A mortgage for the 21st Century.

A MORTGAGE for the 21st CENTURY

Creative solutions like HUD's new reverse mortgage program may provide seniors with a much-needed step toward affordable housing.

One of the key demographic trends facing lenders is the "graying of America." As a nation we are getting older and living longer. Inflation continues to eat away at the purchasing power of the dollar; alternative housing programs for seniors are not particularly affordable or well developed.

What does this mean to the average mortgage banker? Among other things, it means that there will be an increasingly large percentage of the population with financial needs that cannot be satisfied by traditional lending practices.

Judith V. May, chief architect of the FHA reverse mortgage program, determined that there are more than 11 million elderly citizens who own homes, 73 percent of whom own them outright. May also indicated that almost 2 million elderly own homes valued at more than $50,000, but these people are living on annual incomes below $10,000. Many elderly citizens are property rich and cash poor. Tapping this equity to sustain and enhance the quality of life for our aging population presents mortgage lenders with a major opportunity.

Reverse annuity mortgages, also known as home equity conversion mortgages, or reverse mortgages, were developed to address this need. An experimental program in which the Department of Housing and Urban Development (HUD) will insure a maximum of 2,500 reverse mortgages was established by the Housing and Community Development Act of 1987.

Reverse mortgages: What are they?

With a traditional mortgage, the lender provides funds to the borrower in a lump sum at the time of loan origination, and the mortgagor then repays principal together with accrued interest, in installments during the life of the loan. Reverse mortgages, on the other hand, typically require that the lender make payments over time to the borrower and those advances, plus accrued interest, are repaid in a lump sum at maturity. To address the need to assist elderly homowners, the FHA reverse mortgage program was developed specifically to benefit those persons 62 years of age or older.

Reverse mortgages have been developed and implemented by both private business and government agency sectors. But in the last 10 years, market acceptance of these new loan products has been very slow. The 1989 HUD pilot program is anticipated to be fully implemented this year and may serve as an impetus for this new product.

FHA's reverse mortgage program

For lenders that have received reservations of insurance authority, the FHA program functions essentially as follows. The first step is for a potential borrower 62 years-old or older to apply to a lender with an allocation for insurance authority. That individual is then directed to a HUD-approved housing counseling agency. The lender provides copies of the mortgage, note and loan agreement forms to the prospective borrower. The lender is allowed to complete the borrower's application form prior to referral, but cannot charge for this if the person opts not to apply. The lender can't take any steps that would result in a cost to the potential applicant until after the required counseling.

The counseling agency must review the financial implications of entering into a reverse mortgage including consequences regarding the borrower's taxes, estate and eligibility for assistance under various federal and state programs. Alternative options such as sale-lease-back financing, deferred payment loans, property tax deferrals, and other options through social service agencies, must also be reviewed. The counseling agency provides a certification to the borrower that must be submitted to the lender and ultimately to HUD as a part of the mortgage insurance application.

The shortage of trained and HUD-approved housing counselors is a significant problem for lenders in a number of states. The American Association of Retired Persons, in conjunction with HUD officials, has held a series of programs across the country to encourage program participation by counseling agencies, lenders, HUD regional and field office staff and others.

After counseling has been certified, the lender must submit an application for valuation analysis to the local HUD field office. Once the property is approved, a conditional commitment will be issued. (At this time, reverse mortgages may not be processed under direct endorsement authority.)

Borrower eligibility is determined by verifying the applicant's age and checking the title evidence and existing indebtedness on the property. There is essentially no underwriting in connection with these mortgages. Aside from appraised value, the only credit or quasi-credit factor that would prevent borrower approval is a default on a debt owed the federal government, and even then, only if the debt is not repaid prior to endorsement of the mortgage. Also the lender must provide a credit alert authorization code (CAIVRS) certification. Assuming there are no title problems and existing debt on the property does not exceed the net principal limit or maximum claim amount, and the borrower does not have a default on a debt owed the federal government, the credit underwriting is essentially irrelevant.

Once the title evidence and commitment are reviewed, the mortgage interest rate must be established just prior to closing. Establishing the interest rate this late in the transaction creates some truth-in-lending disclosure concerns for the lender, but until the secondary market changes its policy, this is the way the loans must be priced.

With the interest rate established and the initial principal limit calculated, the borrower makes a final selection from among four possible payment plans and the loan is closed. The lender then elects the assignment or shared premium option and remits the initial mortgage insurance premium (MIP) to Computer Data Systems, Inc. of Rockville, Maryland, which is HUD's agent for collecting premiums. A mortgage insurance certificate is issued endorsing the mortgage for insurance, and loan proceeds are disbursed to the borrower pursuant to the chosen payment plan. As a part of its monthly servicing, the lender will add the monthly MIP which accrues daily to the outstanding balance and remit it to HUD.

