Econintersect: Reverse mortgage loans (RMLs) allow older homeowners to borrow against housing wealth without moving. In spite of growth in this market, only 2.1 percent of eligible homeowners had RMLs in 2011. A Philly Fed Working Paper entitled Reverse Mortgage Loans: A Quantitative Analysis by Makoto Nakajima and Irina A. Telyukova, analyzes reverse mortgages. In case any readers are unsure what reverse mortgages are, an excellent overview follows.
Excepts follow from the Philly Fed Working Paper entitled Reverse Mortgage Loans: A Quantitative Analysis by Makoto Nakajima and Irina A. Telyukova. The first section is an overview of reverse mortgages.
Reverse Mortgage Loans: An Overview
Currently, the most popular reverse mortgage is administered by the Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development (HUD), while the private market for reverse mortgages has been shrinking.[This section is based on, among others, AARP (2010), Shan (2011), Nakajima (2012), and information available on the HUD website.] The government-administered reverse mortgage is called a home equity conversion mortgage (HECM). According to Shan (2011), HECM loans represent over 90% of all reverse mortgages originated in the U.S. market.[Many other reverse mortgage products, such as Home Keeper mortgages, which were o ered by Fannie Mae, or the Cash Account Plan o ered by Financial Freedom, were recently discontinued, in parallel with the expansion of the HECM market. See Foote (2010).]
The number of households with reverse mortgages has been growing. Figure 1 shows the proportion of homeowner households of age 65 and above that had reverse mortgages between 1997 and 2011. Both the HECM loans and private mortgage loans are included. As the figure shows, the use of reverse mortgages was limited before 2000. In 2001, the share of eligible homeowners with reverse mortgages was about 0.2%. This share increased rapidly since then, reaching 2.1% in 2011.
Although the level is still low, the growth motivates our general interest in reverse mortgages and is all the more impressive if one considers that the popularity of RMLs continued to rise even as other mortgage markets remained stagnant through the recent housing market downturn.
Reverse mortgages differ from conventional mortgages in six major ways.
- First, as the name suggests, a reverse mortgage works in the reverse way from the conventional mortgage loan. Instead of paying interest and principal and accumulating home equity, reverse mortgage loans allow homeowners to cash out the home equity they’ve accumulated. That is why RMLs are targeted to older households.
- Second, government-administered HECM loans have requirements different from conventional mortgage loans. These mortgages are available only to borrowers age 62 or older who are homeowners and live in their house.[For a household with multiple adults who co-borrow, age of the borrower” refers to the youngest borrower in the household. Properties eligible for HECM loans are (1) single-family homes, (2) one unit of a one- to four-unit home, and (3) a condominium approved by HUD.] Finally, borrowers must have repaid all or almost all of their other mortgages at the time they take out a reverse mortgage. On the other hand, RMLs do not have income or credit history requirements, because repayment is promised not based on the borrower’s income but solely on the value of the house the borrower already owns. According to Caplin (2002), RMLs may be beneficial to older homeowners since many of them fail to qualify for conventional mortgages because of income requirements.
- Third, reverse mortgage borrowers are required to seek counseling from a HUD-approved counselor in order to qualify for a HECM loan. The goal is to ensure that older borrowers understand what kind of loan they are getting and what the potential alternatives are before taking out a reverse mortgage loan.
- Fourth, there is no pre-fixed due date; repayment of the borrowed amount is due only when all the borrowers move out or die. As long as at least one of the borrowers continues to live in the same house, there is no need to repay any of the loan amount. There is no gradual repayment with a fixed schedule, as with a conventional mortgage or line of credit; repayment is made in a lump sum from the proceeds of the sale of the house.
- Fifth, HECM loans are non-recourse; borrowers are insured against substantial drops in house prices. Borrowers (or their heirs) can repay the loan either by letting the reverse mortgage lender sell the house, or by repaying. Most use the frst option. If the sale value of the house turns out to be larger than the sum of the total loan amount and the various costs of the loan, the borrowers receive the remaining value. In the opposite case, where the house value cannot cover the total costs of the loan, the borrowers are not liable for the remaining amount. The mortgage lender does not have to absorb the loss either, because the loss is covered by government insurance, with the premium included as a part of a HECM loan cost structure.
