Christopher J. Mayer andKaterina V. Simons

Economists, Federal Reserve Bank ofBoston. The authors would like tothank Katharine Bradbumd, LynnBrowne, and Richard Kopcke for help-ful comments, Steven Venti for pro-viding some computer programs fromprevious research, and Michael Jud forexcellent research assistance.

M ’ost elderly hold a significant portion of their non-pensionwealth in housing equity. Over 70 percent of households over

¯ age 62 own their home, and 80 percent of those homeownershave no remaining mortgage. The median elderly homeowner has$64,000 of housing equity and only $15,000 of liquid assets. For manyelderly homeowners this concentration of wealth in housing presents aproblem. Although they might prefer to use their housing equity tofinance current consumption, to pay for an emergency, or to help out arelative in need, utilizing this wealth would force the sale of their home.Traditional home equity lines of credit require that principal and interestbe paid back over a fixed time interval, yet many elderly want to avoidmortgage payments because they live on a limited income.

Reverse mortgages hold the promise of helping elderly homeown-ers out of this bind. In the simplest form, a reverse mortgage wouldallow homeowners to borrow against their housing equity and receivemonthly payments, while still living in their home until they die orchoose to move. After moving, the homeowner would sell the home anduse the proceeds to pay off the balance of the reverse mortgage. Theholder of the reverse mortgage would provide insurance guaranteeingthat the homeowner would never owe more than the future value of thehouse.

Although reverse mortgages have been offered for more than adecade, the market has never gained significant size. Some critics haveargued that elderly homeowners really do not want to use reversemortgages because they intend to give their house to their children, orsave the equity to pay for future expenses such as long-term care.Others suggest that previous reverse mortgage contracts have not metthe needs of most elderly homeowners, requiring repayment within afixed 5- or 10-year term, or loss of all equity in the house even if thehomeowner dies the next year. Financial institutions claim that reversemortgages are very risky and that the housing and interest rate risks are

not easily diversifiable. In addition, recent accountingchanges require holders of reverse mortgages toreport artificial losses until repayment. More re-cently, however, the U.S. Department of Housingand Urban Development (HUD) has begun a demon-stration program to gauge elderly interest in reversemortgages.

This article will explore the viability of the marketfor reverse mortgages. The first part will describe thevarious types of reverse mortgages. Next, the articlewill estimate the potential demand for reverse mort-gages using data from the Survey of Income and

Most elderly hold a significantportion of their non-pensionwealth in housing equity.

Program Participation (SIPP). Assumptions about fu-ture increases in house prices and various interestrates are shown to have a considerable effect on theestimated market size. The results show a largepotential market, whether measured in terms of theincreased income available from a reverse mortgageor the addition to liquid wealth. Given the marketpotential, the article then discusses demand andsupply explanations as to why the current number ofreverse mortgages is so small. The article concludesby looking at policy changes that might stimulate thegrowth of reverse mortgages.

L Types of Reverse MortgagesA reverse mortgage is one specific type of a more

general class of home equity conversion loans, thatis, loans that allow homeowners to borrow againstequity in their homes. The chief characteristic of suchloans, setting them apart from conventional mort-gages and home equity lines of credit, is that theborrower does not need to make periodic interest orprincipal payments during the life of the loan. Bor-rowers can receive regular monthly payments, alump sum, or a line of credit. The interest andprincipal due keep accruing until the loan is repaid ina lump sum when the house is sold, which usuallyhappens when the borrower moves out of the houseor dies. Because of their repayment characteristics,

eligibility for home equity conversion programs, in-cluding reverse mortgages, is usually limited to eld-erly homeowners.

Perhaps the most common type of home equityconversion plan is a property tax deferral program,which a number of state and local governmentsadminister. Under these programs, the governmentplaces a lien on the property in return for the deferralof the property tax. The tax is paid, with accumulatedinterest, when the house is sold. The interest rate isset by law, and is usually between 6 and 8 percent peryear. In New England, these programs are availableon a local basis in Connecticut, Massachusetts, andNew Hampshire. Most programs have eligibility re-quirements that place limits on income or assets ofparticipants.

Local government agencies sometimes makeloans on a similar basis, known as deferred paymentloans, to the elderly with limited means. Such loansare made for a specific purpose, most often homerepair, at a fixed, usually below-market interest rate.A typical loan would be made for replacing or repair-ing a roof, plumbing, electrical wiring, or heating.1

Fixed-Term Reverse Mortgage

The simplest type of a reverse mortgage is ex-tended for a fixed term and becomes due on a specificdate. In New England, such mortgages are availablein Connecticut and Massachusetts. They are offeredthrough nonprofit counseling agencies, which serveas initial points of contact between the lender and theprospective borrower. Since the lender might have toforeclose on the loan unless the borrower sells thehouse and moves or has other funds for repayment,the major function of the counseling agency is tomake sure that the borrower has made adequate plansand living arrangements when repayment is due.

