A reverse mortgage works best as a line of credit that allows seniors to meet their immediate needs, such as home repairs, while preserving the remaining balance as a nest egg in case of emergencies.
But many seniors have used reverse mortgages as a lifeline to deal with more urgent financial needs, such as avoiding foreclosure and paying off other household debts. And that's gotten some of them into financial hot water -- a situation Uncle Sam is trying to rectify by tightening program guidelines.
The National Council on Aging (NCA) says one-third of its counseling clients have mortgage debt that exceeds 50 percent of the value of their home. Using a reverse mortgage to pay off the existing mortgage and other household debt leaves these borrowers with little equity to fall back on.
As a result, the Federal Housing Administration is experiencing "technical" defaults on reverse mortgages. These are cases in which borrowers can't afford to pay their property taxes and homeowner's insurance.
The losses on these defaults take money from the FHA mortgage insurance fund. So the FHA is moving to tighten its requirements for seniors who apply for an FHA-insured reverse mortgage, which the agency calls a Home Equity Conversion Mortgage.
FHA pioneered the reverse mortgage and introduced the HECM product 24 years ago. Now, for the first time, the agency wants to impose a financial assessment test on borrowers.
The test will determine if the borrowers have enough remaining cash flow to pay their living expenses after meeting their HECM obligation to pay taxes and insurance.
For borrowers who flunk the measure, the lender would be required to use a portion of the loan's proceeds to create an escrow account. The amount of the account is still under discussion within the agency, but under consideration is a set-aside of two to three years' worth of taxes and insurance payments.
But it's also possible that the FHA may decide that every HECM borrower, not just those who fail the test, will have to set aside an amount for taxes and insurance in case of an emergency.
Consumer and industry groups support efforts to shore up the HECM program, which is expected to experience increasing demand from the aging baby boomer generation. But there are some concerns the FHA may tighten too much. Consequently, consumer groups want to be sure there is some flexibility, particularly for low-income seniors.
NCA senior director Ramsey Alwin stressed that the set-aside should take into account the numerous public and private programs that provide property tax relief for seniors.
The nonprofit group that provides HECM counseling operates a website -- benefitscheckup.org -- that lists 160 property tax relief programs across the country. It also lists programs that help with Medicare premiums and co-pays and provide assistance with prescription drug and utility costs.
"The average reverse mortgage borrower can identify $5,500 worth of savings a year" from these assistance programs, Alwin said. "That will free up their limited income and could put them on a better financial footing when it comes to the financial assessment."
Many seniors ended up in technical default because they took out a Standard Fixed Rate HECM loan, which FHA has "temporarily" withdrawn from the market.
The standard fixed-rate product turned out to be risky because the borrower had to take out all the equity at one time in one lump sum. As it turned out, too many people didn't know how to handle such a large amount of cash.
Many also ended up in default because they were facing a financial crisis, such as a foreclosure, and had to act quickly.
Seniors should be looking at the reserve mortgage option "early and often," Alwin advised. And they should decide before a crisis when they want to use home equity to supplement their income.
The NCA has a support tool on its website that helps people think through the implications of a reverse mortgage and consider other options to free up cash.
Alwin also pointed out that FHA offers a line of credit option -- the HECM Saver -- that is more "consumer friendly" than the standard fixed-rate product.
The Saver has lower upfront costs, and because it is an adjustable-rate product, the proceeds of the reverse mortgage don't have to be dispersed all at once. So the borrower can tap into his line of credit only as his needs dictate.
The Saver reverse mortgage allows the borrower to "pay off immediate needs and maintain the nest egg for a rainy day," Alwin said.
Jeff Taylor, a reverse mortgage consultant and the founder of Wendover Consulting, noted that the HECM program primarily offered a line of credit when FHA first rolled it out in 1989.
Despite some aversion to ARM products on the part of consumers, Taylor expects demand will revert back to the line of credit product, the unused portion of which grows annually, much like a savings account.
"We are seeing financial planners across the country taking a second look at the HECM Saver ARM program as an option for many seniors to bridge the gap -- so they don't have to sell their stock portfolios or other investments," Taylor said.