Tackling Misconceptions in Reverse Mortgage Guidelines

Reverse mortgage professionals are well aware of the reputational hurdles that their industry faces in terms of connecting with seniors and the wider public. Still, even the most well-meaning reverse mortgage loan officer can have their own, long-held notions about product and industry guidelines shaped by a series of misconceptions, making it necessary to try and quash those askew ideas in order to better present reverse mortgages as a viable financial product category for seniors.

This was exactly the mission of Dan Hultquist, VP of organizational development and Jim McMinn, lead sales trainer of learning and development at Finance of America Reverse (FAR) in a presentation at the National Reverse Mortgage Lenders Association (NRMLA) Annual Meeting in Nashville, Tenn. Donning referee shirts onstage to call “penalties” on potential issues, the pair made clear that the presentation was not specifically oriented around the letter of the law. Instead, it is focused on relevant regulations and guidelines, and calling out potential infractions that may arise from misconceptions surrounding them.

“We want you to think about the messages we put out to our borrowers,” McMinn says. “Because, there may be something in [a loan officer’s long-held notions] that is not accurate. So when it comes to your own situation, we encourage you to talk to your legal or compliance departments.”

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Line of credit growth

The first discussed issue relates to the Home Equity Conversion Mortgage (HECM) line of credit (LOC) growth, with Hultquist citing a hypothetical scenario where a loan officer describes the growth itself as several things that it is not: it is not income; interest; earnings; or a “return on a home equity investment.”

“Really what [the LOC offers] is the ability to borrow more,” McMinn adds. “It’s accurately described as ‘greater capacity to borrow more money in the future, regardless of home value.’”

In the Department of Housing and Urban Development’s (HUD’s) Housing Counseling Program Handbook 7610, chapter 4 part 5(c) reads, “Counselors must not tell clients that HECM credit lines ‘earn interest,’ because credit line growth is simply increased access to borrowing power, comparable to an increase in a credit limit on a credit card.”

Further solidifying this is that if the borrower was earning interest on a HECM LOC, then those funds would be taxable.

“We know they’re not taxable,” Hultquist says. “Some borrowers and loan originators have said that doesn’t seem fair. You need to put it in perspective. The growth and LOC goes away when the last borrower dies. But to bring the point home, imagine this scenario: when you die, do all your credit cards max themselves out and leave a stack of cash on your front porch?”

‘Guaranteed’ LOC growth

The second misconception comes from someone relating that a HECM line of credit is always “guaranteed” to grow, which is not a statement that can be substantiated when looking at the full picture of the credit line itself.

“We say [that there’s guaranteed LOC growth] a lot, and this may seem petty, but there are exceptions,” Hultquist says. “One simple way that the line of credit decreases is when the borrower draws funds, but if the reverse mortgage is not in good standing then that can create another situation in which it’s not growing. If [a borrower] hasn’t paid their taxes and insurance, the lender has the ability to take it out of their line of credit.”

Additionally, if there is a repair set aside that was estimated at too low a level, that money comes from the line of credit. Other instances in which the LOC will not grow can include during the initial disbursement limit in the first year of the loan; if there are negative interest rates; or if the Life Expectancy Set Aside (LESA) is depleted.

Reverse mortgage proceeds as ‘tax-free cash’

While sometimes coming in various forms, the reverse mortgage is often marketed as tax-free cash and tax-free money, Hultquist and McMinn say.

“It’s always been marketed as that, I see it all the time,” McMinn says. “When you’re getting a reverse mortgage, there could be taxes associated with that. We’ve got property taxes, recording taxes, intangible taxes, the list goes on. So, when we look at that, we have to specify which portion of the loan is actually tax-free.”

That portion is, of course, the proceeds. But to get the loan, taxes can and do interact with a reverse mortgage transaction, making it generally incorrect to say to a potential borrower that a reverse mortgage on its face is completely “tax-free.” This was highlighted by the Consumer Financial Protection Bureau (CFPB), when it released a study titled “A closer look at reverse mortgage advertisements and consumer risks” in 2015.

