Wednesday, May 20, 2015

Personal Finance: Reverse mortgages: friend, foe?

It is difficult to avoid TV celebrities endorsing reverse mortgages for seniors needing extra income or cash to pay bills. But are these products truly useful options, or dangerous traps?

Used properly and entered into advisedly, a reverse mortgage can be a valuable tool for older homeowners with limited income and significant home equity. But like any financial contract, it must be well understood and should only be considered under appropriate conditions.

Virtually any homeowner can borrow against the equity in their home by taking out a second mortgage, a home equity line, or a new first mortgage. However, repayment typically begins immediately and continues as a monthly obligation until fully repaid.

A reverse mortgage is effectively a home equity loan with a twist. Homeowners who qualify can borrow against a significant proportion of their home equity to spend today, but are not required to repay the loan until their death or until they choose to sell the property. Technically referred to as Home Equity Conversion Mortgages (HECM), these loans are regulated by the U.S. government through the FHA. To qualify, all borrowers must be at least 62 years of age and have a minimum amount of equity in the home. Furthermore, there must be no other loans outstanding against the home (or the borrower must use proceeds of the HECM to pay off any outstanding loans).

The proportion of equity available for borrowing is limited, and there are significant fees associated with origination. However, unlike a traditional mortgage, these loans are nonrecourse: if the market value of the home falls below the loan value, the lender bears all the risk and the borrower has no obligation to offset the difference.

As beneficial as a reverse mortgage can be in the right situation, too many stories surfaced of borrowers who lost their homes because they had not sufficiently understood the terms or had failed to make required insurance and tax payments. Industry data suggested that in 2012 roughly 10 percent of these arrangements were in default because the borrower had spent all the proceeds and did not have the cash flow to keep up with property taxes and insurance premiums as required by the terms of the loan. A default rate that high was cause for concern, and as a result FHA revised its lending standards.

Effective last month, lenders are now required to verify that the borrower will have sufficient income to meet ongoing required expenses including insurance and taxes. In addition, seniors who enter into reverse mortgage agreements may request that the lender withhold proceeds from the loan in an escrow account to assure sufficient coverage of expenses and minimize the risks of unpleasant surprises later on.

The other main pitfall with reverse mortgages is the risk of fraud. Since these products are specifically designed to benefit seniors, the target clientele is frequently the object of scammers. It is therefore essential that potential borrowers contact the FHA (or its parent agency HUD) to verify the lender is legitimate. New rules require that borrowers speak with a HUD-approved counselor before signing a contract. And as always, if you feel pressured or do not completely understand the terms, walk away. If you suspect fraud, contact the FHA to report the purveyor.

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