Under the Hood: This is the first in a series of articles in which we explore investing, retirement and wealth management issues that your clients may address to you. Written by experts such as advisor Mike Patton, we’ll go ‘under the hood’ to provide some education for advisors but also talking points for use with your clients.
Over the past few years we've seen an explosion in reverse mortgage advertising. Celebrities such as Fred Thompson and The Fonz (Henry Winkler) have relentlessly touted the benefits of these financial instruments as a way to solve the income problem of retirees. A private REIT, Reverse Mortgage Investment Trust, is reported to have raised $230 million this year, betting on a market resurgence of reverse mortgages, which suffered a sharp decline coincident with the housing crisis.
Are these tools as beneficial as Fred and The Fonz claim? We'll discuss how they work, how they're taxed and what you, as an advisor, need to know to advise your clients who may ask you about reverse mortgages.
How They Work
A reverse mortgage is a tool which allows a homeowner to withdraw equity from his home. It does not involve a sale of the home, hence, ownership is never relinquished. The marketplace for reverse mortgages is fairly consolidated. As much as 95% of all reverse mortgages are written through a Home Equity Conversion Mortgage (HECM), regulated by the federal Department of Housing and Urban Development (HUD) and available only through an approved Federal Housing Administration (FHA) lender. To qualify for a HECM reverse mortgage, the following criteria must be met:
1) The homeowner must be at least age 62. If the property is owned jointly, the youngest titleholder must be at least 62.
2) The property must be a single family dwelling, an approved FHA condo, or a multiple family home which contains at least two but not more than four units.
3) The home must be the primary residence of, and occupied by, the homeowner.
4) If the home is leveraged, the equity in the home must be sufficient to pay off all mortgages, liens or legal obligations against the property.
To satisfy the residence rule, the homeowner must reside in the home for at least 183 days per year and confirm this by signing an Annual Occupancy Certificate. If this is a problem due to the homeowner’s health or work situation, the homeowner must notify his Servicer. If the homeowner is out of the home for 12 consecutive months, the loan could be in default.
If the homeowner rented the property, it would no longer be considered his primary residence, and the loan would be in default. Also, the homeowner must continue to pay insurance and property taxes and maintain the property in accordance with FHA requirements.
Money received from a reverse mortgage is considered to be a loan, and as such, is not subject to income tax. In addition, the maximum amount a homeowner may receive from a HECM reverse mortgage is based primarily on the:
1) appraised value of the home
2) age of the individual (or couple)
3) prevailing interest rates
4) government-imposed lending limits.
Who benefits most, an older or younger person? Assuming all else is equal, an older person will be able to receive a larger benefit each month. However, if a younger person establishes a reverse mortgage, and does not draw upon the line of credit, they will benefit more than an older person. This is because the line of credit will grow and the amount which may be withdrawn will be greater than if an older person did the same. (Note: The original content in this paragraph has been edited to more accurately reflect whether a younger or older person would benefit most from a reverse mortgage.-Ed.)
The funds can also be structured in a variety of ways, including:
1) a lump sum
2) a monthly payment
3) a line of credit
4) some combination of each.
The income may be paid out over the lifetime of the homeowner (and spouse, if the home is owned jointly) or for a specified number of years.
Expiration of Program
What happens if the homeowner dies? What if the homeowner is placed in a nursing home or assisted living facility? One of the requirements of a reverse mortgage is that the homeowner continues to reside in the property. Under the criteria listed above, the homeowner would thus fail to meet these criteria and the loan would need to be repaid. If the homeowner didn't have the financial resources to repay the loan, the home would have to be sold. After the home was sold, any surplus which remains after repaying the loan would accrue to the homeowner or to his estate.
However, what if there wasn't enough equity to repay the loan when it was sold? The lender would request reimbursement from the FHA. In short, other than the home itself, no other assets would be attached to the agreement.
The Bottom Line
As you can see, reverse mortgages are fairly complex instruments and as such, should not be implemented without due consideration and proper guidance. Fortunately, there are a number of resources available such as the website of the National Reverse Mortgage Lenders Association (NRMLA). This Washington, D.C.-based organization exists to educate consumers and train lenders on the pros and cons of reverse mortgages. For more about reverse mortgages, visit www.reversemortgages.com.
Although, this may be a good idea for some clients, there are many issues to consider prior to entering into a reverse mortgage agreement. Prudence dictates that you learn as much as you can and recommend them only as a part of the client’s overall plan. It's best not to wait until a client runs out of money before implementing this strategy. Since there is usually no annual fee to maintain a reverse mortgage as a line of credit, why not establish it in advance? Then it will be available if needed.
For additional information on reverse mortgages, see this 2013 ThinkAdvisor article:
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