Reverse Mortgage

By:- Babasab Patil

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Introduction to Reverse Mortgage

Until recently, there were two main ways to get cash from your home the first one is you could sell your home, but then you would have to move and the second one is you could borrow against your home, but then you would have to make monthly loan repayments. Now there is a third way of getting money from your home that does not require you to leave it or to make regular loan repayments that is “Reverse Mortgage”. A reverse mortgage is a loan against your home that you do not have to pay back for as long as you live there. With a reverse mortgage, you can turn the value of your home into cash without having to move or to repay a loan each month. No matter how this loan is paid out to you, you typically don‟t have to pay anything back until you die, sell your home, or permanently move out of your home. Reverse mortgages is a powerful tool to help eligible homeowners obtain tax-free cash flow

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History and Origin of reverse mortgage

The history of reverse mortgage goes back to 1961.In the year 1961 the first reverse mortgage loan was made by Nelson Haynes of Deering Savings & Loan (Portland, ME) to Nellie Young, the widow of his high school football coach.In the year 1963 the first property tax deferral program offered in Oregon, financed through Public Employees Retirement Fund.In 1970 Survey research on a "housing annuity plan" was conducted in Los Angeles by Yung-Ping Chen of UCLA. In 1975 Technical monograph on "Creating New Financial Instruments for the Aged"  authored by Jack M. Guttentag of The Wharton School.In 1977 First RM loan program, "Equi-Pay", introduced by Arlo Smith of Broadview Savings & Loan in Independence, OH.In 1978 "Reverse Mortgage Study Project" funded by Wisconsin Bureau on Aging, directed by Ken Scholen and First statewide deferred payment loan program offered by WI Dept of Local Affairs and Development, designed by William Perkins.In 1979 First national "Reverse Mortgage Development Conference"sponsored by WI Bureau on Aging in Madison

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The Benefits of a Reverse Mortgage

Tax-free funds for as long as you live in your home No loan repayment for as long as you live in your home No income, medical or credit requirements Retain ownership of your home for life this is guaranteed

as long as you maintain your home, and pay insurance and real estate taxes

Choose a cash flow plan tailored to your needs No restrictions on how you may use the funds A tax-advantaged way to pass on part of your estate today

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Guidelines given by RBI for Reverse Mortgage:-

Any house owner over 60 years of age is eligible for a reverse mortgage.

The maximum loan is up to 60% of the value of residential property.

The maximum period of property mortgage is 15 years with a bank .

The borrower can opt for a monthly, quarterly, annual or lump sum payments at any point, as per his discretion.

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Costs which are to be incurred while going for Reverse Mortgage

A. Processing or origination costs: - These are the costs which covers the bank’s operating expenses for making the loan .This cost can be financed as a part of the total loan.

B. Mortgage Insurance: - This is the insurance charges of the insurer who guarantees that if the lender that is the banker goes out of business for any reason, the borrower would continue to get his or her payments. The insurer could also guarantee that the borrower will never owe more than the value of his or her home when the loan is finally repaid.

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Conti……..A. Appraisal fee: - This fee is to be paid to an

appraiser who fixes a value on the borrower’s home which is to be mortgaged. An appraiser must also make sure there are no major structural defects, such as bad foundation, leaky roof, or termite damage. If the appraiser uncovers property defects, you must hire a contractor to complete the repairs. Once the repairs are completed, the same appraiser is paid for a second visit to make sure the repairs have been completed. The cost of the repair may be financed within the loan.

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Conti………..

The revaluation of the property has to be undertaken by the Bank once every 5 years.

The amount received through reverse mortgage is considered as loan and not income; hence the same will not attract any tax liability.

Reverse mortgage rates can be fixed or floating and hence will vary according to market conditions depending on the interest rate regime chosen by the borrower.

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Risks to Reverse Mortgage Lenders

There are some risks faced by a Reverse Mortgage lender. These risks are at the heart of the reluctance of lenders to get into reverse mortgage lending, in the absence of public policy support. The principal and unique problem facing the lender is that of predicting accumulated future loan balances under a reverse mortgage, at the time of origination. The uniqueness is because reverse mortgage is a ‘rising debt’ instrument. Since reverse mortgage is a non-recourse loan, the lender has no access to other properties, if any, of the borrower. Even if the collateral property appreciates in value, it might still be lower than the loan balance at the time of disposal of the property. The following are the basic sources of this risk:-

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Mortality Risks This is the risk that a reverse mortgage borrower lives longer than anticipated. The lender might get hit both ways he has to make annuity payments for a longer period; and the eventual value realised might decline. However, this risk is usually ‘diversifiable’, if the reverse mortgage lender has a large pool of such borrowers. Possibility of adverse selection is counterbalanced by the possibility that even borrowers with poor health may be attracted by Reverse Mortgage’s credit line or lump sum options. However, there is no literature on one possible source of systematic risk. Since reverse mortgage is projected to substantially improve the monthly income and/ or liquid funds of the reverse mortgage borrowers, would it not itself result in a systematically higher life expectancy amongst them than otherwise, now this is a big question.

