A reverse mortgage allows homeowners, typically aged 62 or older, to convert home equity into cash without selling their home or making monthly payments. Key pros include no obligatory mortgage payments, tax-free proceeds, optional flexible payment options, and protection against owing more than the home’s value. Main cons include significant upfront costs and increasing loan balance that can reduce home equity.

Key Pros:

• No monthly mortgage payments: Borrowers can eliminate monthly payments, which can ease financial pressure and allow seniors to age in place.
• Tax-free funds: Proceeds are generally not considered taxable income, and do not affect Social Security or Medicare benefits.
• Flexible disbursement options: Borrowers can choose to receive funds as a lump sum, monthly payments, a line of credit, or a combination.
• Non-recourse loan: Borrowers or heirs will never owe more than the home’s value when the loan is repaid, regardless of the loan balance.
• Retain home ownership: Borrowers keep the title and can remain in their home, provided they fulfill obligations like property maintenance, taxes, and insurance.
• Heirs have multiple options: When the homeowner leaves the home, heirs may repay the loan, sell the home and keep surplus equity, or, if the loan exceeds the home’s value, surrender the property with no further obligation.

Key Cons:

• Accruing fees:  Reverse mortgages typically have higher closing costs, the most significant of which is the upfront FHA Mortgage Insurance Premium.
• Decreasing home equity: If no payments are made, an absolute right of the homeowner, the loan balance grows over time, reducing the equity left for heirs or the homeowners if they sell and move.
• Impact on inheritance: The growing loan balance can reduce the initial home value. 
• Eligibility risks: As with all mortgages in the US, the homeowner must keep the home as their primary residence, maintain the property, and keep up with taxes and insurance.
• Potential impact on means-tested benefits: While Social Security and Medicare are not affected, receiving large lump sums could impact eligibility for Medicaid or Supplemental Security Income (SSI). This subset of homeowners should take care to draw only what they need to spend for the month.

Clearly, the modern FHA-Insured reverse mortgage offers impressive benefits. The main drawbacks are related to cost, mostly the cost of insuring the loan. Many seniors find it reassuring that the loan is backed by the full faith and credit of the United States Government. Nevertheless, there are ways to reduce the overall cost of the reverse mortgage.

Key Methods for Reducing Overall Cost of Reverse Mortgages:

Payments on the reverse mortgage can be made or discontinued at any interval chosen by the homeowner

Paying the largest expense, the upfront MIP, instead of including it in the loan produces higher growth in available credit, and reduces the decline in home equity

Paying the largest expense, the upfront MIP as above, can result, for homeowners who itemize, in a tax reduction if the reverse mortgage is being used to purchase a new home or replace their purchase loan or to substantially renovate for a more desirable environment to age in place.

Making a large payment on an existing reverse mortgage in high-earning year to offset taxes

Taking draws from the reverse mortgage can be used in retirement planning :

Provide cash for living expenses while deferring Social Security

Meet irregular expenses such medical, aging home, or rising tax and insurance 

Self-insure for long-term care. Don’t use it, don’t owe it

Substitute reverse mortgage for portfolio draws in down markets, avoid buying high and selling low

Avoid paying capital gains by not selling to meet expenses

In high appreciation areas, retain the home for continued wealth building

Restrict capital gains for heirs by passing home on stepped-up basis

In senior divorce, equalize housing and reduce drain on marital cash

Over the last decade, there has been an explosion in retirement planning uses for reverse mortgages. Financial professionals appreciate how a usually dormant asset, the home, can be mobilized to work in concert with other assets.

Many are surprised to learn that the 100th U.S. Congress initiated the modern reverse mortgage through the Housing and Community Development Act of 1987, which President Ronald Reagan signed in February 1988.

Congress tasked the Federal Housing Administration (FHA) with designing a reverse mortgage that would protect older homeowners while also encouraging lending in the private sector.

In December 1988, the Department of Housing and Urban Development (HUD) published a notice asking potential mortgage lenders to participate in a demonstration program that would “insure up to 2,500 reverse mortgages on the homes of elderly homeowners, enabling them to turn their equity into cash.”

Through the Home Equity Conversion Mortgage (HECM) Insurance Demonstration, the modern reverse mortgage was born.

How FHA Insurance Works

The FHA addressed the need to protect both the homeowner and the lender by modifying its existing mortgage insurance program to accommodate reverse mortgage lending. Understanding how the FHA operates in traditional lending provides a helpful comparison.

