Reverse Mortgage Definition
A reverse mortgage is a type of mortgage loan that is engineered for individuals with considerable equity, typically senior homeowners aged 62 and older, and that is secured with residential property, with the lender making periodic payments to the borrower in return for periodic transfers of property equity. In such an arrangement, the borrower makes no monthly mortgage payments and retains rights over the unencumbered portion of the home equity.
A Little More on What is a Reverse Mortgage
Reverse mortgages are typically engineered to allow borrowers to use the equity they have accrued in their homes at any point of time, and defer payment of the loan until they die, sell the property, or change accommodations. However, obtaining a reverse mortgage on a property does not exempt the borrower from routine obligations such as paying property taxes, home insurance and maintaining the home in accordance with the guidelines set by the Federal Housing Administration (FHA).
Borrowers typically use reverse mortgage loans to fund substantial expenditures such as property renovations and medical bills or to pay for daily living expenses. Homeowners may also use reverse mortgages to offset existing mortgages on their properties.
The value of a reverse mortgage loan is determined by three factors:
- The age of the youngest borrower.
- Current rates of interest.
- The property’s appraised value, sale price or the maximum lending limit, whichever is the least.
Home equity conversion mortgage (HECM) requirements often restrict the availability of funds to the borrower for the first 12 months after the settlement of the loan. Borrowers may also be required to set aside additional funds from loan proceeds towards payment of property taxes and home insurance.
The borrower (or his heirs) is usually allowed a period of six months to repay the loan, starting from the day the last surviving homeowner dies or evacuates the property. After the passage of the six months, the estate is usually obliged to sell the property to repay the balance of the loan, and remit any balance equity back to the heirs. However, in the event that the property sells for less than the payoff amount of the reverse mortgage loan, the borrower or his estate will not be held liable for any additional mortgage debt in excess of the value of the property.
Eligibility Criteria for Reverse Mortgage
FHA regulations mandate the following eligibility criteria for a borrower of a reverse mortgage loan:
- The youngest borrower on the title has to be at least 62 years old.
- Borrowers will need to satisfy the financial eligibility criteria as put forth by the United States Department of Housing and Urban Development (HUD).
- The borrower must use the proceeds from the reverse mortgage loan to pay off any existing mortgages on the property.
Types of Properties Eligible for Reverse Mortgages
The following types of properties are eligible for reverse mortgages, provided they meet FHA minimum property standards:
- Approved single-family homes.
- Owner-occupied dwellings consisting of two to four units, e.g. townhouses.
- Approved condominiums.
- Manufactured homes.
Reverse Mortgages and Inheritance
The following options are available to the heirs or estate of the borrower when the reverse mortgage loan becomes due:
- The heirs/estate can repay the reverse mortgage loan and retain ownership of the home.
- They can offer the home for sale in the market, the proceeds of which will go towards repayment of the loan. In case the property fetches more than the loan balance, the heirs/estate will duly receive the remaining home equity. If, however, the home fetches less than the loan balance, the heirs/estate is not obligated to pay more than the sale value of the home.
It is important to note here that reverse mortgage loans are non-recourse, that is the issuer of such a loan cannot lay claim to any other asset(s) of the borrower or his heirs/estate as compensation for any unpaid portions of the loan amount.
Receiving Reverse Mortgage Loan Funds
There are several options in which borrowers can choose to receive funds from reverse mortgage loans:
- Line of Credit (LOC): This option allows the borrower to withdraw funds as needed up to a stated maximum limit.
- Lump Sum: This option allows borrowers of fixed-rate loans to receive the entire amount of the loan amount at closing.
- Tenure: This option offers the borrower fixed monthly payments for the total duration of the loan.
- Term: This option offers the borrower monthly payments for a fixed term, i.e. a specified number of years.
References for Reverse Mortgage
Academic Research for Reverse Mortgage
Selection and moral hazard in the reverse mortgage market, Davidoff, T., & Welke, G. (2004). This paper demonstrates the relatively lower levels of adverse selection in the U.S. reverse mortgage market throughout history. Older homeowners with significant home equity but much lower cash reserves can use reverse mortgages loans to fund their immediate or recurring expenses, while deferring payment of the loan to the time the property is sold.
Preliminary evaluation of the HECM reverse mortgage program, Case, B., & Schnare, A. B. (1994). Real Estate Economics, 22(2), 301-346. This article scrutinizes the Home Equity Conversion Mortgage (HECM) reverse mortgage program and lists its various advantages and disadvantages. HECM insurance insures lenders against risks associated with reverse mortgage lending. On the downside, the existence of several legal and regulatory requirements may hinder the growth of reverse mortgages. Moreover, there is an acute shortage of certified housing counselors in several regions of the country.
The reverse mortgage as an asset management tool, Rasmussen, D. W., Megbolugbe, I. F., & Morgan, B. A. (1997). Housing Policy Debate, 8(1), 173-194. The importance of reverse mortgage as an instrument of liquidity for cash-strapped elderly homeowners cannot be underestimated. This paper studies reverse mortgage as a financial instrument that converts home equity into available cash for use in capital investment accounts, care for the elderly and home insurance, besides daily living expenses.
