Reverse mortgages have lots of rules. Specifically, the FHA insured Home Equity Conversion Mortgage (HECM), has more rules than any loan I have ever done. The other challenge is that FHA tends to add, change and update (never subtract), these rules on at least a yearly basis.
That’s just on the national level. A number of states with overbearing governments that think they know what’s best for their residents also like to impose their own rules. For example, the state of New York just signed a new law that caused reverse mortgage lenders to suspend all lending in that state until they can figure out how to work within the new rules.
Luckily, in Colorado we have not seen this government overreach…Yet. Let’s keep our fingers crossed.
But this article is not a complaint about governments. I’m an active member in the National Reverse Mortgage Lenders Association and they keep me informed about what new law, rules and regulations are coming down the pike. As I find out about rule changes, I will keep you informed through this blog and my radio show.
Today, I want to discuss an older rule that tripped up a customer of mine in recent months. It’s called “initial disbursement limits”.
Initial Disbursement Limits
This rule requires a bit of background. From 2009 – 2013 most reverse mortgage loans were on the fixed-rate product. Since fixed-rate loans are what is known as “closed-end” loans, borrowers receive all the funds available in one lump sum at closing, whether they needed it or not. Think of refinancing your mortgage. You tell the bank you want to pay off your current mortgage and maybe roll a car loan in with it. You get a loan for that amount and that is it. No more money is available after the loan has closed. That is known as a closed-end loan.
With the example above, you tell the bank how much you want. However, wit a HECM loan, HUD dictates how much the lender can loan and if the borrower chooses a fixed rate, they do not get to say “I only want half now and the other half in the line of credit” because there is no line of credit available with this option.
During that time when most borrowers chose the fixed rate option and took all the money upfront, some spent it all and did not save any for reserves. This caused a wave of people forgetting, or not having the funds to pay, their property taxes and/or homeowners insurance premiums, (property charges). When a borrower fails to pay their property charges, this is what is called a “technical default”. This means the loan is called due and payable.
Before we go into the rule HUD created to fix this problem, I need to give a couple of definitions:
Principal Limit: The maximum amount of money a reverse mortgage borrower can receive. In normal loan terms, this would be called the loan amount.
Mandatory Obligations: Items that must be paid off at closing. They include mortgages, liens, judgements that affect the home’s title, federal debt, closing costs, and initial mortgage insurance premiums. Mandatory obligations may be financed into the loan or paid by the borrower at closing.
As a result of this wave of technical defaults, in 2013 HUD announced new rules to restrict the amount of money a borrower is allowed to use during the first year of the HECM to 60% of the principal limit (PL) or if mandatory obligations are more than 6% of the PL, the lender can loan enough to cover the mandatory obligations +10% of their principal limit.
This amount is called “initial disbursement limit” and the purpose of it is to limit the amount of funds available to the borrower during the firs 12 months of the loan. However, the way this limit is treated will depend upon which interest rate the borrower chooses – fixed or adjustable.
Fixed-Rate HECM Loans are closed-end loans and the proceeds can only be drawn at closing, (see refinance example above). As such, there is no access to additional funds once the loan is closed. This creates a problem for someone who doesn’t want to draw extra money at closing but may want access to additional money at a later date.
For example, someone who has a PL of $200,000 would have an initial disbursement limit of $120,000, ($200,000 x 60% = $120,000). If they had mandatory obligations of just $50,000, and decided to take a fixed rate, they would have to take $120,000. That would leave them and additional $70,000 that they may or may not want and they would be charged interest on that full $120,000 amount. In addition, since the fixed-rate program is a closed-end loan, they would NOT have access the additional $80,000 ($200,000 PL - $120,000 Initial Disbursement = $80,000).
Adjustable-Rate HECM Loans are open-end loans meaning the additional PL ($70,000) would be available to the borrower after the first month. Additionally, the borrower is not required to pull the entire 60% of the PL at closing.
Using the example above, this borrower would only be required to take the mandatory obligations amount of $50,000 at closing. This would leave the rest of the $120,000 initial disbursement limit during the first 12 months of the loan ($70,000) available to the borrower during that time period.
Once the first year is over, 100% of the LOC would be available to the borrowers. If they only used the initial $50,000 and did not use any of the LOC after that, they would have the full $150,000 LOC available (plus the growth on the LOC).
My customer that was caught in this initial disbursement net owned her home free and clear. She needed to draw down 100% of the funds to pay off her husband who she was planning to divorce. Normally, with a divorce that has been finalized and recorded, HUD allows the homeowner staying in the home to access 100% of the funds because they treat a divorce settlement as part of the mandatory obligations. This case was different because, while they were separated, they were not planning to get divorced for at least another year so she could stay on her husband’s health insurance plan.
Because there was no divorce recorded, we limited her funds she could take to just 60% of the PL. This was not enough to pay off her husband, so she did not get the reverse mortgage.
As you can see, this is just one of many rules that most people do not consider when they’re thinking about reverse mortgages and it is a good reason to make sure you work with an experienced loan officer that specializes in reverse mortgages.