- Finally, there are multiple ways to receive payments from the RML. Borrowers can choose one of fve options, and these can be changed during the life of the loan, at a small cost. The first option is a tenure RML, where borrowers receive a fxed monthly amount as long as one of the borrowers lives in the house. The second is a term RML, where borrowers receive a fixed amount for a fixed length of time. The third option is a line of credit, which allows borrowers to withdraw flexibly, up to a limit, during a predetermined drawing period. Finally, modified tenure and modified term options combine the line-of-credit RML with tenure and term features, respectively. Of the payment options listed, the line-of-credit option has been the most popular. HUD reports that the line-of-credit plan is chosen either alone (68%) or in combination with the tenure or term plan (20%). In other words, it appears that older homeowners use reverse mortgages mainly to flexibly withdraw funds out of accumulated home equity.
How much can one borrow using a reverse mortgage? The starting point is the appraised value of the house, but there is a federal limit for a HECM loan. Currently, the limit is $625,500 for most states.[The limit was raised in 2009 from $417,000 as part of the Housing and Economic Recovery Act of 2008. The $625,500 limit is valid until December 2013.] The lesser of the appraised value and the limit is called the maximum claim amount (MCA).[Private mortgage lenders o er jumbo reverse mortgage loans, which allow borrowers to cash out more than the federal limit. However, borrowers have used jumbo reverse mortgages less and less often as the federal limit has been raised.] Reverse mortgage borrowers cannot receive the full amount of the MCA because there are non-interest and interest loan costs that have to be paid from the house value as well. Moreover, if borrowers have outstanding mortgages, part of the new mortgage loan will be used to pay of the outstanding balance of those other mortgages. Non-interest costs include an origination fee, closing costs, the insurance premium, and a loan servicing fee. The insurance premium depends on the value of the house and how long the borrowers live and stay in the same house. More specifically, the insurance premium is 2% of the appraised value of the house (or the limit, if the value is greater) initially and 1.25% of the loan balance annually.[The annual mortgage insurance premium was raised from 0.5% to 1.25% in October 2010.] Interest costs depend on the interest rate, the loan amount, and how long the borrowers live and stay in the house. The interest rate can be either fixed or adjustable. In the case of an adjustable interest rate, the borrowing interest rate is the sum of the reference interest rate plus margin charged by the mortgage lender, and there is typically a ceiling on how much the interest rate can go up per year or during the life of a loan. The initial principal limit (IPL) is calculated by subtracting expected interest costs from the MCA. The net principal limit is calculated by subtracting various upfront costs from the IPL.
The IPL is thus larger the larger the house value, the lower the outstanding mortgage balance, the older the borrower, and the lower the interest rate. Figure 2 shows the distribution of the initial principal limit as a percentage of the underlying house value. It is clear that many homeowners can borrow around 60% to 70% of the appraised house value using reverse mortgages. If the term option is chosen, the total loan amount is divided depending on the number of times the borrower receives payments. With the tenure option, the amount of payment per period is determined by the number of times the borrower is expected to receive payments.
To understand who the reverse mortgage borrowers are, Shan (2011) looked at the characteristics of areas with more reverse mortgage borrowers and investigated how those characteristics changed over time. She found that areas with more reverse mortgage borrowers tend to have lower household income, higher house value, relatively higher homeowner costs, and lower credit scores. The median house value among reverse mortgage borrowers was $222,000 in 2007, which was about 25% higher than the median house value of all older homeowners ($175,000). Figure 3 shows the age distribution of borrowers at the time of mortgage origination, during 2003-2007. There is a spike at age 62, which is the frst eligibility age. Shan (2011) also showed that the distribution is shifting to the left over time, implying that reverse mortgage borrowers were getting younger, with the spike at age 62 becoming more pronounced.
