Reverse Mortgages Continue to Evolve

With almost all new reverse mortgage loans backed by the federal government, Uncle Sam continues to wield his power to overhaul the Home Equity Conversion Mortgage, or HECM, program. The goal is to reduce a surprisingly high default rate on the loans—about 10%, far above the default rate on regular home mortgages.

The government hopes its new rules will help stabilize the HECM program and shore up the insurance fund the government uses to pay a lender if a house sells for less than the loan balance. Some of the latest proposed changes from the Department of Housing and Urban Development, laid out in mid May, could cost new borrowers more.

If a borrower doesn't have to make regular payments on a reverse mortgage, how can the loan go into default? Easy, if the borrower doesn't keep up to date with property taxes and homeowners insurance bills.

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Under a change that went into effect last year, borrowers must prove they can afford the property taxes and insurance over the life of the loan. HUD now wants to add the cost of utilities to the list of property charges. And that addition would mean that failure to pay utilities could cause the loan to be in default, says Lori Trawinski, director of banking and finance at the AARP Public Policy Institute.

HUD doesn't want more folks kicked out of their homes. Adding utilities to the covered property charges means the financial ability to cover that cost must be considered in the financial assessment that borrowers must pass. The financial test looks at a borrower's credit and income to determine if the borrower can afford the property charges over the life of the loan. Failing the test doesn't necessarily disqualify a borrower, but it can reduce the amount of loan proceeds available.

When a shortfall is detected, the lender is required to carve out a "set aside" from the loan proceeds—effectively reducing the amount that can be tapped. For example, an 85-year-old who failed the test and whose taxes and insurance cost about $740 a month would have to set aside about $62,000 of proceeds to cover those bills. According to recent government data, a set-aside was required for about 10% of borrowers.

HUD's other proposed change that could affect new borrowers is a cap on adjustable-rate loans, which are now the most popular choice with borrowers, says Peter Bell, president of the National Reverse Mortgage Lenders Association. HUD proposes a one percentage point annual cap and a five percentage point lifetime cap on interest-rate changes for an adjustable loan. Currently, rates can rise by as much as ten percentage points over the life of the loan. If that proposal becomes a final rule, Bell says the lowered cap may cause lenders to charge a higher initial rate.

Adjustable-rate loans appeal to borrowers for two reasons: A borrower can tap up to 100% of eligible proceeds, compared with about 60% if they opt for a fixed-rate loan. And the adjustable-rate loan can be taken as a line of credit that can grow at the same interest rate being charged. For example, if you have $100,000 left in your line of credit and the interest rate is 5%, your credit line would increase by about $416 each month ($5,000 a year), says Cliff Auerswald, president of All Reverse Mortgage Company, in Orange, Cal.

Comparison Shop for a Loan

To get a reverse mortgage, you must be 62 or older. The loan is not repaid until the homeowner dies, sells the house or moves out for at least 12 months. The homeowner never owes more than what the home is worth.

Finding a specialized reverse mortgage lender may take some work. The big banks left the market after the financial crisis and have yet to come back. "There's no common household name," says Trawinski.

Start with the National Reverse Mortgage Lenders Association's "Lender Locator". Get quotes from several lenders—interest rates and closing costs will vary, says Auerswald. Download a helpful consumer guide at consumerfinance.gov.