By Legal Cell
Introduction:
A reverse mortgage is a loan available to senior citizens, and is used to release the home equity in the property as one lump sum or multiple payments. The homeowner’s obligation to repay the loan is deferred until the owner dies, the home is sold, or the owner leaves the property.
Reverse mortgage encompasses a range of non-recourse mortgage loans which help a borrower get liquid funds against his home equity, without having to move out or having to make any repayments, till he dies or sells the house or moves out. Since bulk of the savings at retirement is typically locked in home equity, it is a powerful device to increase the incomes of the elderly.
In a typical mortgage the homeowner makes a monthly amortized payment to the lender; after each payment the equity increases within his or her property, and typically after the end of the term the mortgage is paid in full and the property is released from the lender. In a reverse mortgage, the home owner makes no payments and all interest is added to the lien on the property. If the owner receives monthly payments, then the debt on the property increases each month.
If a property has increased in value after a reverse mortgage is taken out, it is possible to acquire a second (or third) reverse mortgage over the increased equity in the home. But in certain countries (including the United States), a reverse mortgage must be the first and only mortgage on the property.
Concept:
A borrower starts with a very high equity in his house. The lender extends a non-recourse loan secured by the house property. The borrower may choose to receive the proceeds through A lump sum at the beginning Monthly payments till a fixed term or a lifelong annuity Establishing a credit-line with or without accrual of interest on credit balance A combination of the above
The borrower need not move out of the house or make any payment to the lender, as long he is alive and continue to live in the house or does not sell it. Therefore the loan and interest accumulates till maturity. There is no credit or income requirement to be satisfied. Even if the accumulated loan and interest goes above the realizable value of the house at disposal, the repayment is capped at that value only. Hence reverse mortgage is a case of ‘raising debt, falling equity’.
The amount of loan will be a function of Age of the borrower (life expectancy/ mortality risks) The current value of the property and expected property appreciation rate (real estate market risk) The current interest rate and interest rate volatility (interest rate risk) Closure and servicing costs Specific features chosen: fixed or floating interest; shared appreciation; interest earning credit-line; and mortgage insurance, if any.
Conceptually the reverse mortgage idea is not restricted only to the elderly. However, the product is particularly suited for old people: the older a person is, the more attractive the scheme is. It is attractive to only people with insufficient current income and little financial savings- by implication, retired persons For a given property value, the lower the life expectancy (older the person is), higher is the additional income through an RM. Public policy support including tax incentives is more likely if the borrowers are the elderly. The elderly are particularly likely to attach significant psychological/ emotional/ sentimental value to ‘ageing in place’ without moving out. In fact, the longer they have stayed in their current home, the more valuable this is likely to be, considering the benefits of a familiar neighborhood .
The Indian scenario :
India is a young country. The average age of its citizens is about 26. Moreover, its population is expected to grow at 1.6 per cent annually. The proportion of the working-age population will rise for a long time and remain at a high plateau for a longer time. Therefore, India’s economy would continue to grow at over 6.5 per cent at least until 2040. The demand for housing, as a result, will remain high. The capital value of seasoned housing stock will rise at least as fast as incomes. Insurance companies would not have to dread any decline in home values for the next 35 years.
This also means that those who are 60 now will enjoy rising incomes or very certain incomes until they are 95. Homeowner in reverse mortgages will be protected against inflation. When capital value adjusts to inflation, incomes too can be adjusted upwards. Goods and services will remain affordable to retirees.
Reverse mortgage is made for India. It is a bankable scheme that takes away the sting from defined-contribution pension plans.
Defined-contribution schemes impose two risks on savers: They may earn insufficient returns. Retirees may live unexpectedly long.
At the same time, reverse mortgage is a good bet. It retains the principal flavor of a defined-benefit scheme and provides a guaranteed base income.
To save for retirement, people have to become better at guessing how much they need and how long they will live. Both guesses are tricky. Most people underestimate their longevity and financial needs. Reverse mortgage overcomes a significant part of these problems. It spurs economic activity, provides security and retains the principal flavor of a defined-benefit scheme.
Guidelines – The National Housing Bank (NHB):
A subsidiary of the Reserve Bank of India (RBI), is preparing the guidelines on reverse mortgage. Although the finer aspects of reverse mortgage have still not been finalized, some things have been made public
Loans will be given only to those who have a clear title on their property. This rule applies to both stand-alone houses as well as flats. In case of inherited property, all claimants to it will need to give their consent in writing. Sridhar says that if the property is inherited, the lender (banks or HFCs) will be guided by legal advice on the borrower’s clear rights or title. Another requirement is that prospective borrowers will be able to pledge their house only if they are using it as their permanent primary residence. Sridhar says it may not be possible to provide reverse mortgage for houses on power of attorney. As per the present rule, the lender will take possession of the house, sell it and adjust its dues if the borrower dies. It doesn’t specify what course would be taken if the children of such borrowers neither have the financial means to reclaim the house nor are willing to vacate it.
