Financial ability is one of two major components of the HECM financial assessment guidelines rolled out by FHA in 2014. The intent of the new guidelines is to reduce defaults due to nonpayment of required property charges. Lenders are now required to more extensively analyze an applicant’s income and credit history as part of the qualification process.
The financial ability component of financial assessment focuses on whether an applicant has adequate monthly income to keep up with debt obligations, required property charges, home maintenance, and living expenses using a criteria called residual income.
If the applicant doesn’t have enough residual income to satisfy the lending guidelines, he or she is considered a higher risk for default. The lender may be required to carve out part of the reverse mortgage proceeds into a life expectancy set-aside, or LESA, which is designed to ensure that property charges are paid for the borrower’s remaining estimated lifespan.
How financial ability is determined
Financial ability has two basic components: residual income and compensating factors. To calculate residual income, the lender will first total all monthly debt payments (excluding mortgage payments to be eliminated by the reverse mortgage), property charges, and an estimate of utility expenses based on the square footage of the home. The total expenses are subtracted from the total monthly qualifying income to calculate the residual income.
The residual income must meet a certain threshold based on region and the number of people living in the home. If the residual income falls short, the lender may still approve the application without a LESA by documenting certain compensating factors.
Compensating factors can include (but are not limited to) other income sources, liquid assets, or unused proceeds from the reverse mortgage. Additional sources of income or cash such as these compensate for an income shortfall and make it easier for the lender to approve the loan without a LESA.
If one or more compensating factors cannot be documented, the lender may require a LESA.
If the residual income shortfall is large enough, it’s possible the loan won’t be approved at all, with or without a LESA.