Some counseling agencies see their mission asmuch broader. For instance, H.O.M.E. (Home Op-tions for Massachusetts Elders), the agency thatserves as the referral point for all fixed-term reversemortgages in Massachusetts, helps prospective bor-rowers identify options other than a reverse mort-gage, such as government programs for which theymay be eligible. Indeed, the agency considers this tobe its priority and regards a reverse mortgage to be a"last resort" when no alternative sources of incomeare available to the client. Because of their nonprofit

1 Redecorating the house or making other cosmetic changes isnormally not permitted under such programs.

16 March/April 1994 New England Economic Review

status and emphasis on serving the elderly in need,independent counseling agencies usually impose in-come ceilings and other eligibility limits on theirclients. Moreover, since the volume of fixed-termreverse mortgages is small, banks and thrifts thatmake them usually regard making such loans as"good corporate citizenship" rather than a line ofbusiness worth developing for its profit potential.

Home Equit~y Conversion MortgageInsurance Demonstration

In order to encourage the growth of the reversemortgage market, in 1987 Congress authorized theDepartment of Housing and Urban Development(HUD) to administer a new reverse mortgage pro-gram, called the Home Equity Conversion Mortgage(HECM) Insurance Demonstration. The program al-lows borrowers to access equity in their single-familyhomes through a line of credit or regular monthlypayments. The payments can continue as long as theborrower lives in the house, or for a fixed term. Evenif the borrower elects to receive payments for a fixedterm, the loan does not become due at the end of theterm. Instead, interest accrues until the borrowermoves out of the house or dies, when the house issold and the loan is repaid. To insure lenders againstthe risk that the loan balance may, over time, growlarger than the value of the house, the Federal Hous-ing Administration collects insurance premiums onall loans.

To guard against potential misuse of the pro-gram, HECM requires the borrower to undergo coun-seling from an independent, HUD-approved counsel-ing agency. While the HECM program does not haveincome ceilings or other eligibility restrictions, it doesimpose limits on how much can be borrowed. Thoselimits vary by geographical area and currently rangefrom $67,500 to $151,725 (AARP 1993). Even at theupper limit, however, the HECM-permitted loanamounts fall short of home values in some areas ofthe country, particularly in California and the North-east, and thus do not allow many borrowers to takefull advantage of their home equity.

Lender-Insured Reverse Mortgages

Currently, three lenders--Providential Home In-come, Freedom Home Equity Partners, and Trans-america HomeFirst--offer self-insured reverse mort-gage programs (AARP 1993). Unlike the HECMprogram, these lenders do not restrict the size of the

loan, but instead vary the loan size in proportion tothe amount of equity the borrower has in the house.This feature makes the programs particularly popularin California, where even the median house valueexceeds the HECM limit in many metropolitan areas.The programs also allow borrowers the option ofreserving some portion of their equity for their estate;this portion would not be accessible to lenders for thepurpose of eventual loan repayment. The lender mayalso take an equity position in the property by claim-ing a share of the future price appreciation, in addi-tion to repayment of the loan balance.

Insurance against the risk that the balance of theloan may eventually exceed the value of the house isfinanced through a risk premium charged on loans inaddition to interest. Providential offers a reversemortgage with three loan options: lump sum pay-ments, lines of credit, and monthly payments for aslong as the borrower lives in the house, while Free-dom and Transamerica purchase an annuity for theborrower that pays monthly installments for life,regardless of whether the borrower continues to livein the house.

IL The Sample DataThe data used in this study come from the

Survey of Income and Program Participation (SIPP), asurvey of about 20,000 households collected from astratified random sample of all U.S. households bythe U.S. Bureau of the Census. This data set isparticularly appropriate for estimating potential de-mand for reverse mortgages because it provides de-tailed information on household income and balancesheets---including housing equity, other assets, anddebt--as well as demographic data on the household.

This study uses the fourth wave of the 1984 and1990 panels of the SIPP, which were conducted fromJanuary through April of the subsequent year.2 Thesample for this study includes only households con-sisting of single persons aged 62 or older or coupleswith both spouses aged 62 or older. The 1984 and the1990 panels have 4,114 and 4,840 such households,respectively. Sixty-eight percent of the sample werehomeowners in 1984; the homeownership rate in-creased to 70 percent in 1990.

Table 1 reports median values of the variablesused in the analysis by homeownership status for the

2 For example, respondents in the fourth wave of the 1984

SIPP were surveyed between January 1985 and April 1985.

