REVERSE MORTGAGES

In 1961, a kind soul named Nelson Haynes, a banker with Deering Savings and Loan (Portland, ME, USA) developed and delivered a financial product to help out Nellie Young, the widow of his high school coach. Today, almost fifty years later, that financial product has come a long way and metamorphosed into a popular financing option for the senior citizens. This unique instrument is called a Reverse Mortgage. Reverse mortgage is a type of mortgage in which a homeowner can borrow money against the value of his/her home. No repayment of the mortgage is required until the borrower dies or the home is sold. After accounting for the initial mortgage amount, the rate at which interest accrues, the length of the loan and rate of home price appreciation, the transaction is structured so that the loan amount will not exceed the value of the home over the life of the loan. What differentiates a reverse mortgage from a regular mortgage is that in a regular mortgage, a borrower mortgages his new/existing house with the lender in return for the loan amount; the same is charged at a particular interest rate and over a predetermined tenure. The borrower then has to repay the loan amount in the form of EMI’s(Equated Monthly Instalments), which comprise of both the principle and interest amounts. Under a reverse mortgage loan however, citizens aged 60 years and above (62 and above in the United states) will be able to pledge their house and derive a monthly income or a lump sum while living in it. It is mainly meant for home-rich senior citizens who are otherwise cash-poor. Reverse mortgages works like a traditional mortgage loan, only in reverse direction. A borrower does not make regular payments to a lender, instead he receives payments from the lender. There are an array of reasons why this distinctive financial instrument has gained astronomical popularity over the last couple of decades. The prima facie reason is the benefit it offers to the elderly citizens who are looking for sound financing options of their lifetime savings in their twilight years. A prominent feature of this particular loan is the absence of the need for and irrelevance of healthy credit and salary stubs; the reason being that the borrower does not need to make any payments. All the

borrower needs is to own a house which has no lien attached and the loan can be borrowed against its current equity. Another reason for its popularity is the sense of independence and ownership associated with the instrument albeit it being a mortgage loan. It allows the borrower to remain in the house and retain its ownership. This kind of mortgage avoids the necessity of the senior citizen selling his property and thereby losing possession. Usually, the pension or interest he/she gets loses its value due to inflation, making it inadequate for their living, so that reverse mortgage offers a solution for them with the house that they live in. they can continue to live in the house till death and if the agreement is so worded, till the demise of oneself or their spouse (sometimes even children and relatives, depending on the contract) whichever is later. Yet another benefit as can be obviously implied is the lack of monthly mortgage payment requirements. The borrower need not pay back the loan nor make any monthly mortgage payments until he/she permanently moves out of the house.

However, of all the benefits concerned with any loan or investment or a mortgage, the chief benefit is that of tax relaxation and no other mortgage loan offers a more appealing tax rebate as does a reverse mortgage loan. From the tax planning angle, a person who has to mortgage the property for his living expenses is not likely to have any tax liability, especially in the light of exemptions available to senior citizens. Since what he/she receives is a mere loan, even if he/she receives it in instalments and cannot be considered as income, it is tax-free. A supplementary incentive is that it does not affect the social security or Medicare benefits. A pleasant element of the reverse mortgage loan is the liberty, autonomy it bestows on the receiver to use the funds in whatever way he pleases. The proceeds from a reverse mortgage can be used for anything, whether to supplement retirement income, to cover daily living expenses, repair or modify your home, pay for healthcare, pay all existing debts, cover property taxes and prevent foreclosures, et al.

Notwithstanding the enticing benefits of a reverse mortgage, there are a string of drawbacks attached, which a borrower has to consider before he embarks on a reverse mortgage loan. A crucial concern apropos a reverse mortgage is the cost attached to the loan. They tend to be very expensive compared with a conventional mortgage. This is due to their rising-debt nature. For example, a typical reverse mortgage may provide a homeowner with a rupees 15000 per month payment with a yearly interest rate of 12% compounded monthly. Over the course of ten years, the homeowner will receive rupees 18 lakh in payments, but will owe almost 35 lakh, almost twice as much as received. A second disadvantage is the complex and confusing contracts of reverse mortgages that can have tremendous impact on the overall cost of a reverse mortgage to the borrower. The complexity of the contracts often allow lenders and third parties involved in arranging reverse mortgages to not fully disclose the loan’s terms and fees. These numerous other front-end or back-end fees can quickly drive up the cost of a reverse mortgage. These fees can include origination fees, points, mortgage insurance premiums, closing costs, servicing fees, shared equity and shared appreciation fees. Yet another disadvantage is the interest rate. Once the lender starts making payments, it charges an interest rate on the growing debt. Essentially the borrower is giving the lender his hard earned equity and is charging him/her more for it. Also the interest is not deductible. Perhaps the major drawback of a reverse mortgage has to do with control. Simply put, you are giving it away. For most people, their home represents their biggest asset. By entering into a reverse mortgage agreement, you lock up that asset. It might make sense to do so if you were getting a great deal, but that is not the case. It is outrageous to pay fantastic costs and interest rates on equity you have spent years building up.

“Reverse Mortgages could be the next sub prime mortgage product to experience rapid growth while taking advantage of a vulnerable segment of the population”, top U.S bank regulator John Dugan said while speaking at a conference held last month. Dugan, who heads the office of the controller of the currency and supervises some of the nations largest banks, said regulators are crafting guidelines to ensure that robust consumer protections are in place for reverse mortgages. “While they can provide real benefits, they also have some of the same characteristics as the riskiest types of sub prime mortgages, and that should set off alarm bells”, Dugan said in prepared remarks to an American Bankers Association Conference. Fannie Mae, the largest provider of U.S home mortgage funding had about 90% share of the reverse mortgage market at the end of 2008. Many large banks such as Bank Of America and Wells Fargo were big players in the reverse mortgage market. The consequent fall of these premier banks stresses on more stringent introspection before going in for these mortgages. The extent to which the potential of reverse mortgages gets realized will depend a lot on the guidelines that govern it. The government must play its part in ensuring that only the most credible institutions are allowed to offer reverse mortgages products; that they keep interest rates and service charges reasonable, with no hidden increase of rate that would make the entire loan due immediately.

By: - Ben C Kurian PGDM(Finance) D-208

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