Going forward with reverse mortgages: the benefits and pitfalls of borrowing against your home.

EXECUTIVE SUMMARY

* Increased life expectancy has caused the elderly to need more funds after retiring, especially if they elect early retirement. The home is often the most valuable asset an individual owns.

* Reverse mortgages allow homeowners to continue to live in their homes while borrowing against the equity. A reverse mortgage may provide a lump-sum advance, a line of credit and/or periodic advances. Monthly advances may be received as long as the homeowner lives in the home. Best of all, the homeowner never needs to make a mortgage payment.

* A lump-sum advance from a reverse mortgage may be used to pay off the existing first mortgage and eliminate the monthly mortgage payment, reducing monthly cash requirements.

* Caution is required because reverse mortgages can be prohibitively expensive unless the homeowner has a substantial amount of home equity, plans to convert all or most of the equity into retirement funding and lives in the home and benefits from the reverse mortgage for the long term.

* A homeowner who allows reverse mortgage payments to in crease checking or savings balances beyond certain limits may lose government benefits.

**********

Reverse mortgages were created in 1987 by the Department of Housing and Urban Development (HUD) to provide greater financial security to American homeowners age 62 and older. With the aging population in the United States and the rapid appreciation of residential property, the reverse mortgage industry is destined to continue to grow. Reverse mortgages often are thought of as the solution for elderly citizens who need additional funds; however, they can be a costly solution and should be used with caution.

This article will help CPAs recognize situations where reverse mortgages can provide much-needed supplementary retirement income--and equally important, when they should be avoided.

WHAT ARE REVERSE MORTGAGES?

A reverse mortgage is a loan against home equity that requires no repayment as long as the owner continues to live in the home. An HECM (see box below) must be a first mortgage, which means any existing mortgage debt must be paid off first, possibly with some of the reverse mortgage funds. This reverse mortgage provides a line of credit, one or more lump-sum advances and/or a series of periodic advances that may continue until the last surviving borrower leaves the home permanently Reverse mortgage debt increases over time as a result of advances to the homeowner that increase the principal, and the accumulation of service fees and accrued interest.

The reverse mortgage debt does not become due until the house is sold or the homeowner(s) move out permanently At that time the lender likely will receive payment of the loan balance through the sale of the home, though in order to keep the house in the family, the homeowner or family members may choose to pay off the mortgage with other funds. If the sales proceeds are insufficient to pay off the mortgage, the shortfall is covered by mortgage insurance, which is required with an HECM. Sale proceeds in excess of the debt go to the homeowner(s) or the estate.

REVERSE MORTGAGE LIMITS

Since the homeowner is not expected to make payments on a reverse mortgage, no minimum income level is needed to qualify for the loan. The borrower's health and credit rating also are irrelevant. The amount of debt that may be incurred is based on the value of the home, the age of the homeowner and expected interest rates. An older taxpayer can qualify for larger monthly advances and/or a larger lump-sum advance because of the shorter life expectancy over which the loan balance will grow (see exhibit 2). Lower interest rates also allow greater borrowing because there will be less accrued interest. The impact of age on borrowing capacity is seen in exhibit 2 with a $250,000 home, where mortgage rates are 6%.

Exhibit 1
Reverse Mortgage Meets
Needs of Elderly

Joe Homeowner is 85 years old and his wife Jan is 84. Their home,
valued at $300,000, is debt-free. They are committed to living in
their home as long as possible. Their Social Security benefits and
interest on savings have been adequate for their living costs, but
they now need in-home nursing care several days a week at a cost of
about $1,000 per month.

Joe and Jan do not want to be a financial burden to their children.
They do not qualify for a bank loan to cover these extra costs because
they do not have extra income to cover loan payments. They could sell
the home, but they would need to find alternative housing. A reverse
mortgage may be a good way to get the funds they need to balance their
budget.

Exhibit 2
Know Your Limit

Sample age and credit-line limits for a
$250,000 house at 6% interest.

Age                      Credit line

65                         $129,425
75                         $154,538
85                         $181,460
90                         $194,150

Source: AARP, HomeMade Money, page 11.