March/April 1994 New England Economic Review 17

Table 1Descriptive Statistics for All Elderly Households in the Sample (Age 62 and Over)

ItemSample Size

Median:Age (years) 72 72Monthly Income ($) 1,274 1,401Monthly Income, after Debt Payments ($) 1,259 1,340Home Equity ($) 36,452 39,347Pension Wealth ($) 92,377 98,994Liquid Wealth ($) 11,908 9,093Total Wealth ($) 176,305 191,322

Percent under Poverty Line 22.8 11.8Percent with Total Debt Payments Greater

than 25 Percent of Monthly Income .5 3.8

Total Sample Homeowners Non-Homeowners

1984 1990 1984 1990 1984 1990

4,114 4,840 2,786 3,405 1,328 1,435

71 71 73 731,514 1,663 887 9161,488 1,570 872 906

57,108 61,420 0 0106,860 113,661 70,889 73,17918,193 14,395 1,823 ,1,391

225,424 246,064 90,030 91,146

16.0 8.0 37.0 20.8

5.1 .5 .6Note: Income and wealth data in 1990 dollars, deflated by the CPt.Source: U.S. Bureau of the Census, Survey of Income and Program Participation, 1984 and 1990.

1984 and 1990 surveys. Two things are apparent fromthe table: First, elderly homeowners are muchwealthier than non-homeowners: in 1990, totalwealth of homeowners was almost three times that ofnon-homeowners, and their monthly income wasalmost twice as large. Second, both homeowners andnon-homeowners in the 1990 sample are wealthier inreal terms than those in the 1984 sample. Between1984 and 1990, both monthly income and total wealthincreased more than 9 percent in real terms forhomeowners, while increasing only 3 percent or lessfor non-homeowners.

Despite their relatively high median income,however, 8 percent of homeowners had incomesbelow the poverty line in 1990, and 5 percent haddebt burdens in excess of one-quarter of theirmonthly incomes. It is likely that members of eithergroup could benefit from the income-enhancing fea-tures of a reverse mortgage.

III. The Reverse Mortgage Model

This section simulates the effect of taking out areverse mortgage on available income and liquidwealth for a sample of elderly households. Usingassumptions about reverse mortgage contracts thatclosely mirror terms for contracts offered by privateinstitutions, the simulations show that a significantnumber of households can substantially benefit from

a reverse mortgage. This section also tests the impor-tance of some of these assumptions by varying theinterest rates used in the analysis.

The monthly payment of a reverse mortgagedepends on the prospective borrower’s age, sex, andmarital status and the amount of equity in thehouse~all information available directly from SIPP.In addition, loan payments vary according to themortgage interest rate, the ratio of the loan amount tothe home’s value, the origination cost, and the pro-jected rate of appreciation in the home’s value.3

The simulations assume that a household’s max-imum loan-to-value ratio, including the reverse mort-gag~ balance plus any existing mortgage debt, is 75percent. Banks often use this ratio to limit the maxi-mum amount of funds that a homeowner can obtainin a home equity loan, or a "cash-out" refinancing.The origination cost of the loan, set at 3 percent of theprincipal amount, is financed from the proceeds ofthe loan and is similar in amount to the closing costsand points paid on a conventional mortgage. Further-more, the model assumes that borrowers receivereverse mortgage payments for life even if they moveout of the house. Thus, the length of time the loan

3 The model assumes that the lender has no equity stake in thehouse. The rate of home price appreciation is still important for thecalculations, however, because the lender wants to make sure thatthe loan amount does not exceed the value of the house when thehouse is sold.

18 MarddApril 1994 New England Economic Reviezo

Computing the Reverse Mortgage Payment

The lump sum reverse mortgage payment(LS) for a single borrower4 is calculated as asum, from the borrower’s current age (a) to themaximum allowable age in the model (110), ofthe initial house equity (HEQ) compoundedyearly at the house price appreciation rate (RG)discounted by the mortgage rate (RM) andweighted by the probability that the borrowerdies in each year (Pt)"

~ (1 + RG)(t-a) ]LS =t=a (HEQ) * (1 3- RM)(t_a)* pt ¯

If the borrower used the proceeds from thelump sum payment (LS) to purchase an annu-ity, the annuity payment (PMT) is computedsuch that the lump sum payment equals thepresent discounted value of the stream of annu-ity payments (discounted at the annuity rate,RA) multiplied by the probability that the bor-rower is still alive.

110

LS = ~ [(PMT) * (1 + RA)(t-a) * (1 - Pt)].t=a

Solving the above equation for the annual an-nuity payment (PMT) gives:

PMT =LS

110

~ [(1 + RA)(t-a) * (1 - pt)]t=a

4 In the case of married couples, the formula is modifiedto account for the combined probability of survival wherethe spouse continues to receive the benefit.

payments are expected to continue depends only onthe borrower’s life expectancy, and not on the lengthof time the borrower can be expected to stay in thehouse before moving, for example, to a nursing home.

