Eat your equity

American Demographics, March, 1998 by Marcia Mogelonsky

Reverse mortgages could be a boon to thousands of seniors who are house-rich and cash-poor.

They could also force thousands of baby boomers to face old age with no inheritance.

Reverse mortgages are a hot new financial product. They allow people who have a lot of home equity to borrow against it without making monthly payments on the loan. They are a boon for cash-strapped older Americans. They also solve an immediate problem for baby boomers who find themselves in the "sandwich generation," those who pay their children's college tuition while also supporting their elderly parents.

More than 67 million households own their own homes, according to the Census Bureau. About two-thirds of homeowners regard the mortgage payment as an inevitable chore, like mowing the lawn. But 23 million households, or 37 percent of all homeowners, own their homes free and clear, according to SMR Research. These homeowners are mostly seniors aged 65 and older. A sizable chunk of their equity is tied up in their homes--it's the one asset they have worked for years to maintain.

Debt-free homes are secure assets against which homeowners can borrow, should they need liquid funds. But senior homeowners are often not good candidates for home-equity loans and other traditional forms of lending, because they are usually living on fixed incomes that do not allow them to pay down a loan on a monthly basis. At the same time, many senior homeowners find themselves in need of cash to pay medical expenses, buy a car or other durable goods, or even help children and grandchildren buy their own homes.

Assisting Living

A reverse mortgage is a home-equity loan with a twist. It allows the homeowner to convert a proportion of the equity in his or her home to cash, while at the same time retaining homeownership. In a traditional mortgage, the homeowner pays a monthly sum to the lending institution; in a reverse mortgage, the lender makes a monthly payment to the homeowner. Reverse mortgage holders are expected to pay back the principal and the interest that has accrued during the tenure of the loan when they sell their homes, move permanently, or reach the end of the pre-elected loan term. If the loan holder dies, the heirs must pay back the loan, usually by selling or refinancing the home.

By law, reverse mortgages are available only to homeowners aged 62 or older who own their homes free and clear, and who occupy them as a principal residence. The amount that eligible homeowners are allowed to draw against their homes depends on a formula based on the value of the home and the age of the borrower. Homeowners can receive their money as a lump sum, in monthly payments, or as a line of credit, depending on the loan plan and the lending institution.

"With reverse mortgages, our parents are getting their own inheritance and spending it."

Currently, there are two kinds of federally supported reverse mortgages: the Home Equity Conversion Mortgage, administered by the Federal Housing Authority (FHA), in which the home being considered cannot be worth more than $170,362; and the Fanny Mae Homekeeper, for higher-value homes with a maximum value of $227,150. The FHA mortgage is far more common than the Fanny Mae product, which accounts for only 10 to 15 percent of the market. In addition, some states allow private lenders to sell reverse mortgages for homes of even greater value.

A regular income is not required to qualify for a reverse mortgage, and the payments from a reverse mortgage are tax-free. These loans also have "non-recourse" clauses that prohibit lenders from pursuing heirs for payment. If the home is sold for less than the amount owed on the reverse mortgage, the difference must be forgiven by the lender. The borrower's other assets are not attached to the loan, and the lender cannot take possession of the house as long as the borrower uses it as a principal residence.

Reverse mortgages can give seniors the financial and emotional security of remaining in their homes for as long as they wish, even if unforeseen expenses arise. This is a critically important issue to the oldest old: 86 percent of homeowners aged 75 or older consider remaining in their homes for life a top priority, according to a survey by the American Association of Retired Persons (AARP). For financial services firms, reverse mortgages are a way to tap into the hidden wealth of the lower-income elderly.

The downside of reverse mortgages only becomes apparent at the end of the loan term, or when the borrower dies. If a reverse mortgage is in the family, heirs who are counting on a bequest to finance their own futures may come up short. Many of those heirs are baby boomers who don't have adequate retirement plans. And when they retire, boomers probably won't have as much home equity as their parents do.

One Step Ahead of Poverty

The average reverse mortgage holder is a 76-year-old widow who lives on less than $13,000 per year, including Social Security benefits. The reverse mortgage allows her to maintain an independent lifestyle and remain one step ahead of poverty. But reverse mortgages are not used by the majority of elderly homeowners. Even elderly people in poverty aren't using the product.