What follows here is the overview of the study on reverse mortgages:
Introduction
Reverse mortgage loans (RMLs) allow older homeowners to borrow against their housing wealth without moving out of the house, while insuring them against significant drops in house prices. Despite potentially large benefi ts to older individuals, many of whom want to stay in their house as long as possible, as well as frequent coverage in the media and attempts by the Federal Housing Administration, which administers RMLs, to change the contract to increase the appeal to borrowers, research on reverse mortgages is not extensive. This paper is intended to ll some of the void.
In previous work, Nakajima and Telyukova (2012) found that older homeowners become borrowing constrained as they age, since it becomes more costly to access their home equity, and that these constraints force many retirees to sell their homes when faced with large expense shocks. In this environment, it seems that an equity borrowing product targeted toward older homeowners may be able to relax that constraint and hence potentially benefit many owners later in life. Empirical studies have suggested a similar possibility, though estimates range widely. For example, Merrill et al. (1994) suggest that about 9% of homeowner households over age 69 could benefit from RMLs.
Using a less conservative approach, Rasmussen et al. (1995) argue, using 1990 U.S. Census data, that the number is nearly 80%.[Rasmussen et al. (1995) assume that elderly households with home equity exceeding $30,000 and without mortgage loans in 1990 bene t from having the option of obtaining reverse mortgages. Merrill et al. (1994) assume that households with housing equity of between $100,000 and $200,000, income of less than $30,000 per year, and a strong commitment to stay in the current house (i.e., those who had not moved for the previous 10 years), and who own their house free and clear bene t from reverse mortgages.] Despite the apparent benefits, RMLs were used by just 2.1% of older homeowners in 2011, although this represented the highest level of demand to date.
In this paper, we study the determinants of demand for reverse mortgages and their market potential in terms of consumer demand, in the face of complex trade-offs that retirees face in deciding whether to borrow. Speci fically, we answer four questions about RMLs. First, we want to understand who benefi ts from reverse mortgages, and how much, in welfare terms. Second, we ask, given the current available RML contract, what prevents more retirees from taking the loans. Here we focus on retirees’ environment, such as the magnitude of risk that they face, and preferences, such as their bequest motives. Third, we study whether and how the existing reverse mortgage contract can be changed to make the RML more attractive. We are motivated here by the frequently advanced argument that the low take-up rate in the data is due to the high fees on reverse mortgages. Finally, we want to understand what the largest potential market size for reverse mortgages may be.
To answer these questions, we use a rich structural model of housing and saving/borrowing decisions in retirement based on Nakajima and Telyukova (2012). In the model, households are able to choose between homeownership and renting, and homeowners can choose at any point to sell their house or to borrow against their home equity. Retirees face idiosyncratic uninsurable uncertainty in their life span, state of health, medical expenses, and house prices, and no aggregate uncertainty. Bad health may force older individuals into nursing homes, which we capture with an idiosyncratic moving shock. The model is estimated to match life-cycle pro les of net worth, housing and financial assets, homeownership rate, and home equity debt, which we construct from the Health and Retirement Study data. Into this model, we introduce reverse mortgages, study their use and value to different household types, and conduct counterfactual experiments to answer the questions posed above.The model predicts that the ex-ante welfare benefit of reverse mortgages is equivalent to providing a lump-sum transfer of $1,000 per retiree at age 65, or about 5% of median annual after-tax income. The welfare gains double, for example, for low-income retirees who are more likely to use RMLs. Nearly all homeowners value, ex-ante, the option of being able to tap their equity some time during their retirement; however, ex-post, only 2.1% of eligible retirees use RMLs, consistent with the data. Indeed, we estimate the potential market size for reverse mortgages at 5.5% of eligible retirees, which is an increase over the current level of 260% but far from the majority of households.
