I think a large portion of my posts begin with some variation of the phrase, “There is a great deal of confusion surrounding aspect xx of reverse mortgages.” While this certainly speaks to a lack of originality in my part, let’s face it, reverse mortgages are complicated. There are a lot of aspects which seem superficially similar to conventional mortgages, but are actually quite different. Reverse mortgage interest is one such aspect.

It’s not the the calculation of reverse mortgage interest which is complicated. Just like any other loan, interest is calculated on the outstanding balance of the loan. Whether you take the proceeds from a reverse mortgage as an upfront payment or in installments, interest charges will be calculated monthly based primarily on the amount of money that has been withdrawn to date. However, since you aren’t expect to make payments (interest or otherwise) to the lender with a reverse mortgage during the life of the loan, the loan balance will actually increase over time, such that you are not only paying interest on the principal, but also on the accrued interest. In this sense, a reverse mortgage can be thought of as a kind of negatively amortizing mortgage.

When it comes to the issue of tax deductibility, things get a little hairy. Unlike a conventional mortgage, the accrued interest associated with a reverse mortgage is not tax-deductible on an annual basis. Thus, while you can write off all (in most cases) of the interest on your conventional mortgage when you file your taxes every April, you can’t include interest on your reverse mortgage.

Instead, reverse mortgage interest can only be deducted when the loan matures. According to the IRS, “Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable. Any interest (including original issue discount) accrued on a reverse mortgage is not deductible until you actually pay it, which is usually when you pay off the loan in full.” Thus, the IRS feels that since it has been kind enough not to tax you on the proceeds you receive under your reverse mortgage, borrowers then don’t have any grounds for complaint when it comes to not being able to deduct the interest.

If you drill even deeper, however, into the abyss that is the US tax code, you will learn that IRS treats reverse mortgage proceeds as home equity debt, rather than conventional mortgage debt. While this distinction might sound trivial, it actually has serious implications. That’s because the IRS limits the amount of tax-deductible home equity debt to $100,000. Interest on any proceeds that you receive(d) in excess of that threshold, cannot be deducted.

It gets even more complicated when you consider that reverse mortgages are ultimately repaid not by the borrower (assuming he has passed away when the loan “matures”), but by his heirs. This introduces estate tax issues into the equation. Unfortunately, this is beyond my personal expertise, and anyone who ultimately wishes to minimize the tax burden associated with the repayment of a reverse mortgage is encouraged to consult a tax specialist. A financial planner might also be able to make some suggestions about some of the products (insurance and otherwise) which are designed to similar ends.

Speculation is mounting that the Federal Reserve Bank will hike its benchmark federal funds rate (FFR) at some point in 2010. The rate has hovered around 0% for more than a year now, and analysts reckon that the remaining time it can possibly be held at this record low is running out. The question – as far as readers of this blog are concerned – is: How should this potential change be weighed when shopping for a reverse mortgage?

Let me first offer some background. For the purpose of this discussion, reverse mortgages can generally be categorized as either fixed-rate or variable-rate. Fixed-rate reverse mortgages accrue interest at the same (fixed) rate for their entire duration, whereas the rate associated with variable rate mortgages rises and falls in accordance with a stated benchmark rate, such as the FFR, 3-month LIBOR, and other obscure rate indexes that you’ve probably never heard of. In short, when the associated benchmark rate rises, so does the mortgage rate. [This is the exact same principle that governs conventional mortgages, by the way].

In this case, if/when the Fed hikes the Federal Funds Rate, all variable-rate mortgages (reverse and otherwise) linked to the FFR will all rise by a fixed increment. Technically, those mortgages that are linked to other benchmarks won’t rise, but given that most of the oft-quoted short-term rates are highly correlated and tend to move in tandem, it’s likely that a Fed rate hike would affect all variable-rate mortgages.