When the debt on the mortgage exceeds 98 percent of the maximum claim amount, lenders that have chosen the assignment option should elect to assign the mortgage to HUD and receive a payment on the claim not greater than the maximum claim amount.

Payment plans and interest rates

Unlike the conventional programs on the market, HUD provides flexibility to borrowers and lenders with regard to the available types of FHA-insured reverse mortgages. Borrowers can choose from three payment plans: a fixed-year term; tenure, or a line of credit; or some combination thereof. Further, borrowers have the option of changing from one plan to another at different times. If a borrower elects a tenure payment option, he or she will receive level-installment payments for as long as the home serves as a principal residence. The term option offers level monthly payments for a fixed term selected by the borrower. The line of credit option is similar to existing home equity lines of credit except that it does not require repayment until the mortgage is due in full. In any case, lenders are encouraged to advise borrowers to establish lines of credit to allow for unanticipated financial needs. Additionally, it is likely that most borrowers will take some type of lump sum at closing in order to pay off existing mortgages, loan fees or other related expenses.

The lender may choose to offer either fixed-rate or adjustable rate mortgages and may have a shared appreciation feature. Although the HUD program offers fixed-rate mortgages, the secondary market does not have a fixed-rate option presently available. Last October, Fannie Mae indicated it could not competitively price fixed-rate reverse mortgages, and although it was exploring the possibility, such a fixed-rate option would not be available for HUD's 2,500 experimental reverse mortgage loans. Unless lenders are willing to issue these mortgages for their own portfolio without any type of secondary market outlet, they will be constrained to the adjustable program.

To determine the maximum claim amount, the lender must utilize the lesser of the appraised value of the property or the maximum FHA insurable mortgage on a single- family/one-unit residence in the appropriate geographic area.

Calculating payments to mortgagor

HUD manual number 4235.1 includes detailed instructions (Chapter six) for the calculation of installment payments to the borrower. Appendices 19-22 offer more specific instructions, including factors for determining principal limit, using worksheets and instructions for calculating payments using a Hewlett Packard-12C calculator. Having worked through examples both manually and using a HP-12C, I strongly recommend downloading the spreadsheet. This software is available at no charge from HUD's housing information and statistics division and reduces calculation time to a few simple keystrokes on a personal computer.

In addition to the payment plan options of tenure, term or line of credit, the borrower can change the payment plan throughout the life of the loan, including obtaining a cash advance equal to the current balance of the available principal limit. The only restriction on the borrower's ability to select a payment plan is that the payments plus accrued interest, monthly MIP and any funds set aside for a line of credit cannot exceed the principal limit.

The net principal limit is calculated by substracting from the principal limit any initial payments to, or on behalf of, the borrower, such as the initial MIP, closing costs, a line of credit, and first year property charges such as real estate taxes. The future value of the net principal limit is then calculated using the number of months in the term of the loan and the compounding rate. Term or tenure monthly payments are determined using this future value, the term in months, and the compounding rate in a sinking fund formula for payments made at the beginning of the month.

The borrower is allowed to select a payment amount that is less than the maximum to which he would be entitled. Payments to the borrower would stop when the outstanding balance, consisting of the payment to the borrower plus accrued interest and MIP, equals principal limit. For ARMs, however, the payments continue until the end of the selected term, even if the outstanding balance exceeds the principal limit because the actual, average, mortgage interest rate exceeded the expected rate (i.e., the 10-year T-bill rate selected at origination plus margin).

Negative amortization-Loss of equity and the assignment--Some lenders are troubled because the program assumes that at some point the outstanding balance on the mortgage will eventually exceed the value of the property. This type of reasoning is contrary to the traditional mortgage underwriting position of always having a protective equity cushion in case of default. The FHA reverse mortgage program includes a mortgage insurance premium with two separate components. At origination, a fee equal to 2 percent of the maximum claim amount is collected and throughout the life of the loan a periodic MIP of 1/2 percent per annum of the loan balance is collected until the loan is paid in full. The annual MIP premium is assessed in equal installments on a monthly basis and is added to the outstanding balance on the loan and remitted to HUD monthly by the lender. The MIP premium is intended to anticipate the discounted present value of losses emanating from the shortfall between realizable expected property value and outstanding principal and interest on the loan.

