Reverse Mortgages: What They Are, and Why Boards Should Allow Them

A reverse mortgage is a type of loan available to people at least 62 years old. It's a way of converting their home equity into cash payments while letting them retain their property, live there and avoid monthly mortgage payments. Loan repayment is deferred until the borrower no longer lives in the home.

In a typical mortgage, a homeowner pays a monthly, amortized amount and, after each payment, has more equity in the house. In a reverse mortgage, the homeowner pays nothing each month, and all interest on the debt is added to the lien on the property. If the owner receives monthly payments, then the debt increases each month.

The loan ends when the homeowner dies, sells the home, or moves out for 12 consecutive months, such as to enter an assisted-living facility. At that point, the reverse mortgage has to be satisfied. If the proceeds exceed the loan amount, the homeowner or, if he or she is dead, the heirs receive the difference. If the proceeds aren't enough to pay the debt, the bank (or insurance that the bank has on the loan) makes up the difference.

Obtaining

To qualify for a reverse mortgage, the borrower must be at least 62 and pay off any existing mortgage(s) with the proceeds from the reverse mortgage. There are no minimum income or credit requirements, and generally the money can be used for any purpose. Before borrowing, applicants must seek Department of Housing and Urban Development-approved counseling as a free safeguard to help ensure they fully understand reverse mortgages.

The amount of money that a homeowner can receive depends on one's age, the home's appraised value, and the starting interest rate. A borrower can be paid in a lump sum; monthly; through an increasing line of credit; or by a combination of all three.

The money received — considered loan advances — is not taxable and does not affect Social Security or Medicare benefits. There are some accounting and public-benefit eligibility issues if the homeowner receives Medicaid, Supplemental Security Income or other such benefits.

Negative Aspects

On the downside, the cost of a reverse mortgage from a private-sector lender exceeds the costs of other types of mortgages. Usually, there is an insurance premium of two percent of the loan, and a two percent origination fee in addition to normal closing costs. Thus, a $200,000 loan would have $8,000 in extra costs. In addition, a monthly service charge is usually added to the total amount.

A borrower may encounter financial hazards in taking out a reverse mortgage. First, reverse mortgages are very expensive while promising an uncertain amount of benefits. For example, a typical reverse mortgage may provide to a consumer with a $300-per-month payment with a monthly compounded interest rate of one percent. Over the course of ten years, the borrower will receive $36,000, but by that time he or she will owe almost $70,000 – almost twice as much as he or she has received. In addition, reverse mortgages have complex contract terms that are confusing and can greatly affect the overall cost of a reverse mortgage to the borrower.

Alternative

Seniors may want to consider other options to tap their home equity, particularly if they do not think they will remain in the home for at least five years : for example, a home equity line of credit requiring interest-only payments for 10 years. These loans typically have low or no upfront costs, but, unlike a reverse mortgage, the borrower must make monthly interest-only payments. These can be made for several years by drawing on the line of credit itself. Of course, the balance needs to be paid off when the house is sold or the owner dies – just as with a reverse mortgage.

Whichever route a senior might choose, the apartment corporation faces no risk. In fact, as a result of the borrower not being required to make a debt service payment until he/she sells the apartment, it actually is less risky to the corporation than a traditional loan. The co-op retains its first lien on the shares and proprietary lease, so if a default occurs in the payment of maintenance or performing any lease obligations, the shareholder or the lender must cure the default or lose its collateral for the loan. The lender has the same lien on the shares and lease as in any other loan product.

The advantage to you is that this enables the seniors to meet their financial obligations to the corporation. As well, it reduces the likelihood that seniors will be forced to sell their apartments because they can no longer afford them.

Stuart Saft is a partner at Dewey & LeBoeuf.

 Adapted from Habitat December 2006. For the complete article and more,  join our Archive >>