Reverse mortgage risks remain after program changes

Blue, two-story model house sitting on top of a pile of money

You might hear about big changes coming to reverse mortgages, as the federal government will soon ban the most popular form of this loan.

The government says this will make reverse mortgages safer.

But the changes don't fully address the biggest criticism of these loans: Many homeowners are taking large up-front payments (typically to pay off their existing mortgage) that leave them with little remaining income to meet their retirement expenses.

Indeed, older Americans and their families still have reasons to be wary of reverse mortgages.

This type of loan against your home's equity is available in a number of forms. Come April 1, the Federal Housing Administration, which insures nearly all reverse mortgages, will eliminate the option seven of 10 borrowers use.

This fixed-rate, lump-sum option allows you to take the maximum amount of equity from your home — typically 62% to 77% of the appraised value — at closing.

That means you receive one big check as opposed to smaller, regular payments over time, as some of the other reverse mortgage options allow.

The Department of Housing and Urban Development will eliminate the fixed-rate Standard Home Equity Conversion Mortgage (HECM), as it's known, because the insurance program that backs these loans faces a multibillion-dollar deficit.

Why?

Too many people are defaulting.

Why Homeowners Want a Reverse Mortgage

Reason for Interest Age 62-69 Age 70+
Pay Off Debt 73% 62%
Pay for Everyday Expenses 31% 36%
Enhance Quality of Life 26% 28%
Plan Ahead for Emergencies 21% 24%
Source: Consumer Financial Protection Bureau

They're defaulting because they have no money left after taking (and spending) the lump-sum payout. When they have no money, they cannot pay taxes, insurance and for general upkeep.

Unlike traditional mortgages, in which the lender uses money in escrow to make those payments, most reverse mortgage borrowers are responsible for making the payments themselves. If they don't make these payments, their mortgage is in default.

HUD believes it can address its deficit problem by steering borrowers to a Standard variable-rate loan or into a so-called Saver loan, which can either be a fixed- or adjustable-rate reverse mortgage.

Saver loans charge far lower fees in exchange for a smaller loan, generally 10% to 18% less than the Standard mortgage.

Our guide can help you determine whether the Standard or Saver loan is right for you.

For borrowers, though, the options really remain wide open.

You can still take a lump-sum payout for the maximum amount of equity, which means you still can be at risk of default. But instead of taking out a fixed-rate loan, you'll be taking out an adjustable-rate mortgage.

Jeff Taylor, president of Wendover Consulting in Greensboro, N.C., a pioneer of the reverse mortgage industry, says Standard loans with a variable interest rate shouldn't scare off borrowers, particularly older ones.

After all, since you don't have to pay back the loan as long as you live in the home, it should be of little concern to you whether the interest rate is fixed or not, unless you want your heirs to retain some equity.

And yet the federal government is banking on borrowers taking a pass on adjustable-rate loans, or at least not taking a lump-sum payment, saying its historical loan data suggest that is the likely outcome.

The government also says it will ensure that adjustable-rate loans have "appropriate, consumer protections" to reduce reverse mortgage risks.

Reverse mortgage rules

Category Restriction
Borrower age Borrower must be at least 62.
Maximum loan 51% to 77% of the appraised home value based on age, type of loan
Mortgage insurance premium Up front: Up to 2%; ongoing: up to 1.25% of outstanding loan balance per year.
Source: Consumer Financial Protection Bureau

The Consumer Financial Protection Bureau, which was critical of reverse mortgages — and lump-sum payouts, in particular — in its 2012 report to Congress, declined to comment on the changes. The CFPB is currently seeking feedback on how consumers use reverse mortgage proceeds.

The watchdog agency found this type of loan had strayed from its original purpose, to let retirees supplement retirement income.

"It was anticipated that most, though not all, borrowers would use their loans to age in place, living in their current homes for the rest of their lives or at least until they needed skilled care," the report notes.

But, according to the CFPB, a lump-sum payout — the option chosen by three-quarters of borrowers in 2011 — puts a person "at risk of losing their home.”

There are safer options.

Saver loans are more appropriate for a senior looking to establish a line of credit they can tap to provide a monthly income stream, pay medical expenses or create an emergency fund — in line with HECM’s original intention.

Saver loans are competitive with home equity loans, and the borrower isn't required to make monthly payments, Taylor notes.

Peter H. Bell, president and CEO of the National Reverse Mortgage Lenders Association, an industry trade group, says that while most borrowers prefer fixed-rate mortgages, those loans aren't necessarily the best choice for them.

Saver loans may be a better choice for many borrowers to ensure they don't take out more money than they really need, he says.

Both Bell and Taylor say seniors who are considering a reverse mortgage should meet with a counselor to discuss what they are trying to accomplish and then decide what type of loan is appropriate for their situation. Bell says you should talk to multiple lenders and discuss all the options they offer.