The home value that may be used in calculating an HECM is capped by the FHA. The limit varies from $200,160 in areas with lower median home values to a maximum of $362,790 in many major metropolitan areas where home values are higher. So a $1 million home and a $400,000 home might be eligible for exactly the same loan amount. Of course the maximum loan would be lower for a home worth less than $200,160. The lower limit of $200,160 is applicable in about 80% of the counties in the United States.

HUD cautions homeowners that they should not need to hire a paid consultant to find a reverse mortgage lender, because HUD provides a list of HUD-approved lenders. But all loan applicants must obtain HUD-approved, third-party counseling before proceeding, because reverse mortgages are complex and potentially costly HUD requires the counseling to include topics such as alternative sources of financial assistance, other home-equity conversion options, the financial implications of the HECM such as rising debt-falling equity, the possible effect of the loan on public programs such as Medicaid and details of loan options and payment plans. This counseling is provided free or at a nominal cost. The HECM, which provides funds for medical costs and other living expenses during retirement, is not intended to be used by seniors as a source of funds for making investments, loans to relatives and so on. Exhibit 3, at right, describes some situations in which a reverse mortgage may be a good option and some in which it is not.

Exhibit 3
Likely Candidates

Those who can get the most from a reverse mortgage:

* Homeowners who are much older than the minimum age of 62. For an
older homeowner, the life expectancy suggests there will be fewer
remaining years for reverse mortgage advances and less accumulated
interest and service fees. The homeowner can receive larger advances
over a relatively short period without projecting a loan balance that
will exceed the value of the home.

* Homeowners with small balances on their mortgages and those who are
debt-free can receive larger reverse mortgage advances.

* Homeowners who are having difficulty paying an existing mortgage can
use a reverse mortgage to eliminate the monthly mortgage payment.

Those who can get little benefit from a reverse mortgage:

* Homeowners who are just above the minimum age of 62. Because their
life expectancy suggests there will be many remaining years for reverse
mortgage advances, there will be more accumulated interest and service
fees.

* Homeowners with little equity in their homes are limited to smaller
advances.

* Homeowners who plan to move to another living situation such as a
nursing home within a few years. They may incur high costs and receive
relatively small benefits, especially if they select a monthly advance
option.

COMPARISON SHOPPING

The monthly adjusted HECM provides the largest loan at the lowest interest rate. However, the annually adjusted HECM, with a higher initial interest rate, has less risk, because the increase on interest rates is capped at 5 percentage points, compared with 10 for the monthly adjusted HECM. If a borrower allocates some (or all) of the net principal amount to an HECM line of credit, the unused portion of that credit will increase over time, at a rate tied to the accruing interest rate.

Both the monthly and the annually adjusted HECM have an initial mortgage insurance premium of 2% of the maximum claim amount (the lesser of the value of the home or the FHA loan limit) as well as an annual mortgage insurance premium of one-half of one percent of the loan balance. The origination fee is limited to the greater of $2,000 or 2% of the maximum claim amount. The origination fee, upfront mortgage insurance premium and other closing costs may be financed as part of the reverse mortgage.

Example. Joe and Jan Homeowner have a $300,000 home, but the FHA lending limit for their area is $200,160, which is their maximum claim amount. They choose the monthly adjustable HECM. (Exhibit 4, page 38, shows how to compute the amount of reverse mortgage funds available, loan costs and so on.) The initial interest rate is 5.87% and the expected future rate is 5.85%, with a cap of 15.87%. There is also a charge of 0.5% of the mortgage balance each month for mortgage insurance.

Exhibit 4 FHA/HUD Monthly Adjustment Reverse Mortgage

Part 1--Initial Loan Computations

Applicants' ages: 84 & 85. Home value: $300,000 (No existing debt).
Available principal limit: $156,525.12. Costs financed: Initial
mortgage insurance premium of $4,003.20, origination fee of $4,003.20,
closing costs of $1,561.32.

