A Red Flag on Reverse Mortgages

It is the saddest of paradoxes: a government-backed financial maneuver intended to free up extra money for struggling older people turns out to have left some widows and widowers on the brink of foreclosure.

This week, AARP sued the Housing and Urban Development Department over a handful of reverse mortgages gone awry. Lenders, following the letter of one of HUD’s rules, are requiring newly widowed people who want to stay in their homes to pay off the balance of their loans quickly, even if it is much more than the value of the home. Because they can’t (or won’t), the lenders are foreclosing.

This is happening only to a small number of people who did not have their names on the reverse mortgage for a variety of reasons. Some spouses did not put their names on the applications in order to qualify for a bigger loan, without necessarily realizing that they were putting themselves in jeopardy.

Reverse mortgages were not supposed to work like this. Instead, the big idea was to let people who were cash-poor but relatively rich in home equity draw on some (but not all) of that stored value. They’d get a lump sum, a line of credit or a monthly check for either a fixed period or for as long as they stayed in the home. And nearly everyone thought the rules were clear: homeowners or their heirs would never, even decades later, owe a cent beyond the value of the property.

The fact that it hasn’t turned out that way for some people is yet another warning sign on a financial product that has the potential to help those who have no other money to draw on in their old age. Reverse mortgages, after all, have historically been marked by high fees. Charlatans looking to extract people’s home equity and put that money into high-fee annuities and other questionable financial products sometimes used reverse mortgages to do it.

So if you’re even remotely considering a reverse mortgage or have a parent or friend who is, this is something else that can go horribly wrong if you’re not paying close attention during the application process.

But first, a review session. (And a disclaimer: This should be only the first of many stops in your reverse mortgage research efforts. I’ve linked to a couple of our best articles on the topic in the online version of this column. You should also check out AARP’s “Borrowing Against Your Home” guide, which HUD actually links to from its reverse mortgage information home page.)

In a regular mortgage, you pay the bank. With a reverse mortgage, which you can get only if you are 62 or above, the bank pays you, drawing on the equity you already have in your home. It’s different from a home equity loan in two crucial ways: You don’t have to make payments on a reverse mortgage as you do with a home equity loan, and there’s no credit check involved with a reverse mortgage.

As you can imagine, you need to have a fair bit of equity in your home to even qualify for a reverse mortgage. The amount of money you can get from the loan depends on that equity, along with the prevailing interest rates and your age. Lenders do their underwriting in part based on how long they think you’ll be in the house. The younger you are, the less money you’ll get because you’re likely to stay a while before paying back the loan. (There is more on how repayment works below.)

The mortgage amount also depends on whether you choose a fixed or variable rate loan and whether you take a lump sum, a line of credit or a periodic payment. That payment can be a set amount for a limited number of years or more like an annuity, the same monthly amount for all remaining years that you (or your spouse who is on the mortgage) stay in the home. Lenders often charge origination fees, and you have to pay mortgage insurance. All of this can cost a lot more than a regular mortgage, though as with standard mortgages, you can roll all the costs into the loan instead of paying them out of your own pocket upfront.

It is possible to qualify for a reverse mortgage if you still have a regular mortgage outstanding on your home, but you have to use the proceeds of the reverse mortgage to pay off any existing home loans. To run the numbers for your own situation, try the reverse mortgage calculator on the National Reverse Mortgage Lenders Association’s Web site.

Because this is a loan, the bank does eventually get its money back, with interest. Every dollar you take out gets subtracted from the available equity that the loan allows you to draw on, and the bank keeps a running tab of the interest on the money you draw down, too. Once you (or your spouse, assuming you’re both on the loan) move out, whether because you’ve downsized, moved permanently to a second residence or nursing home or died, you or your heirs sell the home and the bank uses the proceeds to pay off the loan. You or your heirs keep any money that’s left.

HUD sets the rules for these loans and insures them as well. For years, most borrowers and lenders read HUD’s rules to mean that a borrower or the heirs would never owe more than the loan balance or the value of the property, whichever was less. This is all well and good for couples who are both on the mortgage. Even if one of them dies, the other can stay in the home and keep drawing on any remaining money from the reverse mortgage until he or she no longer lives there.

But in 2008, HUD, worried about falling housing prices, issued what it called a clarification, though AARP argued it was a rule change. The upshot of HUD’s notice is that the home is subject to foreclosure upon the death of the borrower if the estate or heir (say a spouse who was not on the original reverse mortgage) wants to keep the home but is unable to pay off the balance. The heir would have to pay that amount, no matter what the home was worth.

Here’s the practical result of all this: Let’s say a widowed spouse who wasn’t a party to the reverse mortgage loan inherited the home. She could sell it without having to pay the lender anything more than the prevailing market price (or a even little less) as long as she followed a few simple rules.

But if she wanted to stay in the home, the HUD rule would force her to pay off the entire original balance fairly quickly, even if it was for way more than what the home was actually worth because of declining home values.

And why might a spouse not be on the reverse mortgage loan? If her husband is 64 and she is under 62, she wouldn’t be eligible. Or one spouse may have owned the home and taken out the reverse mortgage before the marriage.

A more likely possibility, however, and one that comes up in the AARP lawsuit, is that lenders encouraged younger halves of a couple not to put their names on the mortgage. Why? Well, when the older half of the couple applies alone, he or she qualifies for more money.But a 401(k) also requires steady, significant savings. And unlike corporate pension plans, which are guaranteed by the U.S. government, 401(k) plans have no such backstop.

As complicated as this particular legal dustup appears, there is a simple moral. If you’re a couple with plans to take out a reverse mortgage — and it really ought to be a last resort, only for those who can’t make ends meet any other way — both of you ought to be on the reverse mortgage so you don’t end up in this predicament.

HUD requires anyone who is applying for a reverse mortgage to talk to a counselor. I’d urge you to pay to talk to two, preferably two who work for different organizations. Lyn R. Link, a former reverse mortgage lender and the proprietor of reversemortgagecritic.com, suggested consulting an elder law attorney with reverse mortgage experience if you can find such a person.

This may all seem a bit extreme. But my guess is that we’ll see a lot more people (or those who are lucky enough to have any home equity, at least) turning to these products in the next couple of decades if HUD doesn’t tighten its rules too much more.

By the time people need to tap their home equity in this way, it will probably be the biggest asset by far that they have left. At that point, it’s simply not possible to be too careful.

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