“Many consumers we spoke with did not understand that reverse mortgages are loans with fees, compounding interest, and repayment terms,” the CFPB report reads in part. “This confusion is understandable where ads tout that reverse mortgages provide ‘tax-free’ money.”

Borrowers also, of course, need to keep up on their property tax payments to keep the loan in good standing, McMinn says.

Partial prepayments, reduction of loan balance

If a borrower elects to make partial prepayments in an effort to reduce his or her overall loan balance, the mortgage note specifies in what order those payments are to be applied, Hultquist says. This is what’s called the “servicing waterfall,” and when a partial prepayment is made, it’s applied to other aspects of the loan before it reaches and reduces the principal balance: mortgage insurance; servicing fees; and accrued interest, respectively.

For borrowers who make partial prepayments of a certain size within a particular calendar year, they will then receive tax documentation that shows to which segment of the loan that payment was applied, Hultquist says.

“If you make a payment of $600 or more in a calendar year, you’re going to get a [tax form] 1098 in January showing what was actually paid when that [partial prepayment] was made,” he says. “The unpaid principal balance (UPB) needs to drop before your line of credit can increase. So, we need to make sure that we’re consistent in our application of this.”

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  • I hope you will in future posts discuss the additional topics covered in Hultquist’s and McMinn’s presentation at NRMLA, “Knowing The Rules of The Game”. It was one of the most informative and useful presentations given.

  • Interest on HECM loans is NOT deductible even when repaid. Check Pub 936 at http://www.irs.gov. This was a recent clarification. Here is the applicable excerpt:
    Reverse mortgages. A reverse mortgage is a
    loan where the lender pays you (in a lump sum,
    a monthly advance, a line of credit, or a combination of all three) while you continue to live in
    your home. With a reverse mortgage, you retain
    title to your home. Depending on the plan, your
    reverse mortgage becomes due with interest
    when you move, sell your home, reach the end
    of a pre-selected loan period, or die. Because
    reverse mortgages are considered loan advances and not income, the amount you receive
    isn’t taxable. Any interest (including original issue discount) accrued on a reverse mortgage is
    considered home equity debt and isn’t deductible.

    • You are correct that interest that simply ACCRUES on a reverse mortgage is not deductible. However, voluntary partial prepayments, or payments-in-full, change the story… somewhat.
      The current hurdles to deductibility are 1) the standard deduction has recently doubled, making it less likely a homeowner will itemize deductions, and 2) Interest payments must be attributed to debt associated with the acquisition or substantial improvement of the home. This is easily done with a HECM for Purchase loan, but difficult on other HECM product options.

    • Stacy,

      There are two levels of tax information that the courts and IRS Appeals look to when interpreting tax law. IRS publications are not in the primary category. The Internal Revenue Code, its regulations, revenue rulings, and court decisions are normally considered primary. Less official publications by the IRS and the interpretative work of learned scholars are looked upon as secondary sources that are interpretative, not authoritative.

      So unless the information contained in Publication 936 can be found in primary sources, its positions may be right or may be wrong. Neither the Internal Revenue Code nor its regulations address reverse mortgages. To date federal court cases have not addressed reverse mortgages. Only Revenue Ruling 80-248 has addressed them and it clarifies two aspects. Reverse mortgage lenders can account for the interest earned on reverse mortgages on the cash basis as long as the lender also accounts for its income and expenses on the cash method of accounting. Second, the ruling clarified that reverse mortgage interest is eligible for deduction as home mortgage interest in the tax year paid.

      In 1988, new tax rules went into effect on the deductibility of home mortgage interest. It created three categories of interest when it comes to indebtedness on eligible properties. It is required that for any interest to be considered qualified residence interest, the related home must be collateral on the mortgage.

      IRS regulations direct us to trace the use of proceeds in determining the status of the category that each mortgage falls in. So 30% of a mortgage could be classified as acquisition indebtedness if the proceeds used in buying the home were 30% of total proceeds used. So a mortgage could have 70% of its proceeds considered as acquisition indebtedness and 17% considered home equity indebtedness and 13% considered as personal indebtedness.

