The Center for Retirement Research at Boston College is predicting a drop in loan defaults by new reverse mortgage borrowers thanks to changes to home equity conversion mortgage (HECM) rules implemented in 2013 and 2015, according to an issue brief released in July.
The “vast majority” of borrowers are approved for reverse mortgages through the program administered by the Department of Housing and Urban Development, the brief found. The program protects borrowers from the risk that the lender won’t be able to provide funds and protects the lender from the risk that the borrower’s loan balance will exceed the property’s value when it’s sold.
The property could end up in foreclosure, the brief noted, if borrowers exhaust their HECM funds, which the lender may use to pay property taxes and insurance payments borrowers can’t make on their own.
“In the wake of the financial crisis, a rising default rate – which hit 10% in 2013 – coupled with a negative balance in HUD’s insurance fund generated concerns about the plight of troubled borrowers and the program’s solvency,” according to CRR.
HUD announced changes in 2013 to HECM rules, including limits on how much borrowers can withdraw initially, and an assessment of their ability to pay property taxes and homeowners insurance prior to approving the mortgage.
As of 2013, borrowers could only take 60% of the initial principal limit on their reverse mortgage in the first year. The new underwriting rules took effect in April 2015.
Those changes may well have a positive effect. CRR referred to a 2015 study published in the Journal of Urban Economics, and conducted by Stephanie Moulton, Donald Haurin and Wei Shi of Ohio State University, that found withdrawal limits and escrow requirements significantly reduced the probability of default. They also reduced the likelihood that consumers would take out a reverse mortgage at all.
The study analyzed confidential data from ClearPoint Credit Counseling, a nonprofit that provides financial counseling to consumers, on households that received debt counseling services between 2006 and 2011, including demographics, credit scores and other financial health metrics. Of the almost 28,000 households that received counseling, 58% took out a reverse mortgage. That information was compared to data from HUD on reverse mortgage originations, withdrawals, terminations and defaults.
The study found that credit scores and initial withdrawals were significant indicators of a borrower’s likelihood to default. A one-standard-deviation increase in a household’s credit score was associated with a 7.7 percentage-point decrease in the default rate.
Conversely, a one-standard-deviation increase in the initial withdrawal amount was associated with a 6.6 percentage-point increase in the default rate. The study found that when initial withdrawal limits were imposed, the probability of defaulting fell 18%, and it reduced the likelihood that a household would take a reverse mortgage by 8%.
Requiring a credit score better than 580 reduced the default probability by 30% and the take-up rate by 12%.
Approving reverse mortgages for borrowers with lower credit scores if they’re able to set aside funds to pay taxes and insurance in an escrow account reduced the default probability rate by 37%, and the take-up rate fell less significantly than in the first two scenarios: 4%. Adding a withdrawal limit to the escrow scenario reduced the default probability by 50%, and the take-up rate fell by 12%.
“One of the concerns about imposing underwriting criteria is that they could significantly reduce the take-up of HECMs, potentially conflicting with the program’s public mission,” the brief warned. “However, the simulated impact of credit-based underwriting standards on HECM take-up is estimated to be small.”
“Reverse mortgages work best when loan proceeds are used slowly and as part of a broader financial plan. As an industry, we worked with policymakers to craft reforms that would help more borrowers manage their funds over time,” Peter Bell, president and CEO of the National Reverse Mortgage Lenders Association, said in a statement. “The CRR Brief reaffirms our message that reverse mortgages are a safe financial tool that older homeowners can use to supplement their retirement income.”
— Read Pfau: How to Manage Sequence of Returns Risk With Reverse Mortgages on ThinkAdvisor.