Because women have longer life expectancy thanmen, they receive lower reverse mortgage paymentsin this model. Life expectancies were taken from theVital Statistics of the United States.5 Couples receive

lower payments than single borrowers of either sex,because the joint life expectancy of the householdexceeds the individual life expectancies of each per-son in the household.

The simulation computes monthly reverse mort-gage payments in two steps: First, the maximumamount that the elderly homeowner could borrow ina lump sum is determined on the basis of the amountof equity in the house, the borrower’s life expectancy,the projected rate of house price appreciation, andthe mortgage interest rate. Second, the lump sumdetermined in the first step is converted to an imme-diate lifetime annuity with monthly payments for theborrower. The size of the monthly payments from theannuity depends on the annuity interest rate. Calcu-lation of monthly payments is also sensitive to as-sumptions regarding the rate of house price appreci-ation as well as the difference (if any) between themortgage and annuity interest rates. Specifically, themonthly payment increases with the assumed rate ofhouse price appreciation, and decreases with thedifference between the mortgage and annuity interestrates. (See the Box for a more detailed explanation ofhow the reverse mortgage payments are computed.)The model assumes that the mortgage, annuity, andhouse appreciation rates remain fixed for the life ofthe loan.6

In order to gauge the sensitivity of the model tothese assumptions, and to identify a reasonable rangeof possible monthly payments, calculations weremade using nine different combinations of the mort-gage, annuity, and house price appreciation rates.Figure 1 shows the resulting monthly payments for asingle female 71 years of age with $64,000 in homeequity (the median age and equity for the homeown-ers in the sample in 1990). The calculations assumethat the mortgage interest rate is 7 percent in allcases, while the annuity rate takes the values of 7, 5,

5 No attempt was made in this study to correct for any

self-selection that may cause the life expectancy of reverse mort-gage borrowers to differ from that of the general population. Thedirection of such bias is not obvious. On the one hand, the annuityfeature should attract people with longer than average life expect-ancies. On the other hand, if borrowers use reverse mortgages tohelp pay for unusually high medical expenses or long-term care,then they may be in poorer health and have lower life expectancythan the general population.

6 As discussed in Section V, these fixed assumptions exposethe lender to some risk. In particular, if an elderly homeowner liveslonger than expected and the house appreciates more slowly, thelender may find that the loan balance exceeds the availablecollateral--the house. For this reason, lenders may be conservativein assuming housing appreciation rates and attempt to hedge thisrisk.

March/April 1994 Nero England Economic Revi~o 19

Figure 1

Income from a Reverse MortgageSingle Female, Age 71, $64,000 Equity in Home

MonthlyPayment ($)

35O

300

25O

2OO

150

100

50

0

182

160

2

Spread between Mortgageand Annuity Rates

138

35O

3OO

25O

2OO

150

100

5O

05

3Grov,4h inHouse Prices

and 3 percent, resulting in spreads between themortgage and annuity rates of 0, 2, and 4 percent,respectively. The spread is shown on the horizontalaxis in Figure 1, while the house price appreciationrates of 0, 3, and 5 percent are shown on the axisrunning from the front of the chart to the back.

The figure shows that the most "optimistic"assumption (from the perspective of the borrower) ofa zero spread between the mortgage and annuityrates and a 5 percent house appreciation rate resultsin a monthly payment of $326 for the median bor-rower. The most "pessimistic" assumption of a 4percent spread between the mortgage and annuityrates and zero growth in housing prices results in amonthly payment of only $138. More realistically, the"neutral" assumption of a 2 percent spread betweenthe mortgage and the annuity rates and a 3 percentrate of growth in house prices results in a monthlypayment of $224.7 The figure also shows that themonthly payment is more sensitive to the assumedrate of house price appreciation than to the spreadbetween the mortgage and the annuity rates.

Table 2 further illustrates the sensitivity of thereverse mortgage monthly payments to the interestrate and growth rate assumptions, by the age of theborrower. It shows that the reverse mortgage pay-ment is much more sensitive to interest and growthrat6 assumptions for younger borrowers than forolder ones. For example, a 65-year-old receivesmonthly payments that are almost three times greaterunder the most optimistic assumptions than underthe pessimistic ones. By contrast, for an 85-year-old,the most optimistic assumptions produce monthlypayments only one and one-half times greater thanthe most pessimistic assumptions, although the dol-lar difference is greater for the older households thantheir younger counterparts.

7 In practice, private programs assume that house price appre-ciation is equal to expected inflation. A previous study of annuities(Friedman and Warshawsky 1985) found that the spread betweeninvestments and payouts averaged 2.5 to 4.5 percent. The spreadin that study, however, is probably high compared to what wouldresult from a competitive market in reverse mortgages.