      Even though the senior has $3,000,000 in acquisition indebtedness due to a home purchased in Bel Air, CA in 2019 under current tax law only the interest on $750,000 of that indebtedness is deductible.

      As if things could not get more complicated, the Internal Revenue Code provides grandfathering rules and refinancing grandfathering rules. Writing about them would take many more pages.

      The amount of interest which was deductible as interest on home equity indebtedness was very limited. The 2017 Tax Act eliminated interest home equity indebtedness altogether for taxable years 2018-2015.

      There may be adjustments required to be made to the qualified residential interest deductible for regular income tax purposes when computing the alternative income tax.

      In certain cases, the deduction of qualified residence indebtedness may be limited by the adjusted income tax basis of the home.

      A three decades old regulation allows interest on residential mortgages to be deductible under other areas of the Internal Revenue Code depending on how the proceeds were used. This could increase deductible interest by a small amount or more than quadruple it. For those with higher retirement income, tracing the use of proceeds could materially reduce their income tax liabilities.

      On a practical basis, IRS Forms 1098 must be prepared for all payments of interest during a calendar year by lenders; there is no $600 minimum in the case of mortgage interest paid by a borrower. Further, if the records of the taxpayer show a different amount of interest paid in the calendar year then before filing any income tax return for that year, borrowers should work with lenders in determining if an amended or corrected Form 1098 is required.

      As to when interest on a reverse mortgage can be deducted, IF the borrower is on the cash method for deducting itemized deductions then indeed they would deduct the amount that is eligible for deduction as qualified residence interest in the taxable year paid; however, that sounds simpler than the rules make it. BUT if the taxpayer deducts itemized deductions on the accrual method (which many immigrants shortly after World War II do), the deduction is available in the tax year that the interest accrues. The same principles apply to the deduction of such interest if it is deductible under other areas of the Internal Revenue Code. (Once established, the accounting method of a taxpayer can only change to another method by permission of the IRS Commissioner. Such a request is rarely granted.)

      While everyone wants SIMPLE rules to deduct any eligible interest on their home mortgage, few will find them. This is why I, like many of my peers, recommend that reverse mortgage borrowers consult with income tax planners who are not only competent in qualified residence interest matters but in reverse mortgages as well — even before they getting a reverse mortgage if possible.

      Finally, deductible qualified residence interest may not have been deducted by the borrower in his/her lifetime. That plus interest that accrues during the period up to the termination of the reverse mortgage may be deductible by an estate, trust, or heir after the borrower passes if some complex rules are met. (Watch, I will wake up later this morning realizing I forgot something.)

      A very brilliant tax attorney was speaking at the USC Tax Institute in 1988 and turned to the audience at the start of his speech by asking us how many of the tax attorneys in the meeting wanted a simpler tax code. About 95% of the attendees raised their hands. He then told us to keep our hands raised while he took care of a matter. He in a style reminiscent of someone making an introduction told everyone in the room to mentally remember everyone with their hands raised because they were all liars. He then stated that no tax attorney in his right mind wanted to give up any part of the tax laws that help him or her rake in so much money.

      • Thank you! I always appreciate your in-depth knowledge and explanation of things. MUCH appreciated.

      • Stacy,

        Thank you for your kind words.

        As promised, I forgot another important issue. Each year the loan must be reanalyzed to determine how proceeds have been used since closing; however, only the current year computations must be adjusted and the percentage must be based on a weighted average.

        For example last year the interest deduction was based on a ratio of 70% acquisition indebtedness. On the last week of August of the current tax year, the borrowers take a cruise with their children and grandchildren using credit cards. At the time that the cards required payment for that trip, the borrower decides to draw down the necessary cash from their line of credit to pay the bill at the end of September of the current tax year. At year end it was discovered that since closing 60% of the proceeds were used for acquisition purposes and 40% of the proceeds were ineligible to be treated as acquisition indebtedness. But the allocation does not end there, they must use a weighted age to determine the allocation for the new tax year. (Remember that the allocation in the prior tax year was 70% acquisition indebtedness and 30% for other indebtedness).

