How can reverse mortgages become more attractive to both borrowers and lenders? Life annuities could help, according to a new paper written for the Brookings Institution in Washington.
A retiree with a Home Equity Conversion Mortgage receives payment against the value of her home until she dies or moves out of the home, at which point the lender is owed the lesser of the home’s value or the balance of the loan. This presents a risk to the lender: The loan balance they are paying out may grow to exceed the value of the mortgaged home. The borrower has limited liability — the lender cannot collect the difference from her estate. Because of the risks to lenders and the resultant higher fees to borrowers, reverse mortgages are relatively unpopular.
Enter the “annuity-enhanced reverse mortgage loan.”
Thomas Davidoff of the Sauder School of Business proposed what he says is a “novel” new approach to reducing lenders’ risk.
“Loan amounts would be increased at origination to purchase a life annuity,” Davidoff writes in the paper, Annuity-Enhanced Reverse Mortgage Loans. The cash flow from the life annuity would be paid to the lender as long as the borrower is alive and in the home, slowing the growth of the loan balance. “This effectively transfers loan balances from long after loan origination, when the borrowers’ home is likely to be worth less than the outstanding balance, to earlier dates when the home is most likely worth more than the borrower owes,” according to the paper.
“Beyond possibly unfair annuity pricing, this risk reduction would come at no cost to the borrower and lender,” he writes.
If the borrower moves out of the home before he dies, the annuity payments would revert to the borrower until death.
Davidoff offers “numerical examples” to show that the costs to lenders of borrowers’ limited liability “may be significantly reduced by this smoothing of the loan balance across time.” Lenders, he maintains, “may thus be able to provide more cash to borrowers at loan origination while offering lower fees and interest rates.”
This proposal may ease “a significant problem with reverse mortgage loans, which seem like a promising way to improve retirement finance but have not proven popular: Borrowers may not appreciate the significant costs that limited liability imposes on lenders,” he said.
The risk that accumulated principal and interest on the loan will wind up exceeding the home value is a key reason why only a tiny fraction of retirees use reverse mortgages, Davidoff argues.
“By reducing that risk, a very large source of retirement finance might be unlocked.”
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