Ignorance of how reverse mortgages work can hurt you—big time. I’ve written twice on this subject, once to point out that purchasing a true annuity may be preferable to something called “tenure payments” [“Reverse Mortgage Annuity,” Nov. 2009], and again to point out the powerful but little-understood benefits of a line of credit under the FHA-insured Home Equity Conversion Mortgage program (HECM) [“Reverse Wrinkle,” Aug. 2010].
Consider the case of brother and sister Arne and Julia. Emigrating from Denmark 50 years ago, neither married. They lived together in a house they owned as tenants-in-common in Solvang, the touristy little Danish community in Santa Barbara County.
Four years ago, Arne, then 86, and Julia, then 79, took out a reverse mortgage to pay off their existing mortgage of $106,000. They also elected to receive “tenure payments” of $2,000 per month for life, provided they remained in the home.
At the outset of the reverse mortgage, they were credited with an original “principal limit” of $424,925, based upon their ages and the home’s appraised value of $600,000. Their prior mortgage was then paid off, and they began receiving monthly payments of $2,000, which have continued to the present.
Julia died six months ago. At his advanced age, Arne wasn’t doing well at home and decided he should move into a retirement home, costing $3,200 per month. Because this exceeded his combined Social Security and tenure payments, he concluded he should sell the home.
Enter real estate agent Ron. Either Ron didn’t understand how HECMs work, which is inexcusable for any real estate professional working with elderly sellers, or he understood but didn’t tell Arne, which, in my opinion, would amount to elder financial abuse. Ron found a buyer for the home, now in poor condition, at $380,000, and urged Arne to accept the offer. Had Arne done so, after paying off the reverse mortgage and costs of sale including the real estate commission, Arne would have netted $120,000.
A simple review of the lender’s monthly mortgage statement reveals what a bad deal this was for Arne. The latest statement showed that Arne and Julia’s original principal limit had grown from $424,925 to $469,250. Charged against that limit, the total of the original mortgage payoff, the closing costs and tenure payments, plus monthly interest, brought the current outstanding loan balance to $221,250. This meant that Arne had $248,000 remaining principal limit available to borrow.
But wait a minute—hadn’t Arne elected lifetime tenure payments of $2,000 per month? Yes, but an HECM borrower can elect at any time to “recalculate” his or her benefits. By simply requesting recalculation in writing, Arne is entitled to withdraw the full remaining principal limit of $248,000, increasing the outstanding loan balance to $469,250. More on this in a minute.
But wait another minute—how can Arne increase the loan balance to $469,250 when his house is now apparently worth only $380,000? Can’t the lender refuse to allow the loan balance to exceed the equity? No! No! A thousand times no!
The HECM loan is insured by the Federal Housing Administration, which covers the lender to the extent the latter cannot recover the full loan balance from the borrower. Arne and Julia paid for that insurance at the outset, and a portion of the monthly interest charges also went to cover the cost of this insurance. If the loan balance exceeds the equity, the reverse mortgage borrower is free to walk away from the home by offering a deed in lieu of foreclosure to the lender. The lender has no recourse to the borrower or to the borrower’s heirs for any deficiency.
How about that increase in the principal limit I mentioned? What is perhaps least well understood about the HECM is that, while interest at a variable rate is being charged against the outstanding loan balance, the unused principal limit is being credited with interest at that same rate. This makes the HECM a powerful financial tool for a borrower who’s willing to restrain the advances taken to the minimum necessary to maintain one’s lifestyle. In effect, it’s a federally insured savings account earning interest at a variable rate that’s likely to remain much higher than that available from an FDIC-insured bank savings account.
Fortunately, Arne had a cousin in the North Bay who got wind of the proposed sale and intervened. So instead of Arne getting $120,000 proceeds from sale, he’ll be getting $248,000 from his reverse mortgage. He can then move into the retirement home and let the lender worry about selling the home for the maximum the market will presently permit.
How can I stress this enough? All you real estate agents, attorneys, financial planners and CPAs out there, you must familiarize yourself about how HECMs work. If you’re working with an elderly person with a reverse mortgage in declining health or who’s contemplating moving from his or her home, your first move should be to determine how much can be now be withdrawn from the HECM. Don’t surrender the reverse mortgage borrower’s important rights.