        So for allocation purposes, the interest for the year of deduction must be allocated 67.5% to interest on acquisition indebtedness and 32.5% to other (most likely nondeductible) indebtedness.
        No competent income tax planner ever said that determining the deduction for qualified home mortgage interest is simple because it is not. That is why the Tax Acts for 1982, 1984, 1987 and 1988 were specifically nicknamed “The full employment Tax Acts for Accountants.”

      • Jim,

        You are correct on your educated advice goiven everyone. This is pretty much what my CPA has told me as well, maybe not in the exact verbiage, but overall, you are on target!

        Thanks Jim,

        John Smaldone

  • Hi, we also still have the issue of better understanding how different servicers/lenders are treating the early partial repayments. As I understand, we are seeing most servicers do a direct repayment amount back to the credit line no matter what the amount that is credited to MI, interest and then UPB. We have had this discussion before and it is still not clear for everyone. There definitely needs to be clarification on this topic.

    • Melinda,

      Section 6 of the HUD HECM ARM Mortgage Note, starting on Page 3 0f 9, describes not only the borrower’s right to prepay some or all of the unpaid balancer but also how payments are to be applied. The first part of that section focuses on the application of the payments for income tax purposes.

      BUT then in the final paragraph of Section 6 on Page 4 of 9, the following is stated (note I show the title followed by dots that stand for other paragraphs of that section):

      “6. BORROWER’S RIGHT TO PREPAY

      …….

      A Borrower may specify whether a prepayment is to be credited to that portion of the Principal Balance representing monthly payments or the line of credit. If Borrower does not designate which portion of the Principal Balance is to be prepaid, Lender shall apply any partial prepayments to an
      existing line of credit or create a new line of credit.”

      You can find the document quoted above at https://www.hud.gov/sites/documents/HECM_MODEL_ARM_NOTE.PDF.

      Actually how a partial prepayment is to be applied to the contingent asset side of the HECM as presented in the covenant above is the choice of the borrower. It can applied to be tenure payments or term payments not just the line of credit. I hope that helps.

      • Dan or James, I’m confused about one part of the article…….

        Your quote (from RMD):
        “The unpaid principal balance (UPB) needs to drop before your line of credit can increase. So, we need to make sure that we’re consistent in our application of this.”

        I have always been taught that if a prepayment is made, the LOC increases; dollar for dollar. I’m reading your statement to say that MIP & Interest first need to be paid, and only when principal is paid would the LOC increase. Am I over-reading this? (btw, I tried to send you a message from your website but the code would not work)

      • David Stacy,

        Your concept is exactly correct as to the lender; however, if there is no line of credit, the lender MUST create one. As to the borrower, the borrower may elect to have 1) tenure payments increased, 2) the term or the amount of the term payouts increased, or 3) have the line of credit increased by the amount of the prepayment (dollar for dollar). I imagine that if the line of credit was modified, then the borrower could most likely divide up the increase between the line of credit and any payouts he/she has coming.

        So as to a dollar for dollar increase, I have no differing opinion. As to the election available to the borrower, we probably have a difference.

        Just remember as to ongoing borrowers, read their loan docs before giving them any advice. I am not sure if or when the paragraph I quoted was changed.

        Perhaps another point that I could have made plainer is that three steps must be taken when a prepayment is received on adjustable rate HECMs. First, the UPB must be reduced by the prepayment, dollar for dollar. Second, the prepayment must be applied to the required accrued amounts and then to principal using the “servicing waterfall” principle. And finally, third, either the borrower elects whether monthly payouts are proportionately increased or the line of credit is increased by the amount of the prepayment; if no borrower election is made, the lender MUST increase an existing or new line of credit by the amount of the prepayment.

        Finally, the quotation in the comment to Melinda and the remarks made in this comment only apply to adjustable rate HECMs. When a prepayment is made on a fixed rate HECM then 1) the UPB must be reduced and 2) the prepayment must be applied in accordance with the “servicing waterfall” principle.

