoing annual MIP equal to 1.25% of the mortgage balance.
  • Servicing fees of up to $30 per month.

For example, a 72-year-old borrower with a home appraised at $400,000 could have access to $270,800 under terms of the standard HECM as an initial principal limit--a formula that takes into account the percentage of the home's value based on the borrower's age and the interest rate. The maximum origination, MIP fees, and other closing costs allowable under HUD regulation on the loan would total $21,284, according to an analysis provided by the National Reverse Mortgage Lenders Association. After costs, the borrower's net proceeds would total $249,516. However, the association cautions that most borrowers will wind up paying smaller fees because of competitive fee-cutting by lenders.

A lower-fee "saver" HECM was introduced last fall that reduces the upfront MIP from 2% to 0.01%. Saver loan limits are 10%-18% lower than for standard HECMs, making them less suitable for seniors looking to tap a sizable amount of home equity, and interest rates typically are 0.25%-0.50% higher. So far, saver HECMs are a small part of the market, accounting for just 7% of new loans originated, according to HUD data.

Counseling Required
Federal law requires HECM borrowers to receive counseling through a HUD-approved counseling service before a loan can be closed. The intent is to assure that borrowers thoroughly understand HECM risks and expenses.

However, a 2009 report by the U.S. Government Accountability Office pointed to inadequacies in the counseling process, citing instances where counselors failed to discuss other lower-cost options available to them and the financial implications of an HECM.

HUD launched an initiative earlier this year aimed at improving the counseling services. But more recently, Congress voted to eliminate funding that supported the counseling in a budget-cutting move, raising questions about how the program will be funded starting in October, when the government's new fiscal year begins.

 

Market Changes, Greater Risk
Reverse mortgages initially were marketed as a way for seniors to gain access to extra cash to pay for necessities. Most loans carried adjustable rates and borrowers used them as flexible lines of credit or to receive small regular monthly annuity-style payments. Until 2006, most reverse mortgages were purchased by Fannie Mae, which set interest rates and required that all loans have adjustable rates. But during the past few years, the market has shifted.

Fannie Mae exited the reverse-mortgage market in the wake of the mortgage market meltdown and its own ensuing troubles. It has been replaced by major banks, and Wall Street houses issuing mortgage-backed securities backed by Ginnie Mae. Investor demand has been strongest for securities that pool together fixed-rate reverse loans, rather than adjustables.

That, in turn, has pushed the market strongly in the direction of fixed-rate loans.

The percentage of fixed-rate loans soared from less than 3% of HECMs to 70% during 2009, and has remained at high levels since then, according to HUD data.

Although it might seem that the trend toward fixed-rate reverse mortgages would be good for consumers, particularly because mortgage interest rates have trended down during the past few years, in reality, it isn't. In the traditional forward-mortgage market, adjustable-rate loans often are perceived as the more risky choice, but the opposite is true with reverse mortgages. Even though adjustable loans most often are used as a line of credit or to receive a regular monthly income supplement, fixed-rate loans always pay borrowers an upfront lump sum of the full mortgage amount, which means they rack up much higher interest costs and deplete their equity far more rapidly.

"Fixed-rate loans set seniors up for all kinds of fraud and abuse," says Lyn R. Link, publisher of The Reverse Mortgage Critic and a former reverse loan broker. "Say you have a loan with a 6% interest rate and a $200,000 lump sum. The borrower starts getting charged on that amount the day they close. What can they get putting that into a certificate of deposit at the bank? You automatically start losing money on day one. It's hard to see how a fixed-rate loan is more suitable for 70% of borrowers."

Those concerns are shared by Barbara Stucki, vice president of home equity initiatives at the National Council on Aging, which operates one of the HUD-approved counseling services.

"Reverse mortgages originally were designed to give borrowers a small amount of cash each month to supplement their incomes and help pull people out of poverty or up to reasonable standards of living," she says. "They work well for that purpose; you draw down equity slowly and can preserve a fair amount of it.

"Large lump-sum loans are problematic. You're paying interest on the full loan amount right away, so the draw-down of equity is quick. That decreases your flexibility instead of increasing it, and there's no equity left at the end of the day."

Little Room to Maneuver
Many fixed-rate borrowers use the large lump sums to retire a traditional forward mortgage. The strategy improves monthly cash flow by eliminating a mortgage payment but leaves seniors on fixed incomes with little room to maneuver in the event of an unexpected emergency expense, such as an illness. And increasingly, strapped borrowers find themselves in default on the terms of their loans, putting them at risk of possible foreclosure.

Although reverse-mortgage borrowers don't make regular loan payments, they are required to pay property tax and homeowner insurance costs and to maintain their homes at a certain level. A loan can be classified as nonperforming if a borrower fails to meet those conditions, and that's what's happened to an increasing number of borrowers. About 5% of all reverse mortgages outstanding now are nonperforming.

Until recently, lenders were advancing tax or insurance-bill payments in cases where borrowers haven't tapped their maximum loan amounts, adding those costs to the loan balances. That was easy to do in a rising real estate market, where home equity was rising. Now, in cases where loan amounts are exhausted, borrowers have fallen into a limbo of sorts, because of a lack of clear guidance from HUD on how lenders should handle nonperforming loans.

In January, HUD instructed lenders to contact all delinquent borrowers to lay out options, including establishing repayment schedules or restructuring of loans, or to offer assistance from a HUD-approved consumer counseling service. In most cases, the total delinquent amount is $5,000 or less, according to Peter Bell, president of the National Reverse Mortgage Lenders Association.

"Budget management counseling has helped in some cases," Bell says. "Others have been able to apply for various types of assistance with other costs. In some cases, people will forfeit their homes, and a very small number could go to foreclosure."

Worries about rising defaults and the prospect of foreclosures last month prompted one major lender,  Wells Fargo (WFC), to stop originating new reverse-mortgage loans. Wells Fargo's decision followed decisions by two other major lenders this year-- Bank of America (BAC) and Financial Freedom--to stop writing new loans, as well.

The AARP filed a lawsuit against HUD in March focusing on another area of risk for borrowers--the possibility of foreclosure on the spouses of deceased HECM borrowers. The suit focused on cases where only the deceased spouse had signed the loan.

At the heart of the case is what happens to HECMs that are passed on to a spouse or an heir. The HECM is designed so that borrowers can never owe more than the value of their homes, even though the loan balances rise over time. The intent was to assure elderly borrowers that HECMs were safe.

The lawsuit charged that HUD illegally implemented rule changes that would force surviving, nonsigning spouses to repay the full outstanding HECM balances at the time of sale--even if the home's value had dropped. That could have the effect of forcing nonsigning spouses out of their homes through foreclosure.

HUD later reversed itself on the rule changes, but the dispute flared up again this month when AARP filed new litigation against Wells Fargo and the Federal National Mortgage Association (Fannie Mae), charging that they failed to allow surviving spouses and heirs of reverse-mortgage borrowers to purchase the property for the appraised value after loans came due.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Mark Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.