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20 Questions about Reverse Mortgages [CPA Journal, The](CPA Journal, The Via Acquire Media NewsEdge) What CPAs Need to Know The reverse mortgage is becoming a popular financial planning tool, especially for retired individuals with limited savings. This article answers common questions about reverse-mortgage transactions that CPAs might encounter when helping homeowners make important financial planning decisions. Furthermore, it considers the new rules for reverse mortgages, which take effect in 2013 and 2014. What Is a Reverse Mortgage? A reverse mortgage is a loan where the homeowner (borrower) uses the home's equity as collateral. The loan usually does not have to be repaid until the last surviving homeowner moves out of the property or passes away. In other words, a reverse mortgage is similar to a home-equity loan. (The Exhibit illustrates a timeline of the reverse mortgage lifecycle.) How Popular Are Reverse Mortgages? The federal government insures approximately 70,000 reverse mortgages each year. Originations peaked in 2009 with 115,000 transactions. In total, 740,000 reverse mortgages have been written, with approximately 580,000 still outstanding. But to put this in context, only 2%-3% of eligible homeowners have a reverse mortgage. Given the low U.S. savings rate and a stagnant economy, which have resulted in a lack of retirement savings for many, this market has the potential to grow. As a result, homeowners without other options will increasingly ask CPAs for help navigating the risks and benefits of these financial products. What Is the Government's Role? The only reverse mortgage insured by the U.S. federal government is called a home equity conversion mortgage (HECM), and it is the only product available through a lender approved by the Federal Housing Administration (FHA). The mortgage insurance premium (MIP) protects the government, lender, and homeowner; however, homeowners pay the insurance policy premiums. If the lender goes into bankruptcy, homeowners still receive their annuity from the insurance policy. HECMs, which represent 90% of the market, are the least expensive reverse mortgages. There is one caveat: an HECM must be a first mortgage. What Are the Eligibility Criteria? A homeowner must meet the following criteria to receive a reverse mortgage: * The homeowner must be at least 62 years old. * The home must be the homeowners' primary residence; they cannot vacate the property for more than 12 months. * The home must meet minimum FHA property standards. * Any mortgages or liens on the home must be paid with the reverse mortgage proceeds so that the home is owned free and clear. * The homeowner must receive reverse mortgage counseling from an independent third-party advisor. * The homeowner must not be excluded from participation in FHA programs, and cannot have delinquencies on any federal debt nor any suspensions or debarments. * Starting in 2014, there will also be a credit check and income verification of the borrower (homeowner). Reverse-mortgage properties are also subject to eligibility criteria and FHA approval. Generally, the property types eligible for a reverse mortgage are single-family homes, twoto four-unit properties (if owner occupied), condominiums, townhomes, and some types of manufactured homes. What Costs Are Associated with an HECM? Costs associated with a reverse mortgage include third-party fees, such as appraisal, inspection, survey, and lender's title policy fees. These costs can be significant; the larger the loan, the easier they are to justify. FHA upfront MIPs could equal 2.5% of the property's appraised value if the homeowner borrows more than 60% of the property's value. If the borrowing is 60% or less of the property value, the upfront fee is 0.5%. The FHA annual MIP is 1.25% of the annual loan balance. In addition, servicing fees are charged for managing the loan; these range from $30 to $35 per month. There are also loan origination fees, points, and interest expense. Which Costs Are Charged at Closing or Added to the Settlement? With a reverse mortgage, homeowners have practically no out-of-pocket expenses. Transaction fees, such as appraisal, inspection, title policy, as well as the FHA upfront MIP, are deducted from the proceeds as closing costs at the inception of the reverse mortgage. Periodic fees, such as the FHA annual MIP and servicing fees, are accumulated and added to the debt and interest at the end of the reverse mortgage, when the borrower or estate must settle the liability. How Much Can an Individual Borrow? Government-imposed lending limits determined by the FHA put a $625,500 ceiling on reverse mortgages. The amount that the homeowner can borrow generally depends upon a formula that considers the following four factors: * The homeowners' age (older is better) * Current interest rates (lower is better) * The appraised value of the home (higher is better) * The homeowners' equity in the property (higher is better). Which Types