Today’s reverse mortgage loans have built-in protections designed to make sure the loan is a sustainable solution for the borrower. In this article, we’ll explore what a life expectancy set-aside (LESA) is, how it helps a borrower to pay property charges, when the lender’s underwriter will require it, and why, in some situations, it may be advantageous for a reverse mortgage borrower to voluntarily opt for a LESA.
First, let’s cover the basics of a reverse mortgage.
Most, but not all, reverse mortgages are a Home Equity Conversion Mortgage (HECM), the only reverse mortgage insured by the Federal Housing Administration (FHA). This article refers only to HECM reverse mortgages.
A reverse mortgage enables homeowners 62 and older to convert a percentage of their home equity into cash, fixed monthly advances, or a line of credit, without having to make monthly principal and interest mortgage payments. That’s right, the borrower(s) can defer repayment of the loan balance, so long as at least one borrower lives in the home, maintains it, and pays the property charges, like taxes and insurance.
Common uses for a reverse mortgage are to refinance a traditional mortgage; establish a rainy-day fund; pay for big-ticket expenses, like health care or home renovations; and supplement retirement cash flow.
Now let’s turn the focus to a key element of the HECM loan terms: The ongoing property charges must be paid by the borrower.
That’s no different than any other type of mortgage. However, most borrowers who pay a traditional mortgage historically have made those critical property charge payments through an escrow account. The mortgage servicer takes a portion of the monthly mortgage payment the borrower makes and holds it in the escrow account until his or her tax and insurance payments are due. Then those charges are paid on the borrower’s behalf.
Reverse mortgages work differently — as previously mentioned, HECMs don’t require the borrower to make monthly principal and interest mortgage payments, and an escrow account to pay the property charges, like taxes and insurance, is not an option.
Prior to amendments to the HECM program made effective in 2015, HECM loans were underwritten with the primary qualifiers being that the applicant 1) is a homeowner, 2) is 62 or older, and 3) has sufficient equity in an eligible (primary residence) home. Notice that I didn’t mention anything about the lender assessing a borrower’s willingness and/or capacity to pay the ongoing property charges, like taxes, home insurance, flood insurance (if applicable), and homeowner’s association dues (if applicable). Unfortunately, a too-common occurrence prior to HECM program changes was borrowers who would likely struggle to meet property charge obligations with assets beyond home equity took out a HECM as a single-disbursement lump-sum payout and failed to earmark a portion of the loan proceeds for property charge payments for their life expectancy. This approach, obviously, could put the homeowner in jeopardy of eventually defaulting on the loan after they spend their loan proceeds. A default, which can lead to foreclosure, is the opposite of a HECM’s intended purpose: To help older-adult homeowners to age in place, with less financial worries.
Added safeguard for HECM borrowers: A willingness and capacity test
A consumer safeguard implemented in 2014 and effective in 2015 is that there must be a more detailed assessment for potential HECM borrowers to ensure they have a willingness and sufficient capacity to pay property taxes, homeowner’s insurance, maintenance and upkeep, and HOA dues.
Naturally, this change means fewer homeowners would now qualify for a HECM. But it also means those who do qualify are in a better position to stay in their homes throughout a lengthy retirement period.
Also, just because the lender’s underwriter determines that the borrower will struggle to meet the property-charge obligations with assets beyond home equity, it does not disqualify them from the HECM loan. It generally means that a portion of the principal limit (the credit capacity with a HECM) will be set aside to ensure future obligations are met. You guessed it — it’s called a life expectancy set-aside (LESA).
What is a LESA?
A LESA is a form of credit, earmarked for property charges, that is based on the estimated duration of the time the borrower is likely to need to pay the property charges – using the borrower’s life expectancy. When the LESA is calculated at loan origination, monthly charges are grossed up 20 percent to account for potential future increases. While a longer life lived could mean the allotted funds may someday run out, a LESA does help to secure funding for the property charges for the borrower’s life expectancy.
Interest doesn’t accrue on the LESA line of credit until the money is actually used to pay the property charges when they’re due. In fact, the unused portion of the LESA line of credit actually grows at the same compounding rate as the loan balance, meaning more funds will be available over time to meet the property charge payment obligations.
The lender’s underwriter now looks at the applicant’s credit history, property charge payment history, and residual income to determine if the applicant will be approved for a HECM loan — and if approved, if a LESA will be required.
What are the two types of LESAs?
Fully Funded LESA
With a fully funded LESA, the set-asides are carved into the credit capacity to ensure future payment of property charges. The lender or servicer pays these charges directly, similar to an escrow account.
Partially Funded LESA
With a partially funded LESA, the lender or servicer sets aside funds from the borrower’s credit capacity and releases funds semi-annually to the borrower to help fund a gap in residual income. Unlike an escrow account, with a partially funded LESA, the borrower is responsible for directly paying the property charges.
How Is it Determined if a LESA (and which LESA) will be required?
The lender’s underwriter will evaluate if the borrower’s credit and property charge history are acceptable.
If the applicant does not have an acceptable credit and property charge history, then if approved for the loan, he or she will generally need a fully funded LESA.
If the applicant does not have an acceptable monthly residual income, then if approved for the loan, he or she will generally need a partially funded LESA.
There are some exceptions for borrowers with extenuating circumstances to explain unsatisfactory credit and property charge history. There are also exceptions for borrowers with compensating factors to make up a residual income shortfall.
An exception to what is stated above is when the projected partially funded LESA is greater than 75 percent of the fully funded LESA — in that case, the fully funded LESA will be required. Also, if the borrower opts to receive loan proceed via a one-time, lump-sum payout at closing – rather than a line or credit and/or fixed monthly advances — and a LESA is required, it will always be a fully funded LESA, since future distributions with the single-disbursement option are not available after the initial disbursement is made at closing.
If the applicant has both an acceptable credit and property charge history and acceptable residual income, then no LESA is required.
For an applicant who does not require a LESA, the applicant can voluntarily opt for a LESA. While this tactic will reduce the principal limit (available borrowing capacity) that the borrower can use for any purpose, the borrower can still access the home equity he or she needs and won’t have to worry about missing a critical property charge payment – those payments will be taken care of for years to come on his or her behalf.
Let’s start a conversation.
Inflation, taxation, market volatility, home care, and financial shocks can destroy your older adult client’s retirement plan. The reverse mortgage line of credit can address every single one of these items by increasing cash flow, increasing net worth, and reducing risk*. Give your older-adult clients the financial flexibility they desire—with reverse mortgage loans in your financial toolkit.
To learn more, contact a retirement mortgage specialist at Fairway Independent Mortgage Corporation.
About the Author: Harlan Accola
Harlan Accola is the National Reverse Mortgage Director at Fairway Independent Mortgage Corporation. He has been in the mortgage industry for over 20 years and has worked with all types of loans, but his specialty has always been working with the 62+ age group and reverse mortgages. Harlan is the author of Home Equity and Reverse Mortgages: The Cinderella of the Baby Boomer Retirement. Accola may be reached at HarlanA@fairwaymc.com.
*This advertisement does not constitute tax and/or financial advice from Fairway.
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