Changes in rules for reverse mortgages make them appeal to more consumers.

But is that a good thing?

BY LEE KAPLAN—
It was another record year for reverse mortgages, as more than 112,000 U.S. home owners used Home Equity Conversion mortgages ("HECMs") in fiscal year 2008, an increase of about 4.2 percent over the previous fiscal year.

For background on reverse mortgages, see this article.

There might have been even more HECM's in FY 2008 if many home owners hadn't been waiting to see new regulations on reverse mortgages from the Department of Housing's "Housing & Economic Recovery Act of 2008," which was issued in November.

Getting into the Act

The Act's reforms do contain some important consumer protection benefits, but many of its provisions were pushed by the mortgage industry as a way of making the reverse mortgage product more popular.

For example, HUD adopted a new single, national limit for borrowing on reverse mortgages of $417,000. Previously, this amount varied nationally, based on local housing market conditions, with home owners in rural counties being restricted to borrowing $200,160, while those living in more expensive areas could borrow up to $362,790. This single limit makes the reverse mortgage simpler and more attractive to home owners with more expensive homes.

Fees on reverse mortgages, which are generally higher than conventional mortgages, have been reduced, with loan origination fees capped at two percent of the first $200,000 and one percent on the balance, up to a maximum of $6,000. That's still quite high, but it does lower the cost of reverse mortgage borrowing a bit.

The most significant consumer protection feature of the "Act," however, is a requirement that the reverse mortgage be unbundled from other financial instruments. So, sellers of reverse mortgage can no longer require the purchase of other investments, like annuities, as a condition of issuing the reverse mortgage. This has been a source of abuse in the past and an area where many in Congress have been active in pushing for reform.

A growth industry for the mortgage business

The mortgage industry sees reverse mortgages as a growth industry, as more Baby Boomers will try to age in place when they retire. And the Housing & Economic Recovery Act of 2008 makes reverse mortgages more appealing to more people. So, that's a good thing, right?

Not necessarily, says the Financial Industry Regulatory Authority ("FINRA"). They are described as the "largest independent regulator for all securities firms doing business in the United States," on their Web site.

In a recent Investor Alert, FINRA notes, "Reverse mortgages were originally designed as a tool for allowing aging, low-income homeowners to keep their homes by providing a source of additional monthly income to meet expenses. Now, as lenders are realizing that more and more Americans are retiring and sitting on large pools of home equity, they are beginning to aggressively market reverse mortgages to younger retirees as a way to finance a more extravagant retirement lifestyle than they could otherwise afford."

A new use for reverse mortgages

The most controversial aspect of the new rules for reverse mortgages hasn't yet been implemented. Beginning January 1, 2009, those who qualify for a reverse mortgage (See "Reverse Mortgage Basics") will be able to apply the proceeds toward the purchase of a new home.

So, for example, if you were downsizing from your large, two-story home that you could sell for $400,000 to move to a $300,000 condo, you could just pay cash and pocket the $100,000 difference. Or, assuming you qualify based on your age, you could buy the condo with a $150,000 reverse mortgage and another $150,000 cash from your sale and have a reserve of $250,000 to live on.

But should you really do that? Using a reverse mortgage to purchase a home starts the meter running with interest on the full amount of your loan, unlike when you take the money as you need it with a line of credit. If you really wanted to tap the equity of your home at some point in the future without having to move out of the condo, you could take out a home equity line of credit (or, perhaps, borrow from your heirs).

You'd have to qualify for the line of credit and pay off the loan, unlike with the reverse mortgage, which is a non-recourse loan. However, the cost of borrowing this way is much lower and you'd preserve your equity as you pay the loan off. If your condo increases in value over time, you (or your heirs) could sell it and realize the appreciation, or you could take out a reverse mortgage at a later date and qualify for a higher amount because of the appreciation and your advance in age. (The flip side is that if housing prices decline over a long period of time, a reverse mortgage taken out now could look like a shrewd decision in the future.)

The bottom line ... caution

On the whole, however, there seems to be little value in using a reverse mortgage to purchase a new home, unless you have to move for physical or health reasons and can't afford to do it any other way. In any event, be sure to discuss your financial situation with a trusted financial advisor and a qualified, independent mortgage counselor before using a reverse mortgage for this purpose, no matter how good it sounds to you.

A reverse mortgage could be a good option ... or a big mistake. If you're not careful, your accumulated home equity — what for many people is the most valuable financial asset — might not be available when you most need it ... to move to an assisted living facility or nursing home if your health situation dictates it.

(Posted December 9, 2008)