Problem areas

The good news for mortgage lenders is that they are not responsible for whether or not the FHA calculations on the loss potential are accurate. At origination, the lender has two options regarding FHA mortgage insurance. Under the shared premium option the lender holds the loan to term and retains a portion of the monthly MIP. If at the time of payoff, the outstanding balance exceeds the property value, the lender receives the insurance benefits up to the maximum claim amount and is compensated for losses by the retained MIP. Although available, this shared premium program seems unlikely to receive much market acceptance because both Fannie Mae and Freddie Mac require that lenders selling them reverse mortgages elect the assignment option. Under the assignment option, lenders can assign the mortgage to HUD whenever the outstanding balance is greater than or equal to 98 percent of the maximum claim amount. At that time, the lender will receive insurance benefits.

A shared appreciation mortgage feature is also available to lenders. Lenders offering shared appreciation mortgages must select the shared premium insurance option. But the loans are not eligible for purchase by Fannie Mae or Freddie Mac and expose the lender to the risk of shortfall between accrued interest and principal and property values.

When is the mortgage due?

Most conventional, reverse mortgage programs include maturity dates when the loan must be paid off or foreclosed. Such provisions put the lender in the unenviable position of having to evict an elderly person from his or her residence. To respond to these difficulties, the HUD program specifies that the borrower may remain in the property, regardless of what happens to interest accrual, property values or other circumstances.

At the time the mortgage becomes due and payable, in nearly every case, the property will be sold by the borrower or the borrower's estate because the balance will greatly exceed the value of the property and the proceeds used to pay off the mortgage balance. The servicing section of HUD handbook number 4235.1 specifies that the mortgage will be due and payable without HUD approval when either all of the borrowers have died or all of the borrowers have sold or conveyed title to the property. With HUD approval, the mortgage can be declared due and payable when the property is either no longer the principal residence of at least one borrower for reasons other than death; no borrower maintains the property as a principal residence for a period exceeding 12 months because of physical or mental illness; the property is in disrepair and the borrower has refused or is unable to fix the property; or the borrower has violated any other covenants of the mortgage.

Because the covenants to be undertaken by the borrower are generally not payment-related, the lender can anticipate that the borrower will remain in the property until death or incapacity. It should be noted that so long as one of two joint borrowers remains in the property that is sufficient. The borrower is also given the option of requiring that the mortgagee make the insurance and tax payments from the available funds under the mortgage.

To prevent fraud in the sale of these properties by the estate, because no deficiency judgments of any kind are allowed under the program, properties can be sold for an amount that must equal the lesser of 95 percent of the current appraised value or the outstanding balance.

Appraisals and repairs

Appraisals are perhaps even more critical in reverse mortgages than in traditional mortgages. Appraisals must be performed by HUD-designated appraisers who will specify any repairs required to allow the property to meet "minimum property standards for existing properties." If estimated repairs exceed more than 30 percent of the maximum claim amount, the evaluation branch of the HUD field office must review the property to deem it acceptable. VA certificates of reasonable value cannot be substituted for FHA appraisals in connection with these loans. Required repairs that are anticipated to exceed 15 percent of the maximum claim amount must be completed before closing, and loan proceeds can be used to pay these off. This latter situation could create some significant potential exposure where the cost of repairs is not controlled and it eventually exceeds the funds available under the mortgage. If required repairs are estimated at less than 15 percent of the maximum claim amount the loan can be closed and repairs completed with "escrowed" proceeds.

It should be noted that these are not traditional escrow accounts because no funds are withdrawn and put into any type of custodial account. Rather, these "escrows" are akin to a designated line of credit which must be used to fund the repairs but on which no interest accrues until disbursement. The requirements imposed on lenders are quite stringent. Lenders have an affirmative obligation to insure that the property is inspected by a HUD-approved inspector; that all mechanics' and materialmens' liens are released of record; and that the necessary repairs are in fact completed. The maximum fee for these services is the greater of $50 or 1 1/2 percent of the funds used for repairs. Lenders involved in situations with mandatory repairs should exercise extreme caution when reviewing repair estimates and monitoring the progress of repairs. Lenders should keep in mind that HUD only requires the property meet minimum property standards for existing property. Repairs desired by the borrower that exceed this, need not be completed prior to closing.

Eligibility criteria

To be eligible for HUD's program, the properties must be existing one-unit properties or eligible condominiums in a HUD-approved condominium project. Leaseholds are allowed if the lease is for a term not less than 99 years and is renewable, or which has a remaining term of not less than 50 years beyond the 100th birthday of the youngest borrower. Properties in planned-unit developments must be approved by HUD.

