Demand for reverse mortgages has begun to slacken, due largely to factors beyond the control of (potential) borrowers.

In a nutshell, housing prices remain low, as a result of the economic crisis, and FHA recently issued a new directive that cut the maximum reverse mortgage loan size. Both of these factors strike directly at the heart of reverse mortgages, because they limit the amount of cash available to borrowers. This figure is basically determined by multiplying FHA loan limits (which is expressed as a percentage, and varies by age and in accordance with prevailing interest rates) by the appraised value of one’s home. Since both home values and FHA loan limits are both lower, this translates into a smaller reverse mortgage.

For the majority of reverse mortgage borrowers, this constitutes a serious problem, since many are strapped for cash, and need to withdraw a large percentage of the equity in their home in order to make the loan work. This is especially true for borrowers that have existing liens (i.e. primary mortgages) on their homes, and intend to use the reverse mortgages to repay them.

It’s not clear how long housing prices will remain depressed. The most recent data suggests that a recovery might not be far away, but there are plenty of analysts who think that this represents a “false bottom.” In other words, housing prices could conceivably continue to fall, before ultimately exiting from the downturn. This has important implications for potential reverse mortgage borrowers, since it directly effects the amount of cash they can receive if entering into a reverse mortgage today. Instead, many such borrowers might be inclined to wait until the market recovers before considering a reverse mortgage.

The FHA directive, meanwhile, is probably more permanent. It was enacted both in response to the housing market crash and because of it’s insolvency. Apparently, the possibility of government subsides and/or higher insurance premiums had been considered, but ultimately rejected, in favor of simply lowering maximum loan amounts. As the FHA’s financial problems probably won’t abate, higher loan limits seem unlikely in the near-term.

Then again, if home prices rise, reverse mortgage “defaults” will also subside, and the FHA could contemplate returning the old loan maximums. In this case, reverse mortgage borrowers would be rewarded twice.

With last week’s passage of Assembly Bill 329, California officially became the first state to legislate changes in the reverse mortgage industry. Most other states still lack comprehensive reverse mortgage regulation, such that burden of oversight falls on the Federal Government (via the FHA).

While the law that was ultimately passed represents a watered-down version of the original bill (thanks in no small part to lobbying efforts by the National Reverse Mortgage Lenders Association), and hence doesn’t impose many new restrictions. Namely, it seeks to crack down on “cross-selling” of annuities and insurance products with reverse mortgages, and increase counseling requirements for new borrowers.

The former aim is pretty straightforward. One of the biggest criticisms of reverse mortgages is that they are often paired with annuities by lenders looking to make additional profits. However, since reverse mortgages are inherently structured to give the borrower the option of withdrawing the loan balance in an annual payment, there is little advantage of this annuity. In fact, the California law prohibits lenders from altering the annual payout due to interest rate changes, and imposes steep penalties on those who do. In this, the “annuity option” is preserved.

The counseling requirement, meanwhile, aims to redress the problem that many borrowers were being pressured into reverse mortgages without a thorough understanding of the product’s terms and mechanics. Towards this end, the California law requires lenders to furnish a list of non-profit counseling agencies, so that the borrower can complete a mandatory session prior to obtaining the mortgage. At this counseling session, a written checklist must be signed, that discusses the following topics:

(A) How unexpected medical or other events that cause the prospective borrower to move out of the home, either permanently or for more than one year, earlier than anticipated will impact the total annual loan cost of the mortgage.

(B) The extent to which the prospective borrower’s financial needs would be better met by options other than a reverse mortgage, including, but not limited to, less costly home equity lines of credit, property tax deferral programs, or governmental aid programs.

(C) Whether the prospective borrower intends to use the proceeds of the reverse mortgage to purchase an annuity or other insurance products and the consequences of doing so.

(D) The effect of repayment of the loan on nonborrowing residents of the home after all borrowers have died or permanently left the home.

(E) The prospective borrower’s ability to finance routine or catastrophic home repairs, especially if maintenance is a factor that may determine when the mortgage becomes payable.