Behind these low numbers is a combination of substantial risks that households face late in life, such as health, medical expense and long-term care risks, house price uncertainty, bequest motives, and significant costs of the reverse mortgage contract, all of which can dampen demand for reverse mortgages. A caveat is that we compute these numbers under the assumption of stationarity, i.e., absent aggregate booms or busts in the housing market, which certainly affect demand as well, as we show in further experiments. A policy takeaway is that demand for reverse mortgages could be boosted by policy aimed either at reducing certain costs of reverse mortgages, or reducing idiosyncratic risk that retirees face. We find, for instance, that absent most idiosyncratic risks that retirees currently face, demand for reverse mortgages could go up to 8.6% of retirees.
In more detail, we nd that retirees who use reverse mortgages tend to have low income, low wealth, and poor health, and that they use them primarily to support consumption expenditure in general, or large medical expenses in particular. About 20% of RML borrowers use reverse mortgages to pay exclusively for medical expenses, which allows them to remain in their home, where the alternative in the world without RMLs would have been to sell the house. Bequest motives not only dampen RML demand, but also change the dominant reasons for why homeowners take RMLs; without these motives, retirees take RMLs much more frequently and use them overwhelmingly for non-medical consumption. On the contract side, we fi nd that eliminating upfront costs of the loan increases demand for RMLs to 3.5%. In addition, reverse mortgages are non-recourse loans, meaning that if the price of the collateral falls below the loan value during the life of the RML, the lender cannot recover more than the collateral value.
Strikingly, we nd that retirees do not value this insurance component of RMLs, due to low borrowed amounts and availability of government provided programs such as Medicaid, so that making reverse mortgages a recourse loan would increase RML demand by 48%, to 3.1%. In this sense, the oft-heard claim that large contract costs suppress RML demand is supported by our model. However, the HECM Saver loan, which was designed to respond to this claim by lowering the upfront cost of insurance in exchange for lowering the amount of equity accessible to the elderly, reduces demand for reverse mortgages, so that adding it to existing RML contracts is not likely to boost demand. In sensitivity experiments, we show that our results are robust to perturbations in estimated parameter values.
This paper makes three key contributions to the literature. First, we are the first, to our knowledge, to model reverse mortgages in a standard life-cycle environment that incorporates both key sources of risk that retirees face, and aspects of preferences of older households previously deemed important by the literature, such as bequest and precautionary motives. Second, our model allows us to run a rich set of fi ne-tuned experiments, designed to study all aspects of reverse mortgages relevant to current and potential borrowers and to quantify potential market size for reverse mortgages. Finally, we are able to quantify welfare gains from reverse mortgages on average and the distribution of welfare gains across different household types.
Our paper is related to three branches of the literature. First, the literature on reverse mortgage loans is developing, reflecting the growth of the take-up rate and the aging population. Shan (2011) empirically investigates the characteristics of reverse mortgage borrowers. Redfoot et al. (2007) explore better design of reverse mortgage loans by interviewing reverse mortgage borrowers and those who considered reverse mortgages but eventually decided not to utilize them. Davidoff (2012) investigates under what conditions reverse mortgages may be beneficial to homeowners, but in an environment where many of the idiosyncratic risks that we model are absent. Michelangeli (2010) is closest to our paper in approach. She uses a structural model with nursing home moving shocks and finds that, in spite of the benefits, many households do not use reverse mortgages because of compulsory moving shocks. Our model con rms this, but also takes into account many other important risks that older households face, such as health status, medical expenditures, and price of their house. Moreover, we incorporate into the model the initial type distribution of older households from the data, which allows us to capture crucial empirical correlations between household characteristics, such as wealth, income, home ownership, and health, important to household decisions on whether to borrow. Finally, we model the popular line-of-credit reverse mortgage loan, while Michelangeli (2010) assumes that borrowers have to borrow the maximum amount at the time of loan closing. We nd that this distinction in the form of the contract matters.