Line                                            Information

 1  Initial interest rate                             5.87%
 2  Actual interest rate (Includes mortgage
      insurance premium of .5%)                       6.37%
 3  Expected interest rate over life of loan
      (Projected rate)                                5.85%
 4  Cap on interest rate throughout term of
      the loan (Note 1)                              15.87%
 5  Monthly fee to institution that services
      the loan                                          $35
 6  Estimated home value                           $300,000
 7  Lending limit (Lesser of home value or
      FHA limit for area)                          $200,160
 8  Credit line growth rate                           6.37%
 9  Loan principal limit                        $156,525.12
10    Set aside for service fees over life of
        loan                                     (4,207.65)
11  Available principal limit                   $152,317.47
12    Initial mortgage insurance premium
        (MIP) 2% of home value                   (4,003.20)   Financed
13    Origination fee (Assume the fee is
        added to loan amount)                    (4,003.20)   Financed
14    Closing costs (Attorney fees, etc.)
        added to loan                            (1,561.32)   Financed
15  Net principal limit (Note 2)                $142,749.75
16  Less: Advance to pay off existing
      mortgage, etc., if any                          $0.00
17  Less: Set-aside for automatic payment of
      taxes & insurance                               $0.00
18  Cash available for advance, credit line
      and/or annuity                            $142,749.75
19  Monthly payment for life (Tenure option)
      (Note 3)                                    $1,187.42
20  Financed fees & closing costs (Lines 12,
      13 and 14)                                  $9,567.72

Part 2--Computations Over Life of Loan

                Rate      Beginning    Cash to
              (Excludes     Loan        Owner      Service
Year    Age     MIP)       Balance    (Advances)    Fees

  A      B        C           D           E           F

  0     84                Beginning balance--Financed costs
  1     85      5.87%      $  9,568      $14,249      $420
  2     86      5.87%        25,381       14,249       420
  3     87      5.87%        42,231       14,249       420
  4     88      5.87%        60,186       14,249       420
  5     89      5.87%        79,319       14,249       420
  6     90      5.87%        99,707       14,249       420
  7     91      5.87%       121,432       14,249       420
  8     92      5.87%       144,582       14,249       420
  9     93      5.87%       169,251       14,249       420
 10     94      5.87%       195,538       14,249       420
11-12   96      5.87%       223,549       28,498       840
13-14   98      5.87%       285,204       28,498       840
15-16   100     5.87%       355,212       28,498       840

         Mortgage                  Ending
        Insurance     Accrued      Balance
Year     Premium      Interest    (Sum:E-H)

  A         G            H            I

  0     Beginning balance--
        Financed costs             $  9,568
  1         $   90      $ 1,054    $ 25,381
  2            171        2,010      42,231
  3            258        3,028      60,186
  4            350        4,114      79,319
  5            449        5,270      99,707
  6            554        6,502     121,432
  7            666        7,815     144,582
  8            785        9,215     169,251
  9            912       10,706     195,538
 10          1,047       12,295     223,549
11-12        2,537       29,780     285,204
13-14        3,192       37,478     355,212
15-16        3,937       46,219     434,706

                    Cumulative Advances & costs

          Total        Accum.      Average     Percent
         Advances      Costs      Per Year    of Average
Year    (Column E)   (I less J)    (K / A)     Balance

  A         J            K            L           M

  0
  1       $ 14,249     $ 11,132     $11,132   63.7%
  2         28,498       13,733       6,866   26.5%
  3         42,747       17,439       5,813   16.7%
  4         56,996       22,323       5,581   12.6%
  5         71,245       28,462       5,692   10.4%
  6         85,494       35,938       5,990    9.1%
  7         99,743       44,839       6,406    8.3%
  8        113,992       55,259       6,907    7.7%
  9        128,241       67,297       7,477    7.3%
 10        142,490       81,059       8,106    7.0%
11-12      170,988      114,216
13-14      199,486      155,726
15-16      227,984      206,722

Notes

(1) FHA-HLJD loan--The interest rate cap is the initial rate plus 10%
(15.87% maximum rate).