(F) The impact that the reverse mortgage may have on the prospective borrower’s tax obligations, eligibility for government assistance programs, and the effect that losing equity in the home will have on the borrower’s estate and heirs.

(G) The ability of the borrower to finance alternative living accommodations, such as assisted living or long-term care nursing home registry, after the borrower’s equity is depleted.

I think last point is particularly important, since reverse mortgages may inadvertently deprive themselves of “outs” in their twilight years. In other words, well many elderly borrowers would like to remain in their homes for the remainder of their lives, we all know that the reality is otherwise. In other words, it’s important for seniors with reverse mortgages to set aside additional cash, as the equity in their homes dwindles to zero over the term of the mortgage.

With this post, I’d like to examine a couple aspects of reverse mortgages that receive little attention in the media, and from lenders: building code violations (and the resulting fines) and tax deductions. The latter is a plus, as it means the true cost of a reverse mortgage is actually lower than the stated cost. The former, however, is is a serious detriment, which could potentially lead to foreclosure.

Neither of these aspects is unique to reverse mortgages. The tax deductibility of mortgage interest is frequently cited by those within the industry as a great benefit, since it means your true cost of interest is lowered by your marginal tax rate. For example, if you pay 35% tax on your income, then the true amount of interest you pay on your mortgage is 35% less than the amount you pay the lender each month, with the difference “subsidized” by the government.

The same applies to reverse mortgages, although conceptually it’s a bit more complicated. That’s because reverse mortgages are often obtained by borrowers that have no intention of directly repaying them. Rather, the expectation is that the borrower’s heirs will handle the repayment after his death. Thus, it’s conceivable that no mortgage interest (or principal for that matter) is paid by the borrower, and hence no tax benefit can be realized.

Still, borrowers ought to be aware that their heirs can deduct the accrued mortgage interest when it ultimately repaid, perhaps after the house is sold. There are also complex estate planning strategies designed to maximize the benefit of the tax deduction. For example, the future heirs may wish to repay a certain amount of interest each year (prior to the loan being repaid) in order to spread the tax deductions over a longer time period of time.

Another option is to use a reverse mortgage to take out a special insurance plan, the proceeds of which will be received upon the death of the borrower. Assuming the insurance policy and reverse mortgage are congruent, this method will effectively turn an asset that would otherwise have been subject to estate taxes and make it un-taxable. Of course, these strategies are extremely complex and it’s recommended that your seek legal counsel, rather than proceed on your own.

The other side of reverse mortgages that I want to explore in this post is the consequence of not maintaining the property that has been mortgaged. Again, just like with conventional mortgages, unpaid property taxes and/or unpaid fines resulting from maintenance violations can result in foreclosure. This is a potentially serious pitfall for seniors that either didn’t have much equity in their properties to begin with, and/or spent the balance of the reverse mortgage too quickly, without setting aside enough cash for maintenance and property taxes.

Reverse mortgage lenders love to point out that there is only one contingency that can result in the property being foreclosed upon. Unfortunately, this is a very serious contingency, especially when you consider that the product is designed for borrowers with precarious financial situations. If your home declines in value and/or the balance of the loan cannot be repaid, it is HUD (via its insurance arm) that is on the hook for the difference. If you don’t keep up with your taxes, or you rack up too many building code violations, the state could put a lien on your home and force an immediate sale of the property. This could leave with very little money for you to put towards a new place to live.

The importance of this consideration cannot be overstated. Make sure that prior to taking out a reverse mortgage that you have enough funds set aside to maintain the property as before. Otherwise, it may make sense to downsize into a more affordable home.

The reverse mortgage industry has exploded over the last decade, growing to 110,000 loans and an estimated 2,700 lenders in 2009. The only way that kind of growth can transpire over such a short time period is with a massive promotional effort, especially when the product in question was considered relatively obscure only last year. Sure enough, reverse mortgage advertisements have permeated the media, and infomercials have flooded late-night TV.