To take into account any change in the value of the property during the tenure of the loan, there will be a provision for its revaluation at least once in five years.
The rules, however, might need a few modifications to ensure smooth operation of the scheme. One clause that is drawing a lot of criticism is the one that fixes the maximum loan tenure at 15 years. The NHB will need to address the concern of borrowers over their predicament if they outlive the credit period. At present, the rules say that a borrower’s supply of income will be severed if he survives the loan tenure. However, he can continue to live in the house till his/her demise. The response to the product will be affected if this state of affairs persists. There exists a big segment in Tier-II and Tier-III cities and semi-urban areas waiting to be tapped.
Unlike in the West, joint families are still prevalent in many parts of India, although their number has shrunk. In many cases, the culture of joint families persists even after nuclearisation. In this scenario, many parents would still prefer to bequeath their house to their children rather than live off it. Reverse mortgage is a product that requires a great degree of regulation and transparency, both of which are missing in India.
Regulation:
Under the existing regulatory regime, banks come under the RBI and HFCs under the NHB. However, the recommendations of the regulator are only advisory in nature. The NHB plans to provide guarantee to borrowers against default by lenders by starting a loan mortgage company. The company would also safeguard the interest of lenders in case borrowers default the terms of the agreement. The extent to which the potential of reverse mortgage gets realized in India will depend a lot on the guidelines that will govern it. Much will also depend on how Indian society takes to it. But there is no doubt that it can lend dignity and peace of mind to elders by opening a financial lifeline for them.
Basic guidelines for reverse mortgage:
- When applying for a reverse mortgage, all owners must apply and sign the papers. The applicants must be at least 62 years old, own the home, and must generally live in the dwelling. One note though, mobile homes are usually not eligible for reverse mortgages.
- A borrower must seek counseling from a HUD approved counseling agency prior to applying for a reverse mortgage. This counseling is mandatory. During this meeting, the process is explained and a determination of eligibility is made.
- A borrower can request regular monthly payments, a credit line, or a lump sum distribution of cash. A combination of these payment plans can also be requested.
- Typically, a reverse mortgage loan requires no repayment for as long as you live in your home. If the home is sold, the borrower moves, or the last living borrower dies, the loan must be repaid. Usually the home is sold to repay the mortgage.
- Since you still own your home, you are responsible for repairs, taxes, and insurance. A default on any of these could cause your loan to become payable in full.
- There are certain costs involved in a reverse mortgage. The lowest cost mortgages are through the state and local governments and the highest through private lenders. Some costs include application fees, closing costs, insurance, appraisal fees, credit report fees, and possibly a monthly service fee.
- A reverse mortgage could affect eligibility for federal or state assistance. There could also be an impact on an estate when the owner dies. The home is usually sold to repay the loan or the heirs can choose to repay. If the home is sold and the selling price exceeds the amount of the balance owed, the excess goes to the heirs.
- Money received from a reverse mortgage is tax-free and does not affect social security or medicare benefits. It could affect Medicaid or other state assistance programs.
Many senior adults are finding it hard to live on their fixed retirement incomes and are looking for ways to supplement those incomes. For some, the largest asset they own is their home, but they do not want to sell their home and move. For these individuals, there is an option called Home Equity Conversion (HEC).
One type of home equity conversion is a reverse mortgage. The equity or cash value of the house is used to provide income to repay the loan. All reverse mortgage options are not the same. They have different eligibility requirements, income amounts, timing of payments, interest rates, and/or initial costs. Homeowner should compare the different options, keeping in mind their goals and needs.
Advantages: The value of your house, not income, is used to determine eligibility. One can receive a lump sum, a line of credit, or a monthly amount, without having to make a monthly repayment. One does not have to sell ones house and move – one can continue to live in the same familiar surroundings. One does not have to worry about losing one’s house to foreclosure since the payments are made out of equity in the home, not from your income. The loan must be repaid when the house is no longer used as your personal residence. However, the lender can only look to the proceeds from the sale of the house for repayment. They cannot go to your heirs if the house sells for less than what was borrowed. Money can be used for any purpose. The senior citizens are entitled to regular cash flows at their choice – monthly, quarterly, half yearly and annually. The loan is given without any income criteria at an age where normal loans are not available. No loan servicing or repayment required during the lifetime of borrower and spouse. If the borrower dies during the period, the spouse will continue to get the loan amount for 15 years. Tax treatment of a RML will be as loan, not income, so no tax will be payable on the regular cash flows. The borrower and their spouse can continue to stay in the house till both die. Heirs of the borrower will be entitled to get the surplus of sale value of the property. Borrower/heir can get mortgage released by paying loan with interest without having to sell property at any time. Prepayment of loan is allowed. NHB to guarantee obligation of banks/housing finance companies to pay the committed loan amount as regular sums over a period of time.