Created in 1934 as part of the National Housing Act, the FHA provides mortgage insurance on loans made by FHA-approved lenders throughout the United States and its territories. The FHA insures mortgages on single-family and multifamily homes, including manufactured homes and hospitals. In 1965, the FHA became part of HUD.

At the height of the Great Depression, Congress and President Franklin Roosevelt created an incentive for lenders to provide financing to certain higher-risk borrowers by protecting lenders against loss. FHA insurance premiums were assessed on these loans and used to fund that protection.

With traditional FHA loans, homeowners pay upfront and monthly insurance premiums. These premiums protect lenders against losses if a homeowner defaults. FHA lenders bear less risk because the FHA may pay a claim to the lender following a homeowner’s default.

To qualify for FHA insurance protection, loans must meet specific requirements established by the FHA.¹

Adapting FHA Insurance to Reverse Mortgages

Insurance is based on the participation of many people to cover the losses of a few. In other words, participants pool funds by paying premiums, transferring a portion of the risk to the insurance provider.

The HECM program adopted the FHA insurance concept but modified it to accommodate the needs of reverse mortgage lending:

Insurance premiums are not paid monthly. Instead, they are added to the loan balance.

The homeowner or the homeowner’s estate is released from liability if the loan balance exceeds the home’s value.

If the home’s value does not cover the loan balance, the lender is protected by FHA insurance.

The resulting HECM program, which includes FHA insurance, is designed to encourage lenders to provide loan proceeds while protecting them if circumstances do not unfold as anticipated.

The HECM also protects homeowners and their estates if the loan balance grows beyond the value of the home. Its consumer safeguards are substantial and have continued to evolve to protect both individual borrowers and taxpayers.

Unfortunately, these HECM consumer protections are sometimes overlooked by the financial press and by financial advisers upon whom many Americans rely for information about their retirement options.

Addressing Weaknesses in the Program

Despite HUD’s continued efforts to refine the program, weaknesses emerged over time.

During the housing bubble years, HECMs were sometimes used to address financial situations that were already unsustainable. Some borrowers did not take seriously the requirement to remain current on their property taxes and homeowners insurance.

In other cases, younger spouses who were not listed on the property title were displaced when the borrower died. Some borrowers also used the HECM irresponsibly by withdrawing their entire initial credit limit at closing, leaving no cushion if home values declined.

These were serious problems that jeopardized both the program and its reputation.

In response, the 113th Congress passed the Reverse Mortgage Stabilization Act of 2013. The law was enacted to provide additional protections for non-borrowing spouses and to help restore the financial health of the FHA Mutual Mortgage Insurance Fund.

The HECM program’s insurance pool was intended to be self-sustaining, not a taxpayer bailout. However, when the housing bubble collapsed, the fund’s solvency was placed in jeopardy. HUD responded by changing its lending standards, and the HECM program was significantly revised. As a result, the fund’s financial strength began to improve.²

Additional Consumer Protections

Financial assessments are now part of the HECM loan approval process.

To reduce the likelihood of property tax and homeowners insurance defaults, formulas are used to determine whether a portion of the borrower’s available equity must be set aside to cover these expenses. These set-asides may be required when borrowers cannot demonstrate the willingness or financial capacity to meet their basic housing obligations.

Additional protections include:

Limits on how much equity borrowers can access during the early stages of the loan

Financial assessments designed to determine whether borrowers can meet their ongoing housing obligations

Set-asides for property taxes and homeowners insurance when required

Non-borrowing spouse provisions that may allow an eligible younger spouse who is not old enough to borrow to remain in the home after the borrowing spouse dies

A Program That Continues to Evolve

Rather than being a fraudulent scheme designed to take advantage of older homeowners, the modern reverse mortgage, also known as the HECM, is a program established by the United States government.

As former FHA Commissioner Brian Montgomery has said, the HECM is the “law of the land.”

Admittedly, the HECM program was not perfect at its inception. Like many financial products, however, it has evolved. HUD continues to refine the program to strengthen consumer protections and improve risk management for the FHA insurance fund.

A reverse mortgage is neither inherently good nor bad. Its value depends on how the borrower uses it.

Notes

Information about FHA program requirements and history is available through the U.S. Department of Housing and Urban Development.

The original article cited an archived Reverse Review resource concerning the HECM program and the FHA Mutual Mortgage Insurance Fund.