The most significant problem facing this program lies in the limited market acceptability of reverse mortgages and the lack of a true secondary market. Unless you are a portfolio lender content to hold these mortgages to maturity, or until they can be assigned to HUD, you will face the difficulty of only having one or two buyers for this stringently-regulated product. Although Freddie Mac has indicated it will participate in this program, the corporation is buying only monthly adjustable ARMs, with no annual caps and a lifetime cap of 25 percent. HUD is requiring lenders offering reverse ARMs to offer annual adjustments and two to five caps, therefore, unless Freddie Mac is extremely competitive in pricing, it seems unlikely that monthly ARMs will be very attractive to borrowers. In the absence of fixed-rate reverse mortgages, if one-year ARMs become the standard, it seems the only real market for these mortgages will be with Fannie Mae.

Fannie Mae will buy the loans at a price established on the day of closing; the agency has turned over all underwriting, document review and risks with regard to warranty compliance to the originating lender. Lenders should be concerned about the time by which mortgage program documents must be delivered to Fannie Mae. The agency is requiring a 15-day delivery period for receipt of the documents after closing. The program originally provided for a five-day delivery, however, it has been extended to fifteen days.

These mortgages are not intended to have specific maturity dates but rather are intended to come to term primarily on the date of death of the last borrower or the date the last borrower ceases to occupy the property as a principal residence. This issue is of special concern to title insurers because of priority problems.

HUD's initial suggestion on the maturity date question was to pick a date 50 years beyond the 100th birthday of the youngest borrower, (i.e. an 88-year term). This term presents problems of a different nature; it is also excessively lengthy and might create some accounting difficulties with regard to amortization of discount points over the life of the loan and related issues. An application pending with HUD for a waiver of the language in Minnesota requests that an outside maturity date of 40 years from the date of origination, (i.e., the date at which the youngest borrower will be 102 years-old) be included.

Another tricky operational issue is determining whether or not the lender should disburse any proceeds under the loan before HUD has issued the mortgage insurance certificate. Although HUD advises that no delay (other than the truth-in-lending rescission notice delay) is required before the lender may disburse funds, and that the loan documents are binding upon execution, I would recommend deferring disbursement until the mortgage certificate is issued.

Lenders should also be aware of hidden costs associated with this program. HUD's program is somewhat unique by virtue of its double documentation. In addition to the traditional note, mortgage, requisite riders and allonges in favor of the lender, there is a complete duplicate set that secures HUD's interest with regard to any funds advanced by HUD, so that the property will be encumbered with a first and second mortgage. Although the second mortgage will be exempt from mortgage registration tax, recording fees will be changed. The program is silent as to who pays expenses associated with the second mortgage, but I have been advised by HUD that the lender should pay because the motivation for the second mortgage is to insure against default by the lender.

There is no specific provision limiting origination fees other than the usual HUD test of reasonableness, coupled with the limitation that prohibits origination fees in excess of 1 percent from being paid out of loan proceeds. It should be kept in mind, however, that the HUD field offices will have final determination as to the reasonableness of the fees.

Also, it has not been determined whether or not state usury laws restricting origination and similar fees are preempted.

The amount of title insurance required is also unclear. Section 5.3 of the HUD handbook requires the lender to submit a title insurance policy at least equal to the maximum claim amount with the borrower's application to HUD. Remember that the maximum claim amount is the lesser of the appraised value or HUD's maximum mortgage amount. However, footnote 3 to the model mortgage form requires that lenders use as the maximum principal amount of the mortgage an amount equal to or greater than 150 percent of the appraised value of the property. Because this higher amount is required under the mortgage, the same amount should presumably be covered by the title insurance policy. Section 5-5D (4) of the handbook also provides that where a maximum mortgage amount is stated in the mortgage, the title policy may contain an exception for loan advances made in excess of that amount.

Servicing these mortgages can be very costly for lenders. Typically, servicing fees on regular mortgages are established as a percentage of the loan balance, which starts high and declines as the loan pays off. This has the advantage of giving the lender the initial higher fees up front and reducing the fees towards maturity as the likelihood of default goes down. These costs are considered by lenders when they establish their mortgage yield. Principal balances of reverse mortgage, however, begin low and increase with time, resulting in low servicing fees on the front-end and high fees on the back-end, contrary to both the lender's cash flow needs and desire for servicing premiums.