20 March/April 1994 New England Economic Review

Table 2Monthly Reverse Mortgage Payment to aSingle Female with $64,000 EquityDollars

Assumptionsa

Age Pessimistic Neutral Optimistic65 90 164 26375 187 280 38385 420 529 633aMortgage Rate = 7%.Pessimistic: Annuity Rate = 3%, House Appreciation Rate = 0%.Neutral: Annuity Rate = 5%, House Appreciation Rate = 3%.Optimistic: Annuity Rate = 7%, House Appreciation Rate = 5%.Source: Authors’ calculations.

Table 4Ratio of Monthly Reverse MortgagePayments to Monthly Income, 1990Percentage Distribution for All Elderly Homeowners

Assumptionsa

Ratio Pessimistic Neutral OptimisticUnder .1 72 61 51.1 to .19 13 16 16.2 to .29 5 7 11.3 to .39 3 5 6.4 to .5 2 3 4Over .5 5 8 12

100 100 100"See Table 2.Source: Authors’ calculations based on Survey of Income and Pro-gram Participation, 1990.

IV. Benefits of the Reverse MortgageOne way to assess the potential importance of

reverse mortgages is to compare the size of the lumpsum payment available to an elderly homeowner tothe size of the homeowner’s ’liquid wealth, using thecurrent sample. A lump sum .disbursement providesa cushion of liquidity that allows the homeowner todeal w~th financial emergencies such as medical billsor major house repairs. It also allows consolidation ofall the homeowner’s outstanding debts. Table 3shows the distribution of the ratio of lump summortgage payment to liquid wealth under the threesets of assumptions discussed in the previous sec-

Table 3Ratio of Reverse Mortgage Lump-SumPayment to Liquid Wealth, 1990Percentage Distribution for All Elderly Homeowners

Assumptionsa

Ratio Pessimistic Neutral Optimistic

Under .5 50 43 38.5 to .9 12 13 131.0 to 1.9 11 12 132.0 to 4.9 10 11 135.0 to 10 6 7 7Over 10 12 14 17

100 100 100’~ See Table 2. "Note: Columns may not sum to 100 because of rounding.Source: Authors’ calculations based on U.S. Bureau of the Census,Survey of Income and Program Participation, 1990.

tion. Note that even under the most pessimisticassumptions, the lump sum mortgage payment isequal to about half of liquid wealth for the medianhomeowner. Moreover, using neutral assumptions,14 percent of the elderly homeowners in the samplewould receive a lump sum that is at least 10 timesgreater than their liquid wealth.

Table 4 reports a second measure of the impor-tance of reverse mortgages, the ratio of reverse mort-gage monthly payments to monthly income. Clearly,the reverse mortgage taken in monthly paymentshas, on average, a smaller effect on the borrower’smonthly income than a lump sum disbursement hason liquid wealth. Even under the most optimisticassumption, slightly more than one-half of all bor-rowers have a reverse mortgage payment that is lessthan 10 percent of their monthly income. However, asignificant minority can boost their incomes by arelatively large amount: under the neutral assump-tion, 23 percent of reverse mortgage borrowers couldboost their monthly incomes by more than 20 per-cent, while 8 percent of borrowers could boost theirincomes by 50 percent or more.

The Reverse Mortgage Group

Table 5 examines in more detail the characteris-tics of those who are most likely to benefit from areverse mortgage. "The Reverse Mortgage Group" isdefined here to include those homeowners aged 62and older whose simulated monthly reverse mort-gage payments, using the "neutral" assumption,equal 25 percent or more of their monthly income.

March/April 1994 N~o England Economic Review 21

Table 5Comparison of Reverse Mortgage Group"to All Elderh/ Homeowners, 1990

ReverseMortgage All Elderly

Item Groupa HomeownersNumber in Sample 893 3,405Median:

Age (years) 77 71Monthly Income ($) 914 1,733Home Equity ($) 90,000 64,000Liquid Wealth ($) 10,248 15,000Total Wealth ($) 198,999 256,398Monthly Reverse Mortgage

Payment ($) 464 211Remaining Life Expectancy

(years) 10 13

Percent:No Children 27 21Liquid Wealth under $5,000 41 37Incomes below:

33rd Percentile of All Incomes 55 25Poverty Line 20 8Poverty Line after ReverseMortgage 5 3

Geographic Profile:Northeast 27 22Midwest 22 27South 30 35West 22 16

Marital Status:Married 16 46Single Male 20 12Single Female 64 42

aThe Reverse Mortgage Group includes all elderly homeowninghouseholds whose simulated reverse mortgage monthly paymentswould augment their monthly incomes by 25 percent or more ascalculated under the "neutral" assumption of a 2 percent spreadbetween mortgage and annuity rates and a 3 percent rate of growthin house prices.Source: U.S. Bureau of the Census, Survey of Income and ProgramParticipation, 1990; U.S. Department of Health and Human Serw’ces,VitalStatistics of the United States, 1988, Volume II, Part A, Table 6-3.