The second relevant strand of literature addresses saving motives for the elderly, or solving the so-called retirement saving puzzle.” Hurd (1989) estimates the life-cycle model with mortality risk and bequest motives and nds that the intended bequests are small. Ameriks et al. (2011) estimate the relative strength of the bequest motives and public care aversion, and find that the data imply both are significant. De Nardi et al. (2010) estimate in detail out-of-pocket (OOP) medical expenditure shocks using the Health and Retirement Study, and nd that large OOP medical expenditure shocks are the main driving force for retirement saving, to the effect that bequest motives no longer matter. Venti and Wise (2004) study how elderly households reduce home equity. In our previous work, Nakajima and Telyukova (2012) emphasize the role of housing and collateralized borrowing in shaping retirement saving, and nd that housing and homeownership motives are key in accounting for the retirement saving puzzle, in addition to bequest motives and medical expense uncertainty.
Third is the literature on mortgage choice, particularly using structural models, which is growing in parallel with developments in the mortgage markets. Chambers et al. (2009) construct a general equilibrium model with a focus on the optimal choice between conventional xed-rate mortgages and newer mortgages with alternative repayment schedules. Campbell and Cocco (2003) investigate the optimal choice for homebuyers between conventional fixed-rate mortgages (FRM) and more recent adjustable-rate mortgages (ARM). We model the choice between conventional mortgages and line-of-credit reverse mortgages, though we focus only on retirees.
And the Conclusion:
Conclusion
In this paper, we analyze reverse mortgage loans using a calibrated structural model of life in retirement where older households make decisions about consumption, saving, housing, and reverse mortgages. We nd that the expected welfare gain of reverse mortgages is sizable { equivalent to $1,000, or nearly 5% of median annual after-tax income, in a one-time transfer for all households and even higher for homeowners. Our model indicates that under the current environment and RML terms, reverse mortgages are used by about 20% of the borrowers to pay for medical expenses while allowing them to remain in their home. The model also predicts that RMLs are particularly popular among lower-income and lower-wealth households, as well as households in poor health, which is consistent with RML use in the data.
Through counterfactual experiments, we identify that, conditional on the existing RML contract in the data, bequest motives, compulsory nursing-home moving shocks, and house price fluctuations all dampen RML demand to various degrees. However, not surprisingly, we also nd that the costs of the RML contract are an important determinant of demand. In particular, the insurance costs inherent in the current contract dampen RML demand because households do not value this insurance, owing to relatively low borrowed amounts and government-provided insurance such as Medicaid. Along these lines, the model predicts a 50% increase in demand if the reverse mortgage were made a recourse loan. On the other hand, the HECM Saver loan of 2010, which lowers the upfront insurance costs in exchange for lowering the total amount of equity accessible to the borrower, actually lowers RML demand among homeowners, which suggests that adding this option to the already existing RML contract is not likely to boost demand significantly. Finally, by lowering upfront costs of RMLs and making RMLs recourse, the loan could reach the market size of 5.5%, which is still far from the majority of retirees. One possible interpretation of these results is that, given the risk that lenders have to take on to o er the RML and given retiree preferences and risks, the resulting contract is too expensive to be desirable to the majority of homeowners, so that many are better o selling their homes in the event of needing to liquidate their home equity, as detailed in Nakajima and Telyukova (2012).
The above results come from the model where households do not face aggregate trends in house prices. In experiments, we find that if households expect a housing boom of the magnitude of 2000-06, this quadruples demand for reverse mortgages because households would want to front-load consumption by borrowing, then repay from the capital gains. In the data, we have observed a run-up in RML demand during the housing boom consistent with this story, as it could be postulated that households continued to expect price growth throughout those years. However, we have also observed this increase continuing in the data through the housing bust. This can still be consistent with the findings of the model. The decrease in house price growth in and after the Great Recession could dampen the take-up rate of reverse mortgages, in a mechanism opposite to the one just described, as long as it is perfectly predicted. At the same time, some homeowners might be using reverse mortgages more extensively in response to the downturn, in order to relax the increased borrowing constraint that they face, particularly if the downturn was a surprise. Our model cannot be used to formally evaluate these possibilities because we do not model aggregate dynamics and expectations about them. We leave this issue for future research.
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