What is a life expectancy set aside on a reverse mortgage?
Reverse mortgage applicants who don’t meet certain income and credit requirements may have a significant part of their loan proceeds set aside to cover property taxes and insurance requirements, thus reducing how much money is available to them.
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.
Life expectancy set-aside
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 by the borrower’s current age and property tax and insurance obligations. The amount will also factor in future increases for taxes and insurance. The idea is to have enough set aside to pay taxes and insurance for the life of the loan.
One calculation shows that a 65-year-old with current tax and insurance obligations of $1,500 a year would have to set aside $19,500 upfront for taxes and insurance for the estimated life of the loan. The same calculation shows a 75-year-old would have to set aside $15,200, and an 85-year-old would have to set aside just over $9,000 because of their life expectancies.
If a borrower’s current tax and insurance obligations are $3,500, then the 65-year-old would have to set aside $45,350, the 75-year-old would need $35,500, and the 85-year would need a LESA of $21,000.
Impact on income
Having a LESA will affect the monthly income amount a homeowner will receive from a reverse mortgage.
For example, a 65-year-old with a fully paid for $300,000 home can borrow, after fees, about $153,000 from a reverse mortgage. If this homeowner does not take any cash upfront, he or she can expect to receive about $780 a month in lifetime income.
If that same individual is required to have a LESA, one estimate shows that if his or her current taxes and insurance total $2,500 a year, the LESA amount would be just over $32,000. That means the principal amount would be $122,000, reducing the monthly lifetime income amount to $620.
Although monthly income is lower with a LESA, it should be noted that property taxes and insurance will be paid for by the lender from the LESA. Therefore, what you have to spend after taxes and insurance from your reverse mortgage should be about the same.
A LESA has a larger impact on reverse mortgage borrowers taking a lump sum. Keep in mind that reverse mortgage rules state that borrowers can only claim 60 percent of the loan’s principal amount in the first year, unless they are using it to pay off the existing mortgage balance. The principal amount will be reduced by the amount of money placed in the LESA.
So in the above example, the borrower without the LESA could claim about $91,800 in the first 12 months on the loan ($153,000 x 60%). The borrower with the LESA, on the other hand, could only collect $73,200 ($122,000 x 60%).
Borrowers should also be aware that they are responsible for taxes and insurance if the funds in the LESA run out or are insufficient to cover the next year’s charges.