This definition is not meant to imply that all suchhouseholds would necessarily be interested in a re-verse mortgage, but rather to investigate the charac-teristics of those most likely to benefit from it.

Table 5 shows that the reverse mortgage groupcomprises about one-quarter of all elderly homeown-ing households. Single women represent almosttwo-thirds of the reverse mortgage group, marriedcouples only 16 percent. Members of the reversemortgage group can be found in all regions of thecountry in roughly similar proportions. The largest

concentration (30 percent) is in the South, followedby the Northeast (27 percent).

Persons in the reverse mortgage group typicallyare older than other elderly homeowners. Theirgreater age implies shorter life expectancies, so theyreceive higher monthly reverse mortgage paymentsthan all elderly homeowners. The median monthlyincome, liquid wealth, and total wealth of the reversemortgage group are all significantly lower than thoseof all elderly homeowners; nonetheless, their homeequity is greater. The median monthly reverse mort-gage payment in the reverse mortgage group is $464,which would increase median monthly incQme ($914)by over 50 percent.

Reverse mortgages can be particularly helpful tolow-income elderly. Twenty percent of the reversemortgage group are below the poverty line; incomefrom a reverse mortgage would reduce the povertyrate in this group by three-quarters (to 5 percent).

More than one-third of all elderly homeownersand 41 percent of the reverse mortgage group haveliquid wealth below $5,000. Without a cushion ofliquid assets, these households are at risk of beingforced to sell their homes when they incur unfore-seen expenses. A reverse mortgage in the form of alump sum payment or a line of credit can help anelderly homeowner through a financial emergency.

V. Difficulties in Developingthe Reverse Mortgage Market

Although reverse mortgages may at first seem tobe a logical financial product for many elderly per-sons, questions remain as to the number of consum-ers Who would actually purchase the product if itwere available. A number of barriers also limit thewillingness of lenders to offer reverse mortgages.

Limits on the Demand for Reverse Mortgages

Barriers to consumer acceptance of reverse mort-gages include product design, information availabil-ity, bequest motives, and the view of home equity as"savings of last resort" (precautionary savings). Pos-sibly for the above reasons, Venti and Wise (1989,1990) argue that most elderly really do not want to usethe savings in their home to finance current consump-tion. In support of their view, Venti and Wise presentevidence that elderly who had moved recently didnot decrease the amount of home equity, despite theopportunity to do so at relatively little cost.

22 March/April 1994 New England Economic Review

The difficulty with such evidence is that it con-fuses housing consumption with housing equity.Many elderly movers might prefer not to reduceoverall housing consumption, but instead to substi-tute different types of housing. For example, a couplemight choose a Florida condominium overlooking theocean instead of their four-bedroom family home inNew England, even though both cost the sameamount of money. They might also prefer to cash outsome of their housing equity, while maintaining thesame level of housing consumption. Such house-holds would be prime candidates for a reverse mort-gage, which would allow them to maintain their levelof housing consumption, while providing a fixedmonthly payment.

Questions remain as to thenumber of consumers who would

actually purchase a reversemortgage, and barriers limit the

willingness of lenders to offer them.

Product Design. Most reverse mortgage productsoffered to date have not been very flexible. Thefeatures that can make them unattractive to manyborrowers include the low equity caps of the HECMprogram and the requirement of some private pro-grams that the proceeds of the reverse mortgage beplaced in an annuity without the option of a lumpsum or credit line.

In this regard, private reverse mortgages couldcopy the myriad of different annuities and life insur-ance plans available in the private market. Like theHECM plan, consumers could have the option ofhaving any combination of a credit line, a lump sumpayment, and a regular monthly payment (a fixedannuity). Unlike the HECM plan, however, manypotential purchasers may want a reverse mortgagethat pledges more than $151,000 in equity. (Themedian price of a single-family house sold in theBoston area, for example, is over $170,000.) Someconsumers may find tit attractive to get a higherreverse mortgage payment in return for sharing thegains from possible future house price appreciation.8

Bequest Motives. Even with flexible programs,many elderly homeowners still might not use a

reverse mortgage because they intend to give theirhousing wealth as a bequest. Over three-quarters ofall HECM borrowers have no children, comparedwith 21 percent of all elderly homeowners sampled inthe 1990 SIPP (HUD 1992). Kotlikoff and Summers(1981) estimate that about 80 percent of householdwealth is inherited, indicating that bequests are animportant component in aggregate wealth accumula-tion.

Further evidence regarding bequests comes fromseveral studies (Auerbach and Kotlikoff 1987; Hub-bard, Skinner and Zeldes 1993) that argue that elderlyhouseholds dissave "too slowly" relative to dissavingthat is predicted by standard life-cycle models. Otherpapers (Mirer 1979; Menchick and David 1983) showthat elderly wealth accumulation continues after re-tirement, when households should be reducing theirsavings. The conclusion from much of this literature,that the elderly have "too much" savings, is attrib-uted to the desire of the elderly to leave bequests.