Websites aimed at turning unemployed professionals into successful sellers of reverse mortgages have proliferated, with some using language typically found in “get-rich-quick schemes.” Promises one website, “You really are at the right place at the right time. Not to sound too corny or salesy but this truly is a “GOLDEN OPPORTUNITY” since so few loan officers are working with this niche or have any clue about the secrets to successfully marketing to seniors.” Another advises, “You must never, ever stop marketing. When you take a step back and think about … we really aren’t originators, are we? In reality, we are marketers of our services, and no marketing equals no business.” For anyone on the other end of this transaction, that should set off alarm bells.

For research purposes only, I have spent the last few days watching such commercials and reviewing advertisements. With only a few exceptions, I have been appalled by their inaccuracy. [For the record, I’m not trying to vilify reverse mortgage lenders and loan officers merely for the sake of doing so. I have no truck with those who present the product accurately and market it towards those whose financial circumstances would support obtaining one.]

Unfortunately, the most egregious aspect of reverse mortgage marketing is that lenders present it as a one-size-fits all product appropriate for all retirees. The advertisements often feature happy, older couples enjoying nice meals and luxurious vacations, with the implicit message that “this could be you.” In reality, the product was originally conceived to help those whose financial situations were precarious- hardly a “niche” that would be inclined to use the proceeds for expensive dinners.

For those whose financial situations are already somewhat robust, and simply want a little “play money,” consider that the lending terms of reverse mortgages are somewhat extortionate. This is my second grievance with reverse mortgage commercials: that they gloss over the fees. In reality, upfront fees are substantial, and interest rates are insidiously high, partially as a result of the “yield-spread premiums” which are paid to loan officers for doing little more than standing between you and the lender. They are able to get away with charging these fees because most borrowers don’t know about them and/or don’t understand the way reverse mortgages work. As a result of these costs, you receive only 60% of the value of your home when the loan is obtained, and in exchange, you (or your heirs) forfeit the majority of the proceeds reaped from a sale in the future. As morbid as this sounds, this is fine for those who intend/wish to die in their homes. For those that plan to downsize or move into assisted living facilities in their twilight years, a reverse  mortgage could rob you of the funds to do so. Doesn’t sound like a very reasonable trade, does it?

My final point of contention is that reverse mortgage ads ignore the risks, to the point of being misleading. Many ads draw attention to the fact that loans are government insured. While this is true, the insurance is paid by you, but all of the potential benefits inure to the lender. In other words, the insurance is necessary to protect the lender in case you default. Don’t kid yourself into thinking that it benefits you. It’s true that if you stay current on property taxes and maintenance, your loan can’t be foreclosed upon. For those who can’t stay current and/or sell their home for another reason, they may not be left with much equity (if any) after a sale.

Let this be a lesson for those of you eligible to take out a reverse mortgage. Again, that’s not to say that the product isn’t ultimately a reasonable choice for you. Just make sure you take these ads at face value. The fact that reverse mortgages are extremely profitable for lenders means you need to be vigilant.

Based on feedback from our readers, it seems few (potential) reverse mortgage borrowers are aware of the possibility of refinancing a reverse mortgage. The idea of refinancing is typically associated with conventional mortgages, and for good reason! Who would ever think to refinance a loan that they don’t have to repay directly? [Note: I’m not implying that a reverse mortgage doesn’t need to be repaid, but rather that it is often repaid by the borrower’s heirs, after the borrower passes away.]

In many situations, however, it can be extremely beneficial to refinance. The most obvious trigger would be a change in interest rates. Since the balance of a reverse mortgage continues to accumulate interest until it is repaid (as with a conventional mortgage), a lower interest rate would necessarily translate into less interest. For those with fixed rate reverse mortgages, this notion is pretty straightforward.

For those with adjustable-rate mortgages, the math is slightly more complex, and rests on certain assumptions about the direction of short-term variable rates. However, those that took out reverse mortgages many years ago probably were limited to variable-rate products, and might wish to refinance into a fixed-rate loan for peace of mind. As with a conventional mortgage, the savings from lower interest might be offset by fees associated with the refinancing. In the case of reverse mortgages, these can be significant. In other words, unless interest rates drop dramatically (by 2%+), a refinancing probably won’t be economical.