(2) This is the estimate of the maximum amount of the loan. The loan
balance will be equal to financed initial loan costs, plus amounts
shown in columns E, F, G, H above. Balance would increase by automatic
payments for taxes & insurance if that option were chosen (Part 1,
Line 17).

(3) Homeowners may borrow up to $142,749.75 immediately.
Alternatively, these homeowners may receive advances of $1,187.42
per month for life. They may choose a combination of advances.

(4) The accumulated loan balance may exceed initial home value, but
the home value is expected to increase with inflation (to $561,894 in
this case). If this loan is outstanding for 16 years, the loan balance
is projected to reach $434,706.

The loan principal limit is $156,525.12, which is computed with a formula that takes into account the maximum claim amount of $200,160, a HUD limit factor and expected future interest rates. A set-aside is deducted for future monthly loan processing fees, leaving an available principal limit of $152,317.47. Joe and Jan choose to finance the initial mortgage insurance premium of 2% of the maximum claim amount ($4,003.20) and the origination fee, which also is $4,003.20, as well as other closing costs of $1,561.32. This means that they have a loan balance of $9,567.72 before they begin receiving reverse mortgage advances. These financed costs reduce the net principal limit to $142,749.75.

Their first option is to receive monthly advances of $1,187.42 for as long as either one of them lives in the home. They also have the option of receiving more, say $1,500 per month, for only a fixed period.

TAX IMPLICATIONS

A reverse mortgage may be tax-neutral. Money received from a reverse mortgage payout is not taxable income. The borrower continues to be liable for property taxes, for which he or she still qualifies for a tax deduction. A borrower with no existing mortgage will have no interest deduction to lose, but a borrower who refinances a standard mortgage with a reverse mortgage will lose the annual mortgage interest deduction. Since no interest payments are made, cash-basis taxpayers cannot take a current deduction for mortgage interest and other costs that the lender pays or accrues; that deduction potentially will be available only when the mortgage is paid off.

LOAN ACCELERATION CLAUSES

A homeowner with an HECM is responsible for taking care of the property that likely will be sold in the future to pay the loan balance. Such responsibilities include home repairs, property taxes, and fire and storm insurance. Failure to fulfill such responsibilities may cause the reverse mortgage loan to become due. The homeowner also can cause acceleration of the loan by renting out the home to another party, adding a new owner to the home's title, changing the home's zoning classification or taking out new debt against the home.

THE BOTTOM LINE

A reverse mortgage makes economic sense for you or your clients only when it will be long-term and there is substantial equity in the home. When considering a reverse mortgage, homeowners should evaluate their commitment to remain in the home and their current state of health. They also should consider whether in-home health care will be available if needed from family members, friends or health care professionals. Then, they should obtain a reverse mortgage only if it does not have the downside features listed in exhibit 5, at left. The CPA's advice here may be critical. After all, what's involved is the client's most valuable asset, the home.

Exhibit 5

The Upside and the
Downside of a
Reverse Mortgage

UPSIDE

Keep the home and receive cash. Borrowers can stay in their homes and
convert their equity to cash without having to make current loan
payments.

Larger amounts when alder. Older borrowers are able to obtain a larger
monthly advance because they have a shorter life expectancy

DOWNSIDE

Expensive for short-term borrowers. Substantial loan origination fees
and mortgage insurance premiums are required, as well as annual
interest and service fees. At the end of the first year, the loan
balance will include reverse mortgage advances received during the
year, accrued service fees, all of the costs of getting the loan
that were financed and accrued interest. Part II of Exhibit 4, page 38,
shows that if the loan with a 5.87% initial interest rate is
outstanding for only one year, the accumulated loan costs are 63.7% of
the average loan balance; the average loan cost will be 26.5% if the
loan is outstanding for two years. If the borrower dies or moves into a
nursing home within a few years, the loan will have been a very
expensive source of funds.

Expensive for small amounts. HECM loan costs are based on the home
value or loan limit, not on the amount the homeowner wants to borrow.
If the borrower needs only a relatively small amount (for example,
$10,000 for a new roof), closing costs are very large relative to the
amount of benefit received.