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Interest Rate Risks Said that the typical reverse mortgage borrower is elderly and is looking for predictable sources of income/ liquidity, reverse mortgage loans promise a fixed monthly payment / lump sum / credit line entitlement. However, for the lender, this is a long-term commitment with significant interest rate risks. While fixing the above, the lender has to account for a risk premium and thus can offer only a conservative deal to the borrower. This interest rate risk is not fully diversifiable within the reverse mortgage portfolio. Most of the reverse mortgage loans accumulate interest on a floating rate basis to minimize interest rate risks to the lender, like in SBI the interest rates are revised for every 5 years. However, since there are no actual periodic interest payments from the borrower, these can be realized only at the time of disposal of the house, if at all.

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Moral Hazard Risk Once an RM loan is taken, the homeowners may have no incentive to maintain the house so as to preserve or enhance market value. This might be especially true when the loan balance is more or less sure to cross the sale value. Since the benefit would accrue mainly to the lenders and the cost borne by the homeowner, it is perhaps not sensible to assume otherwise. They conclude that in a competitive market, the lenders will respond by either reducing the loan amount or by charging a risk premium in interest or both. The more important point is that some time during the tenure of a reverse mortgage, an elderly borrower may simply be physically incapable of maintaining the home as per loan requirements.

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Risk Mitigation

• Risk mitigation is the key for the success of any financial product including reverse mortgage. Some of the risk mitigation techniques which the providers that is the banker can apply to reduce the risk on their books are as follow

1. Proper eligibility criterions:-• The first mitigation of risk can be done at the time of

providing loans. This can be done through proper verification of the title of the property, age of the borrower; his/her credit analysis etc. This reduces the risk of default by the borrower

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Conti………

1. Variable interest rates loan as compared to fixed interest rate loan:-To avoid interest rate risk, the lender can go for variable interest rates based on some market benchmark like MIBOR. This will also reduce the risk of Pre-payment as the borrower will not have interest arbitrage on prepayment of the loan

2. Proper analysis of mortality trends:-As the product has significant longevity risk, the lender can do a detailed mortality trend analysis on a macro level and also in the market where it is operating.

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Conti………

1. Geographical diversification :-The lender can look at spreading the business across the country by promoting the product in secondary and tertiary cities also so that the law of large numbers may work properly and if the provider has a bad experience in one market; it can be compensated with good experience in other cities

2. Develop the product for lower age groups:-The lender can develop home equity conversion mortgages for all households and not just for elderly. This will significantly reduce loan to value ratio and that will take care of many of the risks inherent in the product.

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Conti………1. Securitization :-One of the most effective ways of mitigation

risk is securitization It involves many other financial players and thus it spreads the risk of default/prepayment to many other participants.

2. Repayment schedule :-In the Repayment schedule, some default conditions or changes that affect the security of the loan for the lender that can make reverse mortgages payable should also be added, like Declaration of bankruptcy, Donation or abandonment of the house, Condemnation/ Sovereign Takeover of the property by a government agency, adding a new owner to the home’s title, taking out new debt against the home etc.

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Forces affecting “Reverse Mortgage”

Any financial product is affected by some forces. The following are forces that affect this innovative financial product called “Reverse Mortgage”. Borrowers have to bear very high transaction costs.

However, with the latest program we can expect a declining trend in these costs due to growing volumes, increased awareness and learning effects.

There is a definite risk of moral hazard in borrowers being responsible for home maintenance and in ultimate home sale. Given the profile of a typical borrower, there are serious questions on both incentives and ability. It is impractical to enforce the foreclosure clause

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Conti……. Home equity is an important component of precautionary

savings. If a homeowner has drawn down on his equity through a reverse mortgage, his ability to meet unforeseen health care costs or move into alternative housing may be more limited. Those who become seriously ill but would like to continue to stay at home may face a severe problem. If they have to be away from home for long for convalescence, they may fail to maintain the home and pay property taxes. Then, as per the conditions of the reverse mortgage, the lender can foreclose the loan.

Many elderly households may be simply reluctant to take on debt, having spent so much of their lifetime saving for their own house.

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Conti…….

Real estate laws are state specific whereas regulations governing reverse mortgage loans are national in character. If there is a conflict, state laws will prevail unless pre-empted by federal law.

Laws in some states are not clear on the lien priority to be granted to reverse mortgage over other secured creditors, in spite of specific provisions in a reverse mortgage contract.

What happens if a household declares bankruptcy, having borrowed through a Reverse mortgage is a big question.

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Conti……. Uncertainty exists on taxation of the borrower. If reverse

mortgage annuities were considered taxable as income of the borrower, would accrued interest on the loan be a tax-deductible expense is an issue.

The tax authorities may if classify an reverse mortgage as a sale of home rather than a loan, given the high probability that the entire value may ultimately accrue to the lender. If so, the borrower may suddenly find that he has lost out on one-time exemptions on capital gains.

The lender has to account for accrued interest as income, without any corresponding cash flow.

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Thank You