There is another goal of refinancing which is unique to reverse mortgages- increased cash payout. Don’t forget that the initial loan amount was determined largely by factors outside of one’s control: borrower’s age, home value, loan limits, interest rates, etc. In the years since you took a reverse mortgage, you have certainly aged, your house may have appreciated, federally-mandated loan limits may have risen, and/or interest rates may have fallen. All of these trends would entitle you to more cash. This is particularly relevant in the current environment, where home prices are depressed and FHA loan limits are becoming stricter. Refinance five years from now, and there is a good chance that these drawbacks have been alleviated. Not to mention that you are now five years older, which means the lender is actuarially five years closer to being repaid.

The analogy would be to a cash-out refinancing on a conventional mortgage. Again, you must make sure that the increased cash payout more than offsets the fees. One rule of thumb is that the additional cash should exceed fees by two to four times. Consider also that an increased loan size would accrue more interest and possibly erode the value of your remaining equity at an even faster pace.

The latter is an important consideration and could leave your heirs with little if any proceeds after selling your home. It would be even more dire if you were forced to move out, as you could potentially be left with little money to put towards a new home. Thus, even though counseling isn’t usually required with a refinancing, it would probably be beneficial to meet with a professional and be reminded one more time about the potential downsides.

Much is being made of a report just released by National Consumer Law Center (NCLC), entitle “Subprime Revisited: How the Rise of the Reverse Mortgage Lending Industry Puts Older Homeowners at Risk.” Analysts and industry-watchers have homed in specifically on the explicit comparison between reverse mortgages and subprime mortgages.

While the mechanics of the two mortgage products are quite different, there is a tremendous overlap in their essence, and hence the way in which they are being promoted. For example, both subprime mortgages and reverse mortgages are designed to appeal to a class of potential borrowers whose respective financial situations are especially precarious. For many of these borrowers, they are in desperate need of financing, and simply have nowhere else to turn.

Perhaps the most poignant similarity is the way in which the two mortgage products are being marketed. TV commercials are pitching reverse mortgages as some kind of government entitlement program, the proceeds of which can be used to pay for anything, from a sailboat to medical bills. Argues the NCLC, in its report:

Many of the same players that fueled the subprime mortgage boom — ultimately with disastrous consequences—have turned their attention to the reverse market. Lenders, including some of the nation’s largest banks, view that market as a source of profits that have dried up elsewhere. Mortgage brokers see it as a new source of rich fees. Predators who once reaped profits from exotic loans have now focused on wresting more wealth from vulnerable seniors. And securitization, which allowed subprime loan originators to disassociate themselves from the downside risks of abusive lending, is becoming commonplace in the reverse mortgage industry.

In addition, the same perverse incentives (i.e. lack of consequences) that characterized subprime origination is also present in the origination of reverse mortgages. The main difference is that the “victims” in the subprime crisis were the investors foolish enough to underwrite the mortgages. (Of course, some borrowers suffered as well, but many were no worse off than before taking out a subprime mortgage).

Reverse mortgages, in contrast, can potentially victimize the borrower directly, and American taxpayers indirectly. While defenders of reverse mortgages rightfully tout their benefits, the truth is that the product doesn’t make financial sense for the average borrower, since it trades cash for equity at an unfair exchange rate. Certainly, many retirees are grateful to receive seemingly “free” cash while still retaining the right to residency, but many others are shocked when 15 years later, most of the equity in their home has already been depleted. At which point, they basically become hostages (in the words of one columnist) in their home, since moving out would leave them with little proceeds and with no place to live.

The government, meanwhile, bears ultimate responsibility, due to the insurance that it underwrites on 90% of reverse mortgages. The FHA – the agency which manages this process – has seen its reserves fall to the lowest level in 75 years, and analysts are now talking about a bailout in the same manner as Fannie Mae and Freddie Mac, which we all know lost billions guaranteeing subprime and other junk mortgages.

