Income and credit requirements of reverse mortgage applicants
Since 2015, reverse mortgage applicants have to pass a three-part qualification, including a credit history analysis, a residual income test, and a review of extenuating circumstances or compensating factors.
A reverse mortgage is a type of home equity loan that allows certain homeowners to convert their home equity into cash. It differs from a traditional home equity loan in that the homeowner does not make monthly payments to repay the loan. Instead, a reverse mortgage loan is repaid, with interest, when the property is sold, refinanced, or when the homeowner moves out of the house.
A reverse mortgage places a lien on the property. During this time, the homeowner maintains title and property ownership, and thus responsibility for maintenance, taxes, insurance, utilities, and other expenses.
Borrowers who fail to pay property taxes and insurance on their homes will default on their loan, and the lender may call the loan and make it payable immediately. This means the borrower may have to sell the property to repay the debt.
Recent changes in the application process
Before 2015, there were no credit or income requirements for obtaining a reverse mortgage. Eligible homeowners had to be at least age 62, they had to own their homes with little to no mortgage balance left, and the home had to be their primary residence. Also, the property had to meet FHA standards.
All of these requirements remain, but since 2015 borrowers also have to undergo income and credit assessments before obtaining a reverse mortgage.
The reason for the change is a recent surge in the number of reverse mortgage defaults caused by borrowers failing to keep up with taxes and insurance. The Federal Housing Administration (FHA) imposed the new income and credit requirements on reverse mortgage applicants to reduce the chances of borrowers defaulting on their loans by measuring their capacity to pay property taxes and homeowners insurance.
How a borrower is assessed
With the new provisions in place, lenders will examine a prospective borrower’s sources of income and their credit history, similar to how a borrower is assessed for traditional mortgages and other types of loans.
The lender will take into account income beyond what the reverse mortgage will provide, such as Social Security, pensions, rental income, employment income, and distributions from an annuity, IRA or 401(k). Borrowers will have to provide documents indicating these sources of income, as well as past tax returns and bank account statements.
The lender will also conduct a credit history analysis, focusing on past payments of property taxes, homeowners insurance and homeowners association dues. The lender will pay attention to potentially negative issues in the past, such as late payments, collections, judgements, and bankruptcy filings.
Any issues will have to be explained. The lender’s underwriter will then determine if the issue was caused by “extenuating circumstances.” An extenuating circumstance may include financial issues related to death, divorce, or medical situations.
If the borrower can show an extenuating circumstance led to the black mark on their credit history, they can typically proceed with the loan as if their credit history was clean.
Credit problems won’t disqualify a borrower
Even if applicants have problems with their income and/or credit, it won’t necessarily prevent them from obtaining a reverse mortgage. What will likely happen in these situations is that the lender will have to “set aside” part of the reverse mortgage proceeds to cover future tax and insurance obligations.
Known as a Life-Expectancy Set Aside (LESA), this fund is similar to an escrow account on a traditional mortgage. The LESA will hold funds for the purpose of paying future property tax and insurance obligations. This money is taken out of the reverse mortgage proceeds the borrower would have received, thus reducing the amount of money the borrower can collect from the loan. On the other hand, having a LESA reduces the risk of falling behind on taxes and insurance because the lender will make those payments to the taxing authority and insurance company.
The amount of money placed in the LESA will be determined on the borrower’s current age and property tax and insurance obligations. The idea is to have enough set aside to pay taxes and insurance for the life of the loan. The amount will also factor in future increases for taxes and insurance.