        I hope that is complete without becoming more confusing.

  • Good explanation, Jim. I’m so glad this is being discussed. For reference, here is what the HECM handbook says:

    “A borrower may choose to make a partial prepayment to set up or to increase a line of credit without altering existing monthly payments. By reducing the outstanding balance, the borrower increases the net principal limit. All or part of the increase in the net principal limit may be set aside for a line of credit.”

    HUD used the term “net principal limit” here because, as Jim Veale stated, the borrower may have a term, tenure, LOC, or a combination of payouts.

    However, another area of confusion is the term we use for the borrower’s loan balance – “Unpaid Principal Balance” or UPB. The borrower’s UPB is a combination of original principal, accrued interest, accrued MIP, draws, servicing fees, etc. If you substitute the term “loan balance” instead, then the explanation is clearer.

    Therefore, if a HECM ARM (with a line of credit payout only) is properly serviced, a prepayment that reduces that borrower’s loan balance by $10,000 should ALSO increase that borrower’s line of credit by exactly $10,000 at the time the payment is recorded.

    Here are three regulatory references that support this concept: HUD 4235.1 CH 5-12C, Model Adjustable Rate Note, HUD 4330.1 CH 13-21B.

    • Dan,

      Your comments are right to the point. Thanks for addressing HUD sources.

      However, when it comes to what borrowers should rely on, I believe that the loan docs take precedent over HECM regs and mortgagee letters since the borrower has no contractual relationship with HUD until HUD is able to enforce the HECM duplicative loan docs, naming HUD as the successor mortgagor.

      The primary documents that the borrower should look to are the loan docs which were signed at closing and all loan docs that were in anyway modified (and signed by all parties) following closing.

      However when it comes to HECM mortgage docs (as with all legal documents), questions should be addressed to and answered by lawyers who are competent in mortgage and reverse mortgage matters. Borrowers mistakenly rely on the advice of 1) those who are not attorneys and 2) attorneys who have not been engaged to address such matters.

  • Encouraging payments to be made that decrease the loan balance and increase the line of credit is the concept that is most under-utilized in our industry. It’s also, in my opinion, the area that represents the most room for growth.

    When I present this option, it is always met with surprise and also intrigue. Unfortunately it takes a custom amortization schedule to accurately represent the strategy. It would take a marketing rebrand for the message to get traction, and it also might complicate the message.

    • Matt,

      There is also a myth that a large segment of originators has adopted in encouraging prospects to originate an adjustable rate HECM due in large part to this technique. These originators argue that the line of credit grows not only by contractual agreement with the lender but also through paying down the UPB.

      So why should the impact of a prepayment on the available line of credit be classified as myth? Say the line of credit grew by $10,000 in a year due to the effective growth rate of 4.5% (average of the note rate plus ongoing MIP). Then these originators argue that the line of credit could grow another 4.5% (making a total of 9% in a single year) by simply prepaying $10,000. While there is no problem saying that a $10,000 prepayment can increase the available line of credit by $10,000 or 4.5%, that increase was not caused by “growth” but rather by the prepayment.

      Let us look at another case. Let us say that the UPB is only $10,000 and the borrower wants to prepay $200,000 so as to maximize the line of credit and see that money increase by 4.5% in the next year. The problem is that the loan would terminate and the lender would have to refund the borrower $190,000 that has been overpaid. On the other hand, if at the end of a year, the UPB on an adjustable rate HECM was $10,000 and the line of credit increased during that year by $11,000 due solely to the increase in the principal limit, that increase is due to growth and growth alone based on the mortgage contract and nothing else. Notice that the growth only impacts the principal limit and as a result

      In one case the UPB had to decrease to increase the available line of credit. In the other case. nothing happened to the UPB that caused the available line of credit to increase.

      I do not like the subject matter as a separate subject. For me, the impact of prepayments on adjustable rate HECMs falls in the subject of best utilization of adjustable rate HECM features in cash flow planning.

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