of Distributions Are Available? Hiere are several ways that a borrower can receive distributions from a reverse mortgage. First, a borrower can receive a lump-sum loan, with a single sum of cash received at the reverse mortgage closing. Second, there is a line-of-credit loan, with withdrawals available at any time until the line of credit is completely exhausted. Under the new rules in 2014, lump-sum distributions and credit lines will be discouraged and limited. From a long-term perspective, tenure loans offer equal monthly payments, as long as the homeowner lives in the home. Term loans are also available, with equal monthly payments for a fixed number of years. Under the new mies in 2014, term and tenure loans will be encouraged, so that the reverse mortgage can be used by homeowners as a long-term financial planning tool. What Are the Alternatives? Alternatives to reverse mortgages include home-equity loans or second mortg3ges. Generally home equity loans/home equity lines of credit (HELOC) or second mortgages have restrictive requirements for a homeowner's income and credit score. In addition, with traditional loans, the homeowner must make monthly payments to repay the loans. A reverse mortgage usually does not have strict requirements for creditworthiness, and rather than making monthly payments, the homeowner receives cash from the reverse mortgage. Hie homeowner could also consider a saleleaseback of the home to achieve some of the same goals as a reverse mortgage, such as remaining in the house. If the owners are willing to move, then selling and downsizing is another option. What Are the Interest Rate Options? There are two interest rate options on a reverse mortgage: a fixed-rate option or an adjustable-rate mortgage (ARM) option. The fixed-rate programs are specific to each lender and are not indexed to a published interest rate. To determine the currently available fixedrate options, a prospective reverse mortgage lender is required to calculate a good-faith estimate. ARMs have interest rates that increase or decrease as a market interest rate index changes. The indexes employed today are the one-year U.S. Constant Maturity Treasury (CMT) rate or the London InterBank Offered Rate (Libor). Libor is a popular alternative to the CMT for some financial institutions, due to its international recognition as an index rate. Starting in 2013, the HECM fixed-rate option is only available to borrowers who take an upfront lump-sum loan. The longterm income and line-of-credit loans that are currently insured by the U.S. government are all adjustable-rate loans. How Are Adjustable Interest Rates Calculated? Interest rates are adjusted periodically to bring the reverse mortgage rate in line with market rates. The total interest rate is calculated by adding an interest rate index, plus a margin determined by the lender (interest rate = index + margin). For example, an HECM CMT 300 ARM refers to an adjustable-rate reverse mortgage product that employs the CMT index, plus a margin of 3.00%. If the CMT index is 1.25%, then the total interest rate is 4.25% (1.25% + 3.00%) until the index changes. ARMs are usually reset every year, but different lenders have different policies (e.g., introductory rates that are reset at a later date, capped rates, capped adjustments, and various reset time periods). Can the Mortgagee Lose the Real Estate? Yes, a homeowner can lose the real estate behind a reverse mortgage. According to the FHA, default rates on reverse mortgages due to taxes and insurance range from 6% to 14%. Fixed-rate, lump-sum borrowers default at higher rates (10% to 14%), than ARM annuity borrowers (6% to 10%). Clearly, the lump-sum upfront transaction carries more risk than the long-term annuity. As well as living in the home, homeowners must pay the following four expenses or lose the property: * Real estate taxes * Homeowners' and hazard insurance, such as flood insurance * Property maintenance * Homeowners' association (HOA) fees. What Are the Benefits? There are some substantial advantages of a reverse mortgage when used as a longterm financial planning tool. For example, homeowners can convert home equity into cash while remaining in the house, assuming that they can cover the taxes, insurance, and maintenance costs. In addition, homeowners can increase monthly income through an annuity and can possibly increase cash reserves in a retirement account. Finally, a reverse mortgage income and credit check is less rigorous than for a home-equity loan. What Are the Risks? A reverse mortgage is not a transaction without risk. Many times, the home- owner/borrower is in need of cash and going into debt at an advanced age; therefore, the estate will probably sell the home in order to satisfy the liability. As a result, the heirs will probably not inherit the home. In addition, inflation presents a risk. If prices rise rapidly, the annuity might not cover the borrower's living expenses (e.g., property taxes, insurance, and maintenance costs); this could