Several papers dispute the conclusion that eld-erly households have significant bequest motives thatcan explain their savings patterns. Using panel data,Hurd (1990) shows that changes in wealth (net sav-ing) over time are similar for individual elderlyhouseholds, both with and without children, andthus he rejects the bequest hypothesis. More re-cently, several researchers have argued that the stan-dard life-cycle model’s inability to predict individualand aggregate savings patterns can be explained byits failure to account for uncertainty regarding lengthof life, earnings, out-of-pocket medical expenditures,and imperfect insurance and lending markets (Skin-ner 1988; Zeldes 1989; Hubbard and Judd 1987).Hubbard, Skinner and Zeldes (1993) develop a modelthat incorporates all of these uncertainties and showthat this model explains many of the empirical find-ings showing that the elderly save "too much."

Regardless of the appropriate level of saving bythe elderly, the bequest motive is a peculiar explana-tion of the fact that most elderly households have alarge concentration of wealth in housing relative toother assets. The Kotlikoff and Summers estimatesregarding aggregate wealth transfers might not re-flect the desired behavior of most elderly, because ofthe skewed distribution of wealth and unintendedbequests due to early death. If elderly householdswere truly unconstrained by current housing financerequirements, one might expect older households to

8 See Scholen (1993) for more detail about the appeal of reverse

mortgages to consumers.

March/April 1994 New England Economic Review 23

hold a more diversified portfolio to give to their heirs.Also, if wealthy households wanted to maintain highhousing consumption, they could reduce their totaltaxes by slowly liquidating their wealth and givingtheir heirs a constant sum of money each year with areverse mortgage.9

Precautionary Savings. Many elderly householdslook at their house as insurance in case of an emer-gency such as a serious accident to themselves or arelative or the need to purchase long-term care.Without a reverse mortgage, however, the housemust be sold or a mortgage obtained in order to tapinto existing home equity. Reverse mortgages wouldalso make it easier for households to address emer-gency problems when two or more people live in thesame house. A clear example is that of a householdwhose car breaks down, or a person who needsassisted care, but whose spouse would prefer toremain in their lifelong home. Given the asset distri-bution presented earlier, many couples would nothave enough liquid wealth to pay for a new car orspecialized care without selling their house or goingon public assistance. Yet a reverse mortgage wouldprovide an intermediate solution.

Overall, none of the demand issues mentionedabove seem to provide significant deterrents to con-sumer acceptance of reverse mortgages. If anything,the growth of such a market will likely depend onconsumer perceptions and the availability of goodinformation about types of reverse mortgages, toconvince the elderly that these instruments are bothviable and safe. Some senior advocates oppose re-verse mortgages out of the fear that householdsmight be persuaded to spend the proceeds unwisely,with many elderly eventually being forced out oftheir homes. The problem of fraud perpetratedagainst the elderly applies to all financial assets, notjust reverse mortgages, and is mitigated by terms inmost reverse mortgage contracts that allow borrowersto remain in their house as long as they live.

Real Housing Equity and the Aging Population.Recently, some economists have argued that theaging of the baby boomers will lead to declining realhouse prices. Therefore, future generations may haveless real equity than this study suggests. Two offset-ting factors affect the future stock of real housingequity and, thus, the future demand for reversemortgages: (1) a tendency for housing demand to fallwith age, combined with the fact that the baby-boomgeneration will pass the age of peak housing con-sumption within a decade or two; (2) the tendencyfor housing consumption to rise with wealth, corn-

bined with a pattern of increasing wealth of succes-sive cohorts.

Demand for housing generally declines with age.Mankiw and Weil (1989) used a model of age-specifichousing demand to show that housing demand de-clines after age 40. They concluded that aging of thebaby-boom population bulge would lead to a futuredecline in demand for housing in the United States.Their finding implies that housing prices will fall inthe future and that the market for reverse mortgagesmight be smaller than estimated earlier in this study.

On the other hand, each succeeding generationreportedly has been wealthier than its predecessor. Ifso, the wealthier succeeding generations will want toconsume more housing (along with everything else)and thus future levels of real housing equity willincrease over time. This implies that the future de-mand for reverse mortgages might be greater thanestimated earlier in this study. Pitkin and Myers(1992) argue that housing demand declines with ageat any particular time only because older generationsare poorer than their younger cohorts. Using Censusdata, they follow several cohorts through 60 years,showing that homeownership rates for each cohortactually increase up to age 70 to 74. (In individualCensus years’ cross-sections, however, homeowner-ship rates peak between ages 45 and 60.)