Reassessment of property value will be done periodically, or at least once every 5 years. Borrower can cancel the mortgage within three days of approval/disbursement, subject to return of loan amount.
Disadvantages: Interest for a reverse mortgage is compounded, and cannot be deducted on income taxes until you repay it. The income one receives decreases the equity in one’s home and the equity may not be adequate for ones future needs or for ones estate. Interest rates and initial costs (application fees, points and closing costs) are usually higher for a reverse mortgage than for other equity loans. Income ends when one sells ones house or no longer uses it as a principal residence. Payments may affect Supplemental Security Income and Medicaid payments. One may need to pay off ones existing mortgage out of the proceeds of one’s reverse mortgage. One will be required to maintain the house, pay the taxes, and carry property insurance. This loan product has a maximum tenure of only 15 years. If the borrower outlives this period, the regular cash flows will stop. Basis of property valuation is not clear. Requirement of clear title to property in the name of the borrower to get the loan. Three days period to cancel loan is too less. Should be at least 15 days to go through the fine print.Various fees to be added to borrower’s liability, which can be quite substantial.
Eligibility:
One could be eligible if one owns one’s own home, use the home as one’s principal residence, and are at least 60 years of age. One must also have adequate equity in the home.
A lender looks at the equity in the home plus any expected appreciation or depreciation in the value of the home to calculate a base amount. The costs associated with any reverse mortgage loan (application fees, interest rates, closing costs, initial charges, sales commissions, and homeowner’s insurance) also must be considered.
The lender and the homeowner must work together to determine the type of payment, the payment amount, and the time period.
Risks for Lenders:
The risks associated with offering any new product or service in a market can be substantial. Costs have to be recovered from revenue and a required level of sales achieved to turn a profit.
For Reverse Mortgages, however, additional risks are inherent because the contract may last for anywhere up to 30 years or more. Financially, the lender must consider a myriad of possible factors when determining the price and conditions associated with the loan. A miscalculation of the rates and amounts offered may lead to the accumulated amount owed to the lender being greater than the house value. Given that reverse mortgage contracts generally guarantee that the borrower will not pay back more than the house value, this situation will lead to the lender making a loss on the contract. Interest rate variations are an area of primary concern. An increase in rates over the loan term will add substantially to the amount owed to the company due to the compounding nature of the debt. If rates increase for a long period the accumulated debt may exceed the house price and a loss on the loan may eventuate. While some lenders are attempting to remove this risk by the use of fixed interest rates, this may be a hindrance to marketing by making the product appear less attractive.
Also known as home equity release schemes or home income plans, a reverse mortgage allows a home owner to receive a lump sum payment and/or income stream.
These payments to the home owner represent loan payments which accrue with interest until the owner moves house or die. At this point the accumulated loan is repaid from the proceeds of the house’s sale. Because of its structure the reverse mortgage can be very relevant for asset rich, cash poor individuals and offers a way for retirees to supplement their income. Given the above trends and market size it is unsurprising that there is increasing interest in this product from both providers and customers. Further evidence of this interest is in the number of providers, which has increased substantially this year.
Undoubtedly other providers are currently testing the water and will follow shortly. However, while the time for marketing and sales may be right, there are still significant risks to any company wishing to enter or operate in the reverse mortgage market. House price variations are a risk on the asset side of the equation. If house prices for instance were to fall or remain static over an extended period of time, once again lenders may find themselves making losses. Further complexity occurs with house prices since they are influenced by many factors. The type of dwelling (house/flat/townhouse), the construction method, the suburb, the city, the level of maintenance and even the houses’ individual characteristics will all influence the current and future price. Increasing longevity, leading to the possibility of increased tenure in the family home places a risk on the lender.
The longer the reverse mortgage contract runs, the greater the effect of the compounding interest and the greater the probability that the loan will exceed the house value. Other risks such as bad publicity, fraud and the level and accuracy of customer advice are not to be underestimated. The US reverse mortgage market is only now recovering from the misselling of products in the 1980s. Some customers who received poor advice at the time subsequently had their homes repossessed when interest rates turned against them. While the outcome of these risks cannot be directly expressed mathematically they still warrant careful attention and must be considered when designing the product offering. Only by fully understanding the risks involved and designing their product
Example
A wide variety of loan options are available depending upon your age, the amount of equity available, the time period of the loan, and the way payments are disbursed.
For example, Mary Jones, a 75-year-old widow whose home is her principal residence, is looking at a ten-year reverse mortgage that will provide her with additional monthly income of approximately $450. At the end of the ten years the monthly income payment will stop. But because her loan is through an insured lender (loans offered by HUD approved lenders have government guarantees), the loan will not have to be repaid until she sells the home, moves, or dies.
