Reverse-Equity Mortgage

During the 1980s, the U.S. financial system was deregulated in a number of ways. One of the fundamental changes occurred in the freedom that financial institutions received for the first time since the 1930s to develop new and innovative products. Many of these products were new financial instruments intended to expand the range of options for consumers. Among the more unusual instruments was the reverse-equity mortgage (or as it was also called in the early days, the reverse-annuity mortgage, or RAM). In recent years, these products are simply known as reverse mortgages.

Like all financial instruments, reverse-equity mortgages are designed to solve a financial problem. In this case, elderly homeowners typically may have reduced income but continuing or growing consumption needs. At the same time, a large portion of the homeowner's wealth is the equity portion of their home. If their home has a paid-up mortgage, then the equity is equal to the market value of the property. A reverse-equity mortgage provides cash flow payments to the owner in exchange for a claim on the asset when the owner dies or sells the property. In this sense, the flows are reversed from the typical mortgage note: Instead of borrowing a lump sum at the time of purchase or refinance and submitting payments to repay the note, the reverse-equity mortgage sends periodic payments to the homeowner, and at the termination of the tenure, the lender claims a lump sum as measured by the number and size of the payments. In fact, recent reverse mortgage agreements are written as lines of credit so the payments are flexible.

It has been estimated that elderly households in the United States hold more than two thirds of their assets in paid-up equity interests in the houses in which they reside. This appears to be true even after the financial crisis in the late 2000s. Reverse-equity mortgages enable such households to convert this wealth into cash without having to sell their residences or originate a new primary mortgage. The objective is to tap their equity wealth rather [Page 638]than sell and relocate. A new mortgage can provide a lump sum if the homeowner's income can qualify, but the goal is to convert the equity into income. Therefore, reverse mortgages are a solution for dealing with these financial problems.

In this regard, this instrument solves the same type of financial problem for the elderly as a conventional mortgage does for the first-time buyer: the mortgage matches payments and flows with consumption preferences and needs. It trades present and future consumption with the interest rate as the agreed-upon price for this privilege. The equity portion of the homeowner declines with each payment received. This is because the homeowner has collateralized the equity in the home, and the owner's interest declines as the payments are received.

There are a number of risks when issuing a reverse-equity mortgage. There is the chance of prepayment, a risk inherent in all modern U.S. mortgages. If interest rates fall, the homeowner will have incentive to prepay the outstanding balance of the mortgage. There is also uncertainty about the life of the loan. Most reverse mortgages have specific maturities (although some modern instruments are structured like lines of credit in reverse). However, to recover the lender's interest, the property must be sold, and real estate sales do not occur immediately. With declining property values since 2007, this is an added risk for the lender. Finally, there is exposure to risk because, effectively, the date when the lender's interest will be satisfied is uncertain. Changes in the real property market in the years ahead can weaken the lender's collateralized position.

...