FPA San Francisco Newsletter

Rick San Vicente, VP NW Sales Leader, Mutual of Omaha Mortgage

with

Shelley Giordano, Academy of Home Equity in Financial Planning, University of Illinois

The famous physicist Werner Heisenberg reportedly mused that when he gets to Heaven, he hopes that “turbulence” can be at last be explained to him. Tongue-in-cheek, Heisenberg claimed that even the theory of relativity would be easier to grasp than the tendency of things to change in unpredictable ways. For retirees in midst of the Covid-19, the volatility in investments, especially in March 2020, was a reminder that retirement planning is fraught with the need to make assumptions that may or may not provide for a secure future.

Wade Pfau, PhD, CFA, Professor of Retirement Income at the American College of Financial Services, writes that market turbulence, longevity, and spending shocks are the three major threats to financial security in retirement.  To mitigate these risks, Dr. Pfau recommends that the advisor integrate the housing asset into the planning process. Dr. Pfau’s approach is to treat the home as a “buffer asset” that may be deployed to protect the investments should the client live long, encounter unexpected expenses, or even temporarily need an alternative source of cash to avoid selling in a bear market.

With an estimated $7 trillion in senior home equity, would turning this dead asset into a integrated strategy for your clients help restore peace of mind, especially in view of the economic and health consequences that retirement in the Covid-19 world may bring?

The most dramatic use of the reverse mortgage, and the most popular, is to convert a traditional mortgage into a reverse. This immediately removes the dreaded monthly mortgage payment and gives clients breathing room to enjoy life. 

Retirees are often surprised that dental, vision aid, and hearing aid are not only not covered by Medicare but also that they are so expensive. Possible long-term care needs just add to the uncertainty of what the future will cost.

And finally, clients are anxious about their investments lasting as long as they do. Having to take distributions in a down market is unsettling enough that even Congress in the 2020 CARES ACT suspended RMDs.  Selling in down markets is known as “Sequence of Returns Risk. “Clients just know it as buying high and selling low. 

A reverse mortgage line of credit can be used as substitute draws while the market recovers. The modern reverse mortgage, or Home Equity Conversion Mortgage (HECM), is FHA-insured and provides for growing access to borrowing power as the client ages. Although the HECM line of credit is similar to a home equity line of credit, there are critical differences. When there is turbulence in the financial markets, lenders can substantially alter their commitment to lend on home equity. This was a painful lesson in the Great Recession. Just when clients needed liquidity, the banks did, too, and stopped lending. Already we have seen Chase and Wells Fargo suspend HELOCs during the Covid-19 pandemic. 

But clients who have a reverse mortgage line of credit cannot be denied access to their growing line. As opposed to a HELOC, the HECM line of credit cannot be

Cancelled

Frozen

Reduced

Substituting draws from invested funds with draws on a reverse mortgage puts the house to work in a particularly effective way. To prepare for the unexpected, the house is an important part of the retirement planning process.

Few financial threats are more destructive to a retirement plan than a prolonged long-term care event. Medicare covers custodial care for only a short time, leaving families to face difficult choices: spend down assets to qualify for Medicaid, or pay out of pocket — bills that can easily climb into the hundreds of thousands of dollars. One often-overlooked solution is establishing a reverse mortgage Home Equity Conversion Mortgage (HECM) Line of Credit early in retirement, creating a growing financial reserve that exists outside of traditional savings.

Even when long-term care insurance is in place, gaps remain. According to the American Academy of Long-Term Care Insurance (AALTCI), only about half of policyholders ever file a claim. And for those who do, coverage doesn’t begin immediately — most policies include an elimination period, typically 90 days, during which the policyholder pays out of pocket before benefits kick in. Factor in that some people recover or pass away during that waiting period, and the likelihood of actually using the policy drops to around 35%. Beyond the elimination period, daily benefit amounts often fall short of actual care costs, leaving families to cover the difference.

Consider Sharon and Bob, a Massachusetts couple who found themselves in exactly this situation. When Bob needed care, they discovered their policy’s 90-day elimination period would cost roughly $30,000 — far more than they had anticipated when they purchased coverage years earlier. On top of that, the policy’s daily benefit wouldn’t fully cover Bob’s actual care costs, creating an ongoing shortfall Sharon wasn’t sure how to manage. With just $500,000 in savings and Social Security income, she was understandably reluctant to drain their nest egg.

Their solution was a HECM Line of Credit on their home. An initial draw of $50,000 covered the elimination period and helped pay down some existing debt, such as Sharon’s car. The remaining $350,000 credit line now bridges the gap between what Bob’s care costs and what the insurance pays each day. Because no monthly payments are required on the borrowed funds, their cash flow remains stable — and their retirement savings stay invested, continuing to grow for the future.