On balance, evidence is mixed as to whetherestimates based on current demographics underesti-mate or overestimate the future stock of real housingequity and, thus, potential demand for reverse mort-gages. Furthermore, whether any projected declinein housing demand as the population ages will leadto a decline in real housing prices is open to debate.In particular, the response of house prices will de-pend on potential changes in the supply of housing.On net, most economists are still skeptical of theprediction that real housing prices will fall substan-tially as a result of changes in demographics.

Moreover, if reverse mortgages become widelyavailable in the future, this in itself could changedesired housing consumption. Specifically, some eld-erly consumers would no longer be forced to sell theirhomes and move into smaller quarters because of lackof liquidity. They could, instead, continue to live intheir original (larger) house for a longer time. If so,demand by the elderly for housing would increase

9 Under current federal tax laws, an adult can receive up to$10,000 per year from each giver without paying income taxes.These gifts reduce future estate taxes for wealthy givers whoseestate exceeds $600,000.

24 March/April 1994 New England Economic Review

relative to the current situation, in which reversemortgages are not widely available. Greater demandwould cause an increase in real housing prices andthis, in turn, could make reverse mortgages evenmore attractive.

Limits on the Supply of Reverse Mortgages

Reverse mortgages face a number of accountingand regulatory uncertainties, as well as risks that aredifficult to manage in the early stages of a reversemortgage program. Until recently, lenders reportedaccrued interest as income during the term of theloan. The Securities and Exchange Commission (SEC)ruled in July 1992, however, that lenders must eitherreport interest only when it is received (that is, whenthe house is sold and the loan is repaid) or assume noprice appreciation on the house.1° Because reversemortgages are new and few of them are currentlybeing paid off, both of these accounting methodsresult in lenders reporting artificial losses until thereverse mortgages start to be repaid in significantnumbers. While SEC rulings apply only to publiclytraded companies, auditors are expected to adopt thesame standard for privately held firms, discouragingthe development of the reverse mortgage market.

Lenders may have difficulty achieving adequatediversification in their reverse mortgage portfolio ifinitial demand is low. Specifically, tenure risk, or riskthat certain borrowers would live in their homes andreceive payments for longer than the lender assumedin its pricing model, can be reduced only through alarge portfolio, so that long-lived loans are balancedby short-lived ones.

Lenders also face the possibility that when thehouse is sold, the price will not be high enough topay off the loan balance. The risk of adverse regionalshocks in the real estate market could be mitigatedthrough geographic diversification. However, suchdiversification can be difficult to achieve for a lenderwith limited geographical presence and without asufficiently high volume of loan origination.

Conversations with lenders reveal that originat-ing reverse mortgages is at present an expensive andvery time-consuming process. The application pro-cess is long because consumers require extensiveeducation about the complex features of reversemortgage products. In one lender’s experience, asmany as half of the original applicants change theirminds and withdraw their applications before theloans are originated, often at the last moment. Inaddition, houses often require extensive maintenance

and repair work before the loan can be granted,which necessitates multiple appraisals. One lenderestimates that originating reverse mortgages nowcosts $6,000 to $8,000 per loan, though the high costwould presumably be reduced to more acceptablelevels with a higher volume of originations.

Among financial institutions, life insurance com-panies should find issuing reverse mortgages mostattractive. The characteristic cash flows of the tenurereverse mortgage--fixed monthly outlays by thelender followed by a lump-sum repayment at anuncertain future date--are difficult for banks andthrifts to hedge. Life insurance policies, however,have cash flows that closely mirror the reverse mort-gage, with regular premium payments that are fol-lowed by the death benefit payout. This complemen-tarity makes reverse mortgages more suitable for lifeinsurance companies than for banks and thrifts,which do not have a matching liability. In addition,life insurance companies are well-suited for the actu-arial work involved in issuing and pricing a reversemortgage.

Banks and thrifts might prefer to sell off theirreverse mortgages, but the cash flow pattern makesthe instrument difficult to securitize. If reverse mort-gages were pooled and sold to investors, those inves-tors would be obliged to make monthly paymentsinto the pool until the mortgages paid off. The neces-sity of conducting credit evaluations of the investorsand difficulty in administering and servicing suchpools would probably make securitization impracticalor prohibitively expensive, unless these pools weresold directly to a large institution such as an insur-ance company.

The problem of credit risk can be avoided if thereverse mortgage is coupled with an annuity, as inthe model presented here and as two lenders cur-rently do. In this case, the lender makes a one-timedisbursement of the full loan balance which is used topurchase an annuity for the borrower. The loanbalance will be repaid with interest when the house issold or the borrower dies. Since there are no periodicpayments for the lender to make, the loan balancescould be pooled and resold to investors. These poolswould have the cash flow characteristics of a pool ofzero-coupon bonds with an uncertain repayment date.

Participation of government-sponsored mort-gage agