Understanding the Mathematics of Personal Finance

Reverse Mortgages and Viatical Settlements

12.1 REVERSE MORTGAGES

A reverse mortgage is a variation on a home equity loan with some insurance and annuity concepts scrambled into the mix. Before going further, I should mention that government regulations limit the availability of reverse mortgages to people age 62 or over.1

Assume that you, or the youngest of you and your partner, is at least 62 years old. You own your home (or the two of you own it jointly). Your personal credit rating is unimportant except for a few specific items such as an outstanding tax bill.

A reverse mortgage will give you a lump sum loan today (or another option that I’ll present later on). You don’t make any payments on this loan. You continue living in your home until the second of you dies or you decide to sell the home. At that time, your beneficiaries can either pay off the loan (including accumulated interest) from their own funds or sell the home and pay off the loan with the proceeds. If the home has appreciated to a greater value than the amount due on the loan, the benefi­ciaries keep the difference. If the home has depreciated to a lesser value than the amount due on the loan, the lender absorbs the loss—at no time is more than the value of the home due to the lender.

For many people, this deal is wonderful. They get to spend the rest of their lives, or at least as much of the rest of their lives as they want to, in their own home. They do, of course, have to pay property taxes and insurance and maintain the home, but these aren’t unreasonable requirements. They get some money that might be neces­sary or might just be used to make their later years more comfortable, but in any case, it’s useful money. They have no risk of the deal collapsing and of their having either to come up with some money or to get out of their home. There is no cash risk to the beneficiaries.

What isn’t there to like?

1 Again, laws change. Check for current information.

Understanding the Mathematics of Personal Finance: An Introduction to Financial Literacy, by

Lawrence N. Dworsky

Copyright © 2009 John Wiley & Sons, Inc.

• Scams and overly aggressive salespeople are associated with reverse mortgages.

• Start-up costs and administrative fees are high and, before regulation, some had been exorbitant.

• Elderly people are sometimes pressured to buy unnecessary insurance policies to accompany the reverse mortgage.

• The homeowners do not necessarily receive as much as they expect based on the appraisal of the home.

In putting together a reverse mortgage, the lender must first estimate when the homeowner (or the surviving spouse) will die. This is straightforward. In the last chapter, I presented couples’ first to die and last to die tables to augment the indi­vidual Life Tables. Insurance companies are very good at making these estimates. The insurance company also needs to estimate the value of the home at the (esti­mated) time of that last death.

Most reverse annuity loans are adjustable rate mortgages (ARMs). The annual percentage rate (APR) can and almost definitely will vary. Depending on the program chosen, limits are set on how much and how quickly the APR can change.

When selling an annuity, an insurance company is looking to two sources of money to make payments on the annuity and run its business. First, it has the premium itself. Second, the company has the investment income it can earn on the balance of the premium as the company spends it down. When selling a reverse mortgage, the situation is different. The insurance company is handing money to a homeowner and is planning to recoup the money in the future when the home is sold. Conceptually, the insurance company is borrowing the money from somebody the day it gives the money to the homeowner and is planning to pay a lower interest rate than the rate it is charging so that it can run the business, make a profit, and settle the accounts when the home is ultimately sold.

What have I left out? I’ve left out some protection for the insurance company. What if home values aren’t what everyone thought they would be when the time comes to sell the home? While excess home value goes to the beneficiaries, the insurance company doesn’t collect the missing amount on insufficient home value. One of the costs of a reverse mortgage (which is wrapped into the loan) is an insur­ance policy for just this contingency. Various fees and administrative costs are also usually wrapped into the loan.

Reverse mortgages make more sense for very elderly people than they do for younger (but still eligible) elderly people. The shorter the time the insurance company (the lender) has to plan to wait before concluding the deal (i. e., the home is sold, the loan repaid, and the books are closed on the contract), the better its “crystal ball” predicts future home values, interest rates, and inflation, and consequently the more money it can make available for the loan.

A couple of possible variations on the theme: Remember that you don’t have to die to get out of this. You can pay off the loan at any time. You can sell your

house at any time but of course then you must pay off the loan. Next, you don’t have to take the loan in a lump sum. You can structure a payment plan and/or you can use the loan amount as an available equity-based resource—you write a check on part or all of it when you need it. The advantage of either of these alternatives over taking the lump sum is that you don’t pay interest on money you haven’t yet borrowed. Since you’d undoubtedly be paying a higher interest rate on borrowed money than you could get by putting the lump sum into a savings bank, it ’ s to your benefit not to pull out money until you need it or want to spend it.

There are several different programs and plans for getting a reverse mortgage. Each has its own specific details, its own costs, its own way of valuing your home, its own maximum loan amount, and so on. There is a tremendous amount of infor­mation and a calculator with a detailed calculation breakdown at http://www. reverse- mortgage. org/ .

The examples shown in Table 12.1 were run on this calculator at the end of February 2009. I repeated these examples for homes in:

Shoreline, WA—a suburb of Seattle;

Scottsdale, AZ—a suburb of Phoenix;

Barrington, IL—a suburb of Chicago;

San Pedro, CA—a suburb of Los Angeles; and

Middlesex, MA—a suburb of Boston

and got the same answers each time. This is for the Department of Housing and Urban Development (HUD) Home Equity Conversion Mortgage (HECM) loan. The HECM is the most popular reverse mortgage program available today, but not the only available program.

The initial ARM rate on these loans was (approximately) 3.64%. This rate is based on the Treasury Notes, with the ARM adjustable monthly. A fixed rate loan

Table 12.2 Sample HECM Reverse Mortgage Estimates of Maximum Available Loan, Corrected for Bundled Costs

House value ($)

cost was approximately 6.2%. This number includes 0.5% mortgage insurance, so while the actual loan APR is 5.7%, you pay 6.2%.

The total of fees and service charges was about $21,000 for the loans. Table 12.2 is a repeat of Table 12.1 but with $21,000 deducted from each loan. Remember that these are approximate numbers; everything changes with time and not all the loans shown here have exactly the same bundled costs. Assuming you take a lump sum loan for the maximum available amount, you get the number in Table 12.2 while you repay from the number in Table 12.1.

Also in Table 12.2, I rewrote the numbers for what you actually get as a percentage of the value of the home. Table 12.2 is shown in a graph in Figure 12.1.

Figure 12.1 shows that the available loan as a percentage of the house value is greater for a more expensive home than for a less expensive home, but not by much. On the other hand, while only about 50% of the home ’ s value is available to a 65-year-old borrower, about 65% of the home’s value is available to an 80-year-old borrower. Also shown in Figure 12.1 (the dashed line with its axis on the right) is the e value from the Life Tables versus the age of the borrower at the time the loan is taken. The 65-year-old borrower expects to live about another 17 years while the 80- year - old borrower expects to live about another 8 years. The lender is more conservative with longer term loans, as was explained above.

A reverse mortgage is a loan issued by an insurance company. As long as the insurance company can charge a higher APR on this loan than it is paying for money “loaned” to it by other sources of income, such as life insurance premium income or by actual outside loans, this is a profitable business.

I’m not offering my own custom calculator for reverse mortgages. The calcula­tor referenced above is excellent, easy to use, and always current. The level of detail available is excellent. I can’t do better.