What are reverse mortgage set asides?
When homeowners obtain a reverse mortgage, they maintain title and property ownership, and thus responsibility for maintenance, taxes, insurance, utilities, and other expenses.
Falling behind on property taxes or failing to maintain adequate homeowners insurance can lead to a default on the loan. If this occurs, the lender will require immediate repayment, which typically means selling the property.
Lenders want to avoid default as much as borrowers, as the situation often forces them to sell the home for less than market value and less than what is owed on the reverse mortgage loan.
In fact, because of an increasing number of reverse mortgage defaults, the Federal Housing Administration (FHA) now requires potential borrowers to undergo income and credit assessments before they can obtain an FHA-insured Home Equity Conversion Mortgage (HECM).
To further minimize the possibility of defaults due to failing to pay taxes and insurance, lenders will often establish set-aside accounts.
How a set aside works
Set-asides in a reverse mortgage are similar to escrow accounts in a standard mortgage. They hold funds needed to pay for costs beyond the principal and interest of the loan. In the case of a set-aside, the amount needed to fund the account is deducted from the principal limit on your reverse mortgage.
For example, assume a homeowner could receive a maximum of $150,000 from a reverse mortgage based on their age and home equity, without a set-aside. But the borrower’s credit and income raises the possibility that he or she may have trouble paying taxes and insurance, so the lender imposes a $30,000 set aside to cover those costs over the life of the loan. That means the borrower will only receive $120,000 maximum from the reverse mortgage, but the loan amount will still be $150,000.
Set aside amounts are based on the current and future projected costs of the item(s) the account will be paying (e.g. your current and projected property tax obligations), and how long the lender will pay the expense. If the set aside is established for the life of the reverse mortgage, the lender will use your age and life expectancy to determine the amount to set aside.
While set-asides are sometimes mandatory based on your credit and income, you can also establish them voluntarily if you want to ensure that your taxes and insurance are paid. When you establish a set-aside, the lender is responsible for paying those costs, just like they are when you establish an escrow account on a standard mortgage.
Examples of set asides
Below are examples of set-asides that may be included in your reverse mortgage:
Tax set aside. This provision sets up a separate account from which your lender will make property tax payments on your behalf. You can work with the lender to determine how long they will pay your property taxes, which will then determine the set-aside amount. These funds do not become part of your loan balance until they are disbursed.
Insurance set aside. This works the same as a tax set aside, only it pays your homeowner’s insurance bill when it’s due. Just like with the tax set aside, the funds from this account do not become part of the loan balance until they are disbursed.
Life Expectancy Set Aside (LESA). If applicants have problems with their income and/or credit, the lender will likely make a set aside for taxes and insurance mandatory. Furthermore, the lender will set aside an amount it projects will cover these expenses for the life of the loan.
Known as a Life-Expectancy Set Aside (LESA), this fund reduces the amount of money the borrower can collect from the loan. 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.
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.
Repair set aside. Lenders do not want to take on the risk of financing a property that does not meet building and safety codes. In these situations, the lender will attach a repair rider to the reverse mortgage agreement, stipulating that the borrower will make repairs or improvements to the home within a specified timeframe of receiving the loaned funds.
When a repair rider is attached to a reverse mortgage, the loan will include what’s called a repair set aside. This is a portion of the reverse mortgage funds that will be designated specifically for the purpose of funding home repairs.
To determine the set-aside amount, an estimate of the needed repairs will be made. The lender will then add 50 percent above that estimate to account for any cost overruns and follow-up inspections to ensure the work was done properly. So, if a home repair is estimated to cost $5,000, the lender will set aside $7,500 of your reverse mortgage funds to pay for the repair.
Typically, the amount you can set aside for repair work is 15 percent of the home’s appraised value. So, if your home is appraised at $300,000, your set-aside limit will be $45,000 (300,000 x 0.15). If the repairs on your home will exceed the set-aside limit, you will have to make them before you can qualify for the reverse mortgage.
Service fee set aside. Reverse mortgages charge ongoing service fees that cover administrative costs, such as providing customer service, maintaining records, and ensuring that taxes and insurance are paid. This is a separate fee from the upfront closing costs required, such as for loan origination and property appraisal.
The service fee set aside is deducted from your principal limit to ensure future payment of the monthly fee. It’s not part of the loan and does not accrue interest.
Although set-asides will reduce your lump sum or monthly income payments, these are costs you would have incurred without the set-asides because as the homeowner you are responsible for taxes, insurance, and upkeep. In essence, you’re delegating responsibility for paying those costs to your lender.