Inman

Property taxes a surprise risk in reverse mortgage lending

Editor’s note: This is the second of a five-part series. See Part 1, "Financial crisis hits reverse mortgages hard."

Home Equity Conversion Mortgages (HECMs) are FHA-insured reverse mortgages that allow homeowners 62 years of age or older to withdraw cash from their home while retaining the right to live there until they die, sell the home or move out of it permanently.

A major problem with the HECM program is that an increasing number of borrowers are in default — 8 percent of the total in the most recent count. While HECM borrowers don’t have required mortgage payments, they must pay property taxes and homeowners insurance premiums, and maintain their property.

Most of those in default have not paid their property taxes. This problem was never anticipated by policymakers.

Why HECM defaults wern’t anticipated

On forward mortgages, borrowers are generally required to make monthly payments for taxes and insurance into an escrow account, out of which the lender makes the required payments when they come due. The rationale is that the lender needs assurance that the borrower has the capacity to meet this additional payment burden.

Since a HECM borrower does not assume a mortgage payment obligation (on the contrary, a reverse mortgage is a source of additional cash), there seemed to be no need to escrow taxes and insurance.

But this inference was based solely on financial capacity and ignored financial incentives. On a forward mortgage, the borrower has a strong incentive to pay taxes because the failure to do so would result in a lien on the property, which would prevent the mortgage from being refinanced or the property from being sold.

In contrast, many HECM borrowers have no refinance option to lose and no concern about the size of their estate, which gives them a financial incentive not to pay property taxes. The only significant deterrent is the threat of foreclosure and eviction, which most HECM borrowers realize won’t happen.

Lenders must give HECM borrowers two years to repair a default, and FHA must approve the transition to foreclosure status. FHA has not released any figures on HECM foreclosures, but if there have been any they have been very few. Further, foreclosures don’t necessarily result in evictions, and those would hit the news wires if they happened.

Dealing with defaults on existing HECMs

When HECM borrowers who fail to pay their property taxes or insurance bills have unused capacity to draw more funds, their servicers have been advancing the funds required and adding the amounts to their loan balances. The problem arises when the borrower’s loan balance is maxed out. Last year FHA issued guidelines on how lenders should deal with this problem.

The lender must offer "loss mitigation options" designed to cure the deficiency, including repayment plans and free counseling. All such options must be exhausted before the lender asks FHA for permission to foreclose.

Nowhere does FHA say that if everything else fails and the lender requests permission to foreclose, that FHA will grant it and allow eviction. Throwing elderly homeowners out into the street would be a public relations disaster for FHA.

Potential new HECM borrowers should not be deterred by the default problems of existing borrowers. However, new borrowers will face a different set of rules designed to prevent them from defaulting.

Preventing defaults on new HECMs

HECM lenders will soon be evaluating whether HECM applicants have the capacity to pay their property taxes and insurance premiums, and whether their credit history indicates a willingness to do so. If the answer is "no," the lender must either reject the application or (more likely) accept it with a mandatory set-aside for payment of property charges.

To fortify lender resolve, lenders who pay property charges on behalf of a HECM borrower who is maxed out will be stuck for part of the loss.

It is likely that rather than turn down applicants, HECM lenders will offer deals with a set-aside, which reduces the amounts borrowers can draw. The set-aside leaves borrowers responsible for paying taxes and insurance, acting as a reserve account to protect the lender and FHA in the event that the borrower defaults. The set-aside of a borrower who always pays property charges will pass to the estate.

An alternative is to require escrow accounts, which would also reduce draw amounts but would be far better for borrowers because it largely relieves them of the obligation to pay taxes and insurance.

Implementation would require that every HECM include a rising lifetime annuity that would fund the escrow account required to meet all future payments. Because the required annuity cannot be precisely determined, the borrower may still be required to pay small additional amounts.

Nonetheless, it is far more attractive than a set-aside in which the borrower is obliged to pay the full amount every month.