John W. Gilbert
February 8, 2001
John and Jackie are in their mid-70s; they have lived in the same house for over 25 years and owe approximately $5,000 on their mortgage. Their house is valued at approximately $150,000. All the kids are gone, married and living on their own. Their means of support is a government pension and Social Security.
These sources of income allow them to live comfortably. Their desire is to travel frequently while they are still able to physically travel. They enjoy going to Las Vegas twice each year and usually take two cruises each year. With five children, any assets left in the estate will be divided equally among the children.
In their discussions with one of their children, it was noted that Texas had recently passed legislation authorizing financial institutions to provide both residential equity lending which included home equity loans and reverse mortgages. Both home equity loans and reverse mortgages are special types of home loans, which let the homeowner convert their equity in their home into cash. Each has its own particular advantages and disadvantages.
John and Jackie understood that a home equity loan was simply a second loan using the home as collateral. But what was a reverse mortgage?
History
Reverse mortgages first came onto the scene in Great Britain in the early 1930s. The transaction was called a home-equity reversion. This financial practice prospered as a family business until 1970 when outside investors took control of the home-equity company renaming it Home & Capital Trust Ltd.
Following its success in Great Britain, the reverse mortgage concept appeared in other parts of Europe during the 1970s. Finally, during the 1980s, it made its way across the Atlantic Ocean and arrived in the United States.
Although reverse mortgages were commonplace everywhere in the United States in the early 1990s, they were banned in Texas because of a constitutional prohibition against home equity lending. The ban was removed in 1998 after the voters approved a constitutional amendment allowing lump-sum home-equity loans. Now, after three years of delays caused by legal and regulatory tie-ups, reverse mortgages are now available in Texas.
Terms and criteria
Reverse mortgages or home equity conversion (HEC) allow older homeowners to convert the accumulated equity in their home into cash which can be used for any purpose without the homeowners having to move or make regular loan payments. The fact that no re-occurring loan payment is required is the major difference between a reverse mortgage and a home equity-loan or second mortgage.
Generally reverse mortgages have a number of payment options available. These options are as follows:- Term
fixed monthly payments to the homeowner over a pre-determined number of months. - Tenure
fixed monthly payments for as long as one borrower remains in the home. - Line of credit
cash available in amounts as needed (not available in Texas). - Modified tenure monthly payments as in (1) and (2) above plus a line of credit (not available in Texas).
Thus based on the individual borrower's needs, the proceeds of the reverse mortgage can be disbursed in a number of ways. In order to obtain a reverse mortgage, the borrowers must meet certain criteria.
All borrowers (if joint) must be age 62 or older and own and occupy a single family, one to four unit home. Condominium and some manufactured homes built on a permanent foundation are also eligible. Cooperative apartments and mobile homes are not eligible for reverse mortgages.
The borrower must maintain the home as a principal residence during the term of the reverse mortgage. In addition, any existing mortgage balance must be paid off with the reverse mortgage. There are no income or other asset limitations or requirements as there are with other loans. Repayment is not required until the last surviving borrower dies, sells, or permanently moves from the property.
The amount of cash proceeds received in a reverse mortgage is based on a formula using age, home value, debt, and interest rates as factors. For example, generally, a 65-year-old could borrow up to 26 percent of the value of their home, a 75-year-old, 29 percent of the value of their home, and a 85-year old, 56 percent of the value of their home.
Generally interest rates on reverse mortgages are lower than on conventional mortgages. Be aware there are costs associated with a reverse mortgage similar to any other type of loan, such as appraisal fees, origination fees, title search fees, survey and inspection fees, and recording fees.
The receipt of the reverse mortgage proceeds is not considered income for tax purposes.
Repayment
Upon the death of the remaining borrower, the sale of the residence, or the permanent move from the residence, the debt must be paid. The total amount of debt at the end of the loan is all the cash advances received, plus any interest on them. One can never owe more that the value of the home at the time the loan is repaid. Thus, even if one receives monthly payments from now until age 125, and the home declines in value and the total of the cash advances are greater than the home's value -- one can never owe more than the value of the residence.
Not all reverse mortgage borrowers spend their last days in their homes. Many decide to move to perhaps smaller homes, or for health reasons, to assisted living facilities. Others decide to move in with their children.
If at the end of the loan, the loan balance is less than the value of the home, the homeowner or their heirs get to keep the difference. The lender does not "get" the house. The lender is repaid the amount the borrower owes and the remainder goes to the former homeowner or their estate.
Now back to John and Jackie, if they decide to use the reverse mortgage they could receive approximately $52,886.59 (or 35 percent of the value of their home) in lump sum loan proceeds. If they chose the monthly payments option, they would receive $396 per month until they leave their home. The monthly payment is determined through the use of a formula, which takes into account the life expectancy of the borrower, interest rates, expected appreciation, etc.
Prior to entering into the reverse mortgage, it would be wise to take advantage of the HUD (Housing and Urban Development) approved housing counseling services at little or no cost. Also, it is important to understand that although no debt is passed onto your heirs relating to the reverse mortgage (since it is paid off by selling the house), the value of your estate which is passed to your heirs will be diminished due to the debt taken out on the house years ago unless the house appreciates more than the reverse mortgage debt.
John W. Gilbert, CPA, is a tax manager with Sol Schwartz & Associates, P.C. This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice.
© 2001 American City Business Journals Inc.