Loan servicing presents significant problems for lenders given the stiff penalties for delays. Late remittance of MIP will result in a late charge of 4 percent if received after the 10th of the month, plus interest if more than 30 days late. Lenders are urged to review Section 8-7 of the HUD handbook which explains in detail the lender's reporting obligations. There are also significant monetary penalties for delays in remitting payments to the borrower. Late payments (e.g., after the first business day of the month) to the borrower carry a 10 percent penalty, plus interest at the daily mortgage rate, not to exceed $500 on a single late payment regardless of fault. Given the borrower's ability to freely change from program to program at any time during the life of the loan, careful attention should be paid to this issue.

When structuring its program, the lender should require that any draws under a line of credit and any payment plan changes be requested in writing and signed by all borrowers. The lender may prescribe a form to use for written requests for line of credit payments and require that the borrower use that form. Additionally, the borrower must receive and sign a written explanation of the terms of the new payment plan and return it to the lender. I would strongly urge that lenders require these forms be signed by both borrowers. The lender is also obliged to verify annually that the borrower maintains the property as a principal residence. This certification must be done within 30 days before or after the anniversary date of the first month after closing. HUD says the occupancy certification cannot be coordinated with calendar year-end statements or ARM change dates.

It seems likely that most lenders will want to subservice these loans. At the present time, one company offering subservicing for these loans is Wendover Funding, Inc. of Greensboro, North Carolina. Wendover is being used as a subservicer by participants in HUD's pilot phase. Given the risks and penalties associated with servicing these mortgages, lenders should exercise significant due diligence in making contractual arrangements with a subservicer.

Perhaps the most significant documentation problem tied to this loan program relates to the truth-in-lending disclosures. Even though HUD submitted extensive comments with regard to recent proposals to revise Regulation Z, the Federal Reserve Board did not address the disclosure requirements for reverse mortgages. The Fed staff indicated that these reverse mortgages are considered open-end credit mortgages because of the borrower's option to change the methods of receiving disbursements through the life of the loan. Additionally, because these are also home equity mortgage loans, they fall within the scope of the home equity disclosure requirements of Reg Z. Further, at least with regard to adjustable rate reverse mortgages, disclosures for variable rate transactions are also required. Vague responses from the Fed to this tangled web have not resolved many of the open issues confronting lenders and attorneys as they struggle to apply inapplicable requirements to these new loan products.

The most troubling provision requires lenders to provide a statement that outlines the borrower's rights and the creditor's responsibilities under Reg Z sections 226.12 (c) and 226.13 that is substantially similar to the statement of billing rights found in Appendix G to Reg. Z. Because the reverse mortgage regulations require these disclosures be made only to the extent applicable, perhaps the statement need not be made if proper legal grounds can be found for such action. One recommendation would be that lenders prepare a statement for their customers clearly explaining their "rights" in the case of an error in statement regarding the account. Because lenders will not be "billing" customers, it seems that the only statements the borrower could challenge would be the change in payment statements when a new payment plan is implemented or the year-end tax and hazard insurance premium payment analysis form sent out with the IRS form.

Future prospects

The complexity of the pilot HUD program and the allocations of only 50 loans to each lender, when balanced against the risks inherent in the program and the small profit potential available, have prompted almost 40 percent of the original lenders to leave the program. Although the number of loans being closed is increasing regularly, a recent update revealed less than two dozen loans had been closed under the program.

A first step toward increasing the viability of these programs is to expand the number of loans which can be insured; presently Congress is considering a proposal to increase this authority from 2,500 to 25,000. Last November, Senator Bob Graham (FLD) introduced a bill amending the National Housing Act called "The Reverse Mortgage Insurance for Older Americans Act of 1989." In January, an identically titled bill was introduced in the House of Representatives. Neither bill addresses any of the problems currently facing lenders. Instead, they would give the borrower the option to limit his liability to a certain percentage of the equity in the home and add additional disclosure requirements. Changes that would help lenders embrace this new product more actively include: restricting the ability of mortgagors to change from one loan program to another, or to an annual basis rather than at any time during the life of the loan; eliminating the second mortgage aspect of the program; devising specific consumer disclosure requirements for this program and eliminating the applicability of other truth-in-lending disclosures; and providing reasonable grace periods for servicing obligations.

As we enter the decade of the 1990s, and as demographics reshape the housing markets, mortgage bankers may find new business opportunities with reverse mortgages.

Robert J. Pratte is the head of the mortgage banking group at the law firm of Briggs and Morgan, P.A. in Minneapolis. Specializing in the legal representation of mortgage bankers since 1976, he has lectured extensively on regulatory compliance, mortgage banking and real estate finance.