Trying to predict how fixed-rate mortgages would be affected by a short-term rate hike is difficult to say. That’s because fixed-rates are determined by market forces, and fluctuate irrespectively to short-term variable rates. In the past, short-term rate hikes have typically been accompanied by slight increases in long-term fixed rates, but this relationship is anything but certain.

The takeaway from all this is that while variable-rate reverse mortgages currently accrue interest at lower rates than their fixed-rate counterparts, it’s not clear whether this will be the case for long. Moreover, if the credit crisis has taught us anything, it is that the ability to refinance (from variable-rate into fixed-rate, for example), can no longer be taken for granted. That means it’s important to make the right choice from the outset.

In the current borrowing environment, the right choice s quickly tilting towards fixed-rate. While some borrowers might still be tempted by the low rates offered by variable-rate providers, be advised that they won’t remain low forever. And once they start rising, you might wish you had just gone with a fixed-rate, and saved yourself the headache.

Despite what you may have read and heard, reverse mortgages are not inherently evil. At least, I don’t think so. Rather, there is a tremendous amount of misinformation surrounding them, which has created the perception that somehow they are the province of scammers and opportunists. While this generalization is unfair, there are certainly some practices that push the limits of honesty and run contrary to the “spirit” of the product. I have culled a handful of these, below.

First of all, there is the misconception that reverse mortgages are originated directly by the government, or even worse that they are a “government benefit,” on the same level as social security and medicare. On the contrary, all reverse mortgages are issued privately. While the vast majority are insured and regulated by the government (via FHA), this is quite different from saying that they are administered by the government. For all intents and purposes, then, they are private products with private contracts.

Other misconceptions arise from erroneous comparisons with conventional mortgages. For example, some borrowers fail to grasp that a reverse mortgage is still a mortgage, in that it accrues interest and must be repaid. Other borrowers step too far in the opposite direction, and assume that some of the up-front fees will be used to fund an escrow (like with a conventional mortgage), that will in turn be used to make insurance and property tax payments. On the contrary, it is the responsibility of the borrower to continue making such payments as usual; failure to do so could ultimately lead to foreclosure. Along the same lines, other borrowers have taken out reverse mortgages to make simple repairs on the home, when a (government-subsidized) conventional mortgage might be cheaper, and more appropriate.

One of the most common pitfalls, meanwhile, is to borrow more money than necessary under a reverse mortgage. Not only will that cause a faster erosion of home equity (due to the accrual of interest on a larger balance), but thus could also render one ineligible for certain social-security benefits that otherwise could have been obtained. It’s important to understand that money not withdrawn (such as with a line-of-credit payout option) does not accrue interest. Another pitfall (one might be tempted to use scam, but this isn’t always illegal) is to use the proceeds from a reverse mortgage to “cross-purchase” (the counterpart to “cross-selling) another financial product. Many lenders have earned the ire of consumer advocates and government regulators for cajoling borrowers into buying annuity agreements and other insurance products when closing on a reverse mortgage. That’s because such products are rarely – if ever – appropriate for reverse mortgage borrower, who are advised to rebuff this cross-selling.

Finally, there are the outright scams. Surprisingly, research has shown that most scams are perpetrated not by lenders, but by third parties and family members. Lenders could perhaps be faulted for not being vigilant enough when it comes to policing scams (in fact, they are actually incentivized not to report them), but the primary fault rests not with them. Some con artists, for example, persuade borrowers to obtain reverse mortgages in order to pay for products/services that they are selling. Another elaborate scam involves the reverse-mortgage-for-purchase, in which the victim receives the house, and the scammer takes the proceeds from the mortgage. Finally, there are plenty of cases of adult children blatantly stealing from their senile parents, by taking out reverse mortgages without their knowledge/understanding.

Thankfully, most of these “practices” can easily be prevented, simply through increased information. Reverse mortgages have very niche uses, and should only be obtained only as a last resort. Principal and accrued interest must be repaid after a maturity event (death, moving out, failure to pa taxes and maintain the property, etc.). They should be obtained under one’s own volition – and not under duress – and they should be structured so that the funds received are spent almost immediately, but not frivolously. Any questions?

