Taking Care of Mom and Dad: Reverse Mortgages

One great tool for creating liquidity from relatively illiquid real estate is the reverse mortgage. A reverse mortgage is real estate's version of an annuity.

If your parents find themselves without enough usable cash flow, and have considerable equity in their home, a reverse mortgage can be used to generate the extra cash flow your parents need to maintain their standard of living.

Being land-rich and cash-poor is a long-standing problem first addressed in Europe over 100 years ago. European real estate investors bought homes from elderly owners and then allowed them to live in the home rent-free for the remainder of their lives. This process is still popular in Europe today.

After WWII, the concept was imported to the United States and became known as the reverse mortgage or home-equity conversion loan. The first reverse mortgage programs in the U.S. were sponsored by local government agencies and had limited benefits, with payments usually available only for property taxes and home repairs.

In 1989, the U.S. federal government started its own program through the Department of Housing and Urban Development (HUD). The program, called the Home Equity Conversion Mortgage (HECM), is administered through the Federal Housing Administration (FHA) with loans required to be submitted by FHA qualified lenders.

In 1995, the Federal National Mortgage Association (Fannie Mae or FNMA) began its Home Keeper program. Due to Fannie Mae's high profile, Home Keeper brought a lot of momentum to the reverse mortgage market. The Fannie Mae program is similar in structure to the HECM but has higher home value limits.

Through the late 1990s, various private sector lenders followed Fannie Mae's lead and moved into the reverse mortgage business.

When lenders issue a reverse mortgage, a home is used as collateral to structure a loan in the form of monthly payments, a line of credit or a onetime payment. As a rule, the more money your parents receive from the lender, the more of their home's equity will ultimately belong to the lender. The amount of cash that your parents will receive from the lender depends on your parents' age (they must be at least 62), the value of your parents' home and the borrowing limits erected by the lender they select.

The older your parents are, the more money they will get. A 62year-old could expect to get something like 70 percent of what a 76-year-old would receive. This is due to the shorter life expectancy of the 76-year-old.

Along with a reliable source of monthly income, the amounts received subject to a reverse mortgage have the following benefits:

• a reverse mortgage is a loan, so the payments your parents receive are tax free;
• reverse mortgages do not affect your parents' Social Security or Medicare benefits;
• reverse mortgage payments will not be counted as income when your parents apply for Medicaid, so long as they spend the money they receive in the month they receive it; and
• if they stay in their current home, your parents can receive monthly payments for as long as they live there -- even if the lenders end up paying more than the home is worth.

It's worth repeating the last point: No matter how much your parents borrow with a reverse mortgage, the lender can never take their home away. Nor can lenders lay claim to their income, their other assets or your assets when it comes time to settle the loan's final costs. The loan is "settled" when your parents move, die or decide they want the loan to stop.

Though reverse mortgages have some obvious benefits, you shouldn't assume that they are without cost. Lenders hedge their bets, and you bear these costs. First, lenders typically only lend 50 to 70 percent of the appraised value of your home. To reduce their risks, all loans are covered by mortgage insurance. This insurance helps the lender cover expenses if your parents, for example, live in their home until age 100 and opt to receive monthly payments.

Also, if your parents' home needs work, lenders will delay the loan until needed repairs are made. Lenders don't want to get stuck with a loan on a property that's decreasing in value because needed maintenance is not being done. If your parents don't want to make the repairs, they won't get the loan. If they cannot afford to pay for the repairs, the costs of repairs can be paid through their loan.

The costs -- points, closing costs, origination fees, monthly service charges, mortgage insurance and mandated repairs -- can make reverse mortgages very expensive loans, especially if they are only used for five or fewer years. The longer your parents keep the loan, the more cost effective it will be.

Your parents must also realize that even after entering into a reverse mortgage they still have all the responsibilities of homeowners. They must still pay homeowners insurance premiums and property taxes. Failure to cover these expenses can result in a lien being placed on the property and the lien could lead to foreclosure.

Before they even qualify for a loan, borrowers usually have to undergo some form of counseling, administered by a government-approved agent. This counseling reviews the terms and costs of the loan. The agent also goes over the loan's repercussions and discusses alternative ways to raise money -- if there are any.

All of this said, reverse mortgages work if your parents have considerable equity built up in their home and it makes sense for them to continue living there. A reverse mortgage makes the most sense for a single parent, at least 75 years old, who owns his or her home free and is clear of all debts.

Of course, the size of your parents' estate will be reduced by the amount of the reverse mortgage. This, however, should not be a concern because of your parents' awareness to their underfunded cash flow position. Remember that an efficient solution to your parents' cash flow problems may be simply to sell the house.

The reverse mortgage market has a potential to reach the $2 trillion dollar range, so it's no surprise that lenders are preparing to handle the demand. In 2002, there were nearly 15 million seniors eligible for reverse mortgages in the U.S. And there are more each year.