Reverse mortgage decision-making, Leviton, R. (2002). Journal of Aging & Social Policy, 13(4), 1-16. This paper scrutinizes the use of reverse mortgage as a financial instrument. The author samples data collected via interviews with homeowners who had access to reverse mortgage-related counseling. The paper concludes that reverse mortgage is mostly perceived as a last resort by homeowners that desire to remain independent in their later years.
Reversing the trend: The recent expansion of the reverse mortgage market, Shan, H. (2011). Real Estate Economics, 39(4), 743-768. This paper samples reverse mortgage loan data for the period 1989 – 2007 and performs three sets of tests to better comprehend the level of demand that exists among senior homeowners for reverse mortgages. The paper concludes that reverse mortgage originations are positively correlated with property prices. This is corroborated by the reverse mortgage market statistics for the period 2003 – 2007, that showed that an increase in property prices accounted for nearly a third of the overall growth in reverse mortgage originations.
Reverse mortgage loans: A quantitative analysis, Nakajima, M., & Telyukova, I. A. (2017). The Journal of Finance, 72(2), 911-950. In this paper, the authors utilize a calibrated life‐cycle model of retirement to scrutinize reverse mortgages. The paper concludes that the low demand for reverse mortgage loans (RMLs) stems from criteria such as loan costs, bequest motives and unpredictable circumstances such as expenses and health. The authors also noted a threefold increase in demand for reverse mortgage loans for elderly and cash-strapped homeowners during the Great Recession.
The reverse mortgage market: problems and prospects, Caplin, A. (2001). Zvi Bodie, Brett Hammond. This paper summarizes the economic factors, such as transactions costs, moral hazard, and the unpredictability of the consumer regarding future preferences, which contribute towards the disparity that exists between the current market and its theoretical potential. The authors also scrutinize a few psychological factors that negatively affect commitment towards these products among most elderly homeowners.
Willingness to consider applying for reverse mortgage in Hong Kong Chinese middle-aged homeowners, Chou, K. L., Chow, N. W., & Chi, I. (2006). Habitat International, 30(3), 716-727. This study seeks to evaluate the percentage of middle-aged homeowners in Hong Kong who would potentially apply for a reverse mortgage plan after retirement or in their later years. The authors also pick out socio-demographic, economic and health-related factors that could potentially influence the decision to apply for a reverse mortgage loan.
Using the 1990 public use microdata sample to estimate potential demand for reverse mortgage products, Rasmussen, D. W., Megbolugbe, I. F., & Morgan, B. A. (1995). Journal of Housing Research, 1-23. This paper samples 1990 U.S. Census public use microdata in order to evaluate the potential demand for reverse mortgage loans among elderly homeowners in the United States. The authors analyze this demand from two theoretical standpoints – The life-cycle hypothesis, The asset management approach. The authors then supplement these theoretical standpoints by a scrutiny of other popular home equity loan instruments. They conclude that senior homeowners display immense potential as future consumers of reverse mortgage loans.
Reverse mortgage choices: A theoretical and empirical analysis of the borrowing decisions of elderly homeowners, Fratantoni, M. (1999). Journal of Housing Research, 10(2), 189-208. This paper attempts to analyze the factors that decisively influence homeowners’ choice of reverse mortgage loan products. It also highlights the importance of structuring reverse mortgage products so as to cater to the homeowners’ individual requirements. The author develops a theoretical simulation model to demonstrate that elderly homeowners are far more likely to be better off with a line-of-credit plan than they would be with a supplementary fixed income component. The author’s empirical analysis corroborates the findings of the simulation model.
Securitisation and tranching longevity and house price risk for reverse mortgage products, Yang, S. S. (2011).The Geneva Papers on Risk and Insurance-Issues and Practice, 36(4), 648-674. The author devises a tranching security to counter potential risks such as longevity risks and house price risks that are typically associated with reverse mortgage products. Although the paper detects similarities between a collateralized debt obligation (CDO) and the collateralised reverse mortgage obligation (CRMO), the author contends that there are certain fundamental differences between the two. For example, while the CDO uses the default rate, the CRMO utilizes the dynamics of future mortality rates and house price returns.
Reverse mortgage pricing and risk analysis allowing for idiosyncratic house price risk and longevity risk, Shao, A. W., Hanewald, K., & Sherris, M. (2015). Insurance: Mathematics and Economics, 63, 76-90. This paper samples a stochastic multi-period model to analyze how house price risk as well as longevity risk work in tandem to influence pricing and risk profile of reverse mortgage loans. The authors conclude that it is not possible to accurately assess risks underwritten by reverse mortgage lenders by employing pricing based on an aggregate house price index. Moreover, the longevity risk associated with reverse mortgage loans is often miscalculated due to a blatant disregard for cohort trends in mortality improvements.