The most important factor in the size of your reverse mortgage loan (other than your age and your own personal inclination) is the value of your home. As a result, it’s important to understand how the fluctuation of home prices affect reverse mortgage financing, so that you can make an optimal decision.

Basically, HUD – which, through the FHA, administers/insures the majority of reverse mortgages – has calculated a table of “multipliers,” based on your age and prevailing interest rate levels. This multiplier is essentially a ratio of your home equity that HUD has determined you are eligible to borrow at the time you obtain your reverse mortgage. Basically, take the value of your home, multiply it by this ratio, and voila, you have determined the maximum amount (prior to fees and other adjustments) that you can borrow under current market conditions. For example, if you are 65 years old and your lender has quoted you an interest rate of 5.5%, and your home is valued at $300,000, then you can borrow a maximum amount of $175,200 (based on a multiplier of .584) before fees.

Perhaps I’m getting ahead of myself. After all, I keep referring to the value/worth of one’s home, and haven’t yet defined how this is determined. Well, it’s actually quite simple. The value of your home (aka the lender’s collateral) is determined by an appraiser at the time of origination. Remember that with a conventional mortgage, the appraisal serves a tangential function: to merely confirm that the price you paid for the home is supported by market fundamentals. With a reverse mortgage, on the other hand, the appraisal is everything! The lender doesn’t care what you paid for your home, or what you think it’s worth; it only cares about the appraisal. (This distinction between price and worth is especially important when using a reverse mortgage to purchase a home).

If the appraisal is higher than you expected, then Congratulations! As I alluded to in the opening of this post, however, you don’t have to borrow the full amount that you are eligible for. If the appraisal, came in lower than expected, you have a few options. The first is to wait a couple years. During that time, home prices may have appreciated, and you will certainly have aged. Unless interest rates also rise, then, you will almost certainly be eligible for a larger loan when you go to re-apply. Another option, mainly for those that need the cash now, is to go ahead and obtain a reverse mortgage now, and simply re-finance if/when conditions improve. Of course, there are costs associated with this option (just like with a conventional mortgage refinancing) so the first option is probably the most economical of these two, especially if you can afford to wait. The final option is to simply forget about a reverse mortgage for your existing home, and instead, downsize into a smaller home. If you are still dedicated to taking out a reverse mortgage, the decline in home prices would work to your advantage, since the loan would fund a larger portion of the purchase price.

In the end, there is no way to beat the system. If your appraisal is high (presuming that you borrow the full amount you are entitled to), then your equity position will be lower over time then if your appraisal was relatively low. Really, the only way that you can “win” is if your house depreciates over time to such an extent that your mortgage is underwater, and the FHA – thanks to the mandatory insurance policy – picks up the tab for difference. But this is certainly a dubious gain, as it would be better for all parties if your house appreciates so that you still have some remaining equity when the mortgage is repaid.

The only time you really need to pay attention to your appraisal is if you are planning to use the proceeds from the reverse mortgage to repay a large amount of debt associated with a primary mortgage. For those of you to whom this applies, and for whom the fall in home prices has precluded your obtaining a reverse mortgage, my advice is to continue paying your primary mortgage and re-evaluate the situation in a few years. Regardless of how the housing market performs over that time, your own personal financial situation will be more conducive to obtaining a reverse mortgage of adequate size.

For the rest of you, don’t worry too much about trying to time the market. [That’s why I didn’t include any forecast about the direction of real housing prices in this post. It would have been irrelevant, distracting, and probably inaccurate]. Instead, focus more on whether a reverse mortgage is appropriate, given your personal financial situation. Ask yourself: If home prices stay exactly where they are for the next five years, would it appropriate for you to obtain one now, in five years, or never?