result in the homeowner losing the property. Who Is Liable if a Sale by the Estate Cannot Cover the Debt? When the last surviving homeowner passes away, the estate has six months to repay the balance of the reverse mortgage. This includes debt, interest, servicing fees, and annual insurance. The estate can also sell the home to pay off the reverse mortgage balance. Any remaining equity is inherited by the estate. The estate is not liable if the home sells for less than the balance owed on the reverse mortgage-the MIP required by the FHA covers the remaining liability. Can a Surviving Spouse Stay in the Home? Yes-if the owner passes away and the surviving spouse is listed as an owner on tiie reverse mortgage. But any dependents must leave the home at the end of the reverse mortgage period if the borrower cannot pay off the loan balance. Who Is a Good Candidate for a Reverse Mortgage? If the following attributes are present, a homeowner might want to consider a reverse mortgage: * The homeowner is in need of an annuity during retirement. * The homeowner is older and has a significant amount of equity in the home. * The homeowner has no dependents or tiie dependents do not need the house. * The homeowner is in danger of losing tiie home due to expenses such as insurance, taxes, and maintenance costs. * The homeowner is a healthy person who can live in the house for a long time. * Inflation is not expected. * Interest rates are low. * The homeowner wants to maintain a higher balance in a retirement account. * The homeowner wants to stay in the home. What Are the Related Income Tax Issues? The payments that the homeowner receives during the course of the mortgage are not considered income because they represent proceeds from borrowing. Interest is deductible when paid. In the case of reverse mortgages, this is when the mortgage is complete and the repayment of the loan is made to the lender, generally when the homeowner no longer occupies the home. But homeowners can still deduct their property taxes if they are not alternative minimum tax (AMT) taxpayers. If the loan proceeds are used to buy, build, or substantially improve the home, the deductibility of interest on reverse mortgages is subject to the same limitations as interest paid on regular mortgages. Interest is deductible for loans related to acquisition indebtedness up to $1 million for married filing joint taxpayers and $500,000 for a single taxpayer or married filing separately taxpayers. If the loan proceeds are not used to buy, build, or substantially improve the home, the deductibility of interest on reverse mortgages is subject to the same limitations as interest paid on home-equity loans. Homeequity interest is limited to the interest on the portion of the loan that does not exceed $100,000 for taxpayers who are married filing jointly or $50,000 for single taxpayers. For taxpayers subject to the AMT, however, reverse mortgage interest is not deductible and would result in a positive adjustment to AMT income. Interest deductibility is a complex topic; a complete explanation of this issue can be found in 1RS Publication 936, "Home Mortgage Interest Deduction" (http://www.irs.gov/ pub/irs-pdf/p93 6.pdf). Capital gains rules for primary residences also apply to reverse mortgage property. After the house is sold to pay the reverse mortgage, the capital gain is subject to the $250,000 capital gain exclusion for single filers ($500,000 for married taxpayers filing jointly). What Are the Related Estate Tax Issues? Once the homeowners are deceased, the home-along with the reverse mortgage and related interest and fees-will be transferred to the estate. When calculating the taxable estate, the amount used to pay the reverse mortgage will be treated as a deduction on the estate tax return. The amount paid for interest on the mortgage would be subject to the limitations discussed above. If the heirs would like to keep the house, a reverse mortgage can be problematic, because the estate would have to contain enough other assets to settle the reverse mortgage upon death of the homeowner. What Are Sources of Additional Information? The following websites provide additional material on reverse mortgages: * National Reverse Mortgage Lenders Association (http://www.reversemortgage.org) * U.S. Department of Housing and Urban Development (http://wwwbud.gov) * American Association of Retired Persons (http://www.aarp.org) * National Association of Realtors (http://www.realtor.org) * AICPA (http://www.aicpa.org) ? The payments that the homeowner receives during the course of the mortgage are not considered income because they represent proceeds from borrowing. Thomas Tribunella, PhD, CPA, is a professor of accounting in the school of business at the State University of New York at Oswego. Heidi Tribunella, CPA, is a clinical associate professor of accounting in the Simon School of Business Administration at the University of Rochester, Rochester, N.Y. (c) 2014 New York State Society of Certified Public Accountants |