In short, while the analogy isn’t perfect, it’s still apt. Summarized U.S. Senator Claire McCaskill, who is leading the calls for reform, has pointed that 10,000 new borrowers become eligible for reverse mortgages every day (by virtue of reaching the required age of 62), and that as much as $4 Trillion in untapped equity remains “trapped” in their homes. “We’ve seen this movie before, and it didn’t have a pretty ending. Abuses in the subprime lending market almost brought down our economy. Now we’re seeing similar abuses with reverse mortgage lending. Something needs to be done before more life savings are depleted and more tax dollars are drained.”

Those in the process of applying for conventional mortgages couldn’t have picked a better time; housing prices are low, and interest rates are lower. The same, however, cannot be said for reverse mortgage borrowers, who benefit from low interest rates, but not from low housing prices.

The main factor in determining the maximum reverse mortgage for a given borrower is the quality of his collateral (i.e. the house being mortgaged). Further, the value of the house is determined via an appraisal, which is non-negotiable, and afterward, a percentage is applied, based on the borrower’s age and prevailing interest rates, and the size of the mortgage is computed.

In other words, the appraisal is arguably the most important step in the reverse mortgage application process. Significant changes to the way that appraisals are conducted, however, have resulted in lower appraisals. In the wake of the housing crisis, legislation was enacted, seeking to limit pressure on appraisers to confirm overstated home values. The new system hands the reins to the lenders, which are in charge of appointing appraisers and signing off on their work. Moreover, lenders have a vested interest in keeping appraisals low (especially after the housing bubble burst), and anecdotal reports suggest that this has become the norm.

Tough luck for potential reverse mortgagers, most of whom seek to borrow the maximum allowable amounts. Their situations arn’t helped by the housing market, which remains weak, and is projected to remain weak for the foreseeable future. A reasonable option, then, is to simply wait until the housing market improves. After which point, many borrowers will presumably be entitled to larger loans, due both to home-price appreciation and having aged by a few years. The downside is that interest rates could increase, making the loan relatively more costly.

Of course, reverse mortgages are designed to appeal to those whose financial situations are somewhat dire, so many applicants might not have the luxury of being able to wait. For this category of borrowers, you can always refinance (though incurring more fees in the process). In addition, you can still reap the benefit of home-price appreciation- not in the form of a larger loan, but in a greater equity position, the gains from which which will be realized when the home is sold and the mortgage is repaid.

The FHA, which insures most reverse mortgages and is generally regarded as the industry watchdog, has responded to this issue in contradictory ways. On the one hand, its new Reverse Mortgage for Purchase loan (the subject of my last post) is calculated from the appraised value of the home, even if it’s higher than the sale value. On the other hand, it recently moved to curtail loan amounts by 10% on conventional reverse mortgages, due to concerns of depressed housing prices and a consequent increase in defaults. Given the FHA’s increasingly precarious financial position, unfortunately, it seems the latter approach is set to become the norm.

I set out to write today’s post about a clever idea that I had recently conceived: using a reverse mortgage to purchase a home. While reverse mortgages are conventionally used as a last resort by homeowners that want to stay in their respective current homes but lack the means to do so, I figured that such could also be theoretically be used to purchase a new home by retirees that likewise lacked the means to do so.

Alas, a little bit of research revealed that I was not the first to think of such a clever idea. In fact, it turns out borrowers have been utilizing reverse mortgages in this way for over 10 years. Originally, the product of choice was the Fannie Mae Home Keeper for Home Purchase program, which provides modest loans for borrowers that can’t afford an all-cash transaction but want to to avoid the monthly payments associated with a conventional mortgage.

On January 1, 2009, this product became irrelevant, as HUD officially began underwriting Home Equity Conversion Mortgage (HECM) for Purchase loans. Made possible by legislation associated with the economic stimulus, this program exists for the sole purpose of enabling borrowers to fund the purchase of a home using a reverse mortgage. Since I haven’t heard/read otherwise, I’m assuming that the same loan limits apply to this product as apply to vanilla HECMs ($625,500).