Risk of losing government benefits. Reverse mortgage advances will not
be considered income and will not affect Medicaid coverage, but any
resulting unspent cash balance may be a problem if it exceeds Medicaid
asset limits. To avoid this, the homeowner should borrow only enough to
meet current needs.

A total of 157 home equity conversion mortgage loons were mode in fiscal year 1990. By 2005, the number had skyrocketed to 43,131.

Source: Department of Housing and Urban Development, www.hud.gov.

Practical Tips

* Suggest a reverse mortgage only if your client has substantial equity in the home, plans to borrow a large part of that equity and plans to live in the home for the long term.

* Don't recommend a reverse mortgage for small loans such as minor home repairs.

* Advise against getting reverse mortgages for investments or loans to friends or relatives.

* HUD provides information and face-to-face or phone counseling about HECM loans free or at nominal cost.

AICPA RESOURCE

CPE

Retirement Planning That Works for Your Client (# 730840JA)

To order go to www.cpa2biz.com or call the Institute at 888-777-7077.

OTHER RESOURCES

* HomeMade Money: A Consumer's Guide to Reverse Mortgages, AARP, 2006, www.aarp.org/money/revmort/ revmort_basics/a2003-04-07homemademoney.html.

* Money from Home--A Guide to Understanding Reverse Mortgages, Fannie Mae, www.fanniemae.com/ global/pdf/homebuyers/moneyfrorn home.pdf;jsessionid=TLJOMSJSJIUTHJ 2FQSHSFGA.

* National Reverse Mortgage Lenders Association (NRMLA), headquartered in Washington, D.C., is the national voice for lenders and investors engaged in the reverse mortgage business, www.reversemortgage.org.

RELATED ARTICLE

About 90% of all reverse mortgages are Home Equity Conversion Mortgage (HECM) loans, which are discussed in this article. HECM loans were designed by HUD and are insured by the Federal Housing Administration (FHA). Other home-equity loans not covered in this article may have unique advantages, such as the absence of the lending limits that are applicable to federally insured loans, and drawbacks, such as higher costs.

RELATED ARTICLE: The impact of the Deficit Reduction Act of 2005.

BY MICHAEL DAVID SCHULMAN

One major unknown factor concerning reverse mortgages is the impact that the Deficit Reduction Act of 2005 will have on them. Because one of the goals of the act is to reduce government spending on Medicaid, it legislates that Medicaid be denied to applicants with more than $500,000 in home equity. As a result, more and more older adults will be required to pay for their own health care. It is expected that the number of reverse mortgages will increase as a result.

The Deficit Reduction Act also requires the state be named as a remainder beneficiary in annuity contracts, presumably to permit states to recover their Medicaid costs. While the details, on a state-by-state basis, have yet to be worked out, it seems clear that many planning situations that would have been solved through the use of an annuity contract (whether issued by an insurance company or a so-called "private annuity") will need to find an alternative income source. Despite looking like annuities, reverse mortgages are a form of borrowing, so the "remainder to the state" rule referred to above does not apply. Reverse mortgages likely will be used in many of these cases.

Another "not yet determined" aspect of the Deficit Reduction Act and reverse mortgages is who gets the money when the house is sold. Put differently, the lender is in a primary position on a reverse mortgage. However, Medicaid also can put a lien on an older adult's residence as benefits are paid. What will happen if Medicaid insists on being first? Or, if a Medicaid lien is in effect when an adult wishes to take a reverse mortgage, will Medicaid take a subordinate position to the mortgage lender?

As with any financial product being marketed to older adults, CPAs must take care to protect the client from financial fraud. In general, it is inappropriate to purchase a reverse mortgage--or any investment product--from a "door-to-door" vendor. Many of these products have extremely high fees, closing costs and interest rates that can trap the unwary homeowner.

Michael David Schulman, CPA/PFS, is the principal of Schulman CPA, Central Valley, N.Y. His e-mail address is [e-mail].

Howard Godfrey, CPA, PhD, and Edward Malmgren, CPA, PhD, are professors of accounting at the University of North Carolina, Charlotte. Their e-mail addresses are [e-mail] and [e-mail], respectively.