The biggest up-front expense when taking out a reverse mortgage is typically the 2% FHA insurance premium. [If not, there is a possibility that you are being ripped off by your broker- but that’s another story]. Many mortgagers don’t realize that an annual insurance premium of .5% of the mortgage balance must be paid every year until the reverse mortgage must be repaid.

So what purpose is actually served by this insurance premium? I thought the whole concept behind a (reverse) mortgage is that the lender makes the loan with the tacit understanding that there is a risk of default. In the case of reverse mortgages, this turns out to not be the case. Basically, the reverse mortgage insurance protects the lender in the event of default. With a reverse mortgage, this would imply that the value of the home exceeded the balance of the mortgage when it came time to be repaid. Thanks to the insurance, it is the FHA (and potentially taxpayers, if you read my last post) that is on the hook for the difference. In this way, the broker that originated your mortgage bears zero risk. That’s something to think about when he’s pushing you fervently into obtaining one.

Brokers and industry insiders insist that reverse mortgage insurance is ultimately designed to protect you, the borrower. They will try to convince you that if not for the insurance, you could be on the hook for the difference, in the event of default. Theoretically, they are right. In practice, however, many states have laws that prevent lenders from seeking so-called deficiency judgements, which apply to cases of mortgage default involving borrowers that owe more than their homes are worth.

They will also argue that the insurance protects you in case of lender bankruptcy, in which case the title of the home could technically revert back to the bank, such that it would be sold to pay off creditors. Again, this is extremely unlikely in practice, primarily because the reverse mortgage contract guarantees you the right to remain in your home until death, if you desire to do so. In addition, lender bankruptcies are very different from bankruptcies of normal businesses, since the majority of lender bankruptcies end in a sale to a new lender, rather than a court-ordered sale of assets. Given also that reverse mortgages are increasingly being packaged and sold to investors, the possibility of lender/originator bankruptcy is becoming increasingly irrelevant.

In short, it seems self-evident that the insurance premium is designed to protect the lender first and foremost. If it was actually designed to protect homeowners, it would be seen as option, rather than mandatory. That’s not to say that it doesn’t serve a necessary function, but it’s still important to see if for what it is, and to make clear your understanding to your broker.