There are a couple of special features/limitations, however, that distinguish this from a normal reverse mortgage. First of all, the down-payment for the home must be funded completely with cash. Credit card debt, bridge loans, gifts from relatives (bank accounts are to be scrutinized), and of course the reverse mortgage itself, are all forbidden to be sourced. Second, the size of the reverse mortgage is determined based on the appraised value – not the purchase price – of the home. In this way, borrowers receive a “reward” for purchasing undervalued homes.

Next, there is a provision that prevents borrowers from having to pay a second mortgage insurance premium, if they already have a reverse mortgage outstanding. The rules require the borrower only to pay the difference (if any) between the old and new premiums. Finally, there is an anti-flipping stipulation, which essentially aims to prevent the product from being used for fraudulent or speculative purposes, by auditing mortgages on homes that were sold within 180 days from the previous sale.

On the surface, the HECM for Purchase loan is a great way for retirees to buy a new home at a fraction of the cost, without assuming any new debt. Of course, there’s no such thing as a free lunch, and the program is not without its drawbacks. High upfront costs and comparatively high interest rates limit the prinicipal size and erode one’s equity. In effect, reverse mortgaging a new home is tantamount to renting it. Non-refundable fees/costs are akin to rental payments, and it’s impossible to build equity, since any home-price appreciation will probably be offset by the payment of compound interest. Still, for those that have their eyes set on owning a home – even in their twilight years – the program represents a viable way to do it.

A quiet, but important change in reverse mortgages goes into effect today. In one foul swoop, the Federal Department of Housing and Urban Development (HUD) slashed principal limits on all reverse mortgages by more than 10% in some cases. In other words, the total amount that you can borrow using a reverse mortgage (home equity conversion loan) is now 10% less than it was yesterday.

It’s unclear exactly what motivated the change. Government officials and policymakers have long been mulling changes to the regulatory structure of reverse mortgages, due to claims of abuse and concerns that they aren’t appropriate for certain borrowers. This particular change may also have stemmed from fears that if housing prices decline further, many reverse mortgages could soon go underwater, leaving HUD (and taxpayers, indirectly) on the hook for Billions of Dollars.

Naturally, industry insiders are furious. How dare you deprive seniors of their deserved cash, they argue. Of course, it’s not the sense of mortgage injustice that bothers them so much as the potential affect on business. It turns out that an overwhelming majority of reverse mortgage borrowers have existing liens (i.e. primary mortgages) on their home, and use a large portion of the proceeds from the reverse mortgage to retire these liens. Research also shows that most of these borrowers remain unwilling to divert cash from other sources (i.e. savings accounts), which means the HUD-mandated principal decline could ultimately dissuade them from taking out a reverse mortgage. It doesn’t help that many reverse mortgage borrowers have particular tenuous financial situations, such that after this kind of change, a reverse mortgage simply wouldn’t be viable.

The precise principal limits can be found in this table, recently released by HUD. Based on the age of the borrower and interest rate offered under the reverse mortgage. it computes a percentage of the value of the collateral (one’s home) which can be tapped into. A borrower over the age of 98 with an interest rate under 5.5% can withdraw 81% of the value of their home, while a borrower aged 62 paying an interest rate of 19% would be eligible to withdraw a paltry 5% Hardly worth it in that case.

The calculations are based on certain actuarial assumptions regarding life expectancy and house price appreciation, and represent the maximum borrowing amount as stipulated by HUD. For potential borrowers who just can’t make a reverse mortgage work for them under the current limits, the recommended course of action is to wait for housing prices to rise again, continue to pay down your mortgage and/or simply wait until you’re older. Based on the table, you can see that every additional year you wait, you will be entitled to an additional .7% of the value of your home. For a $250,000 a home, that’s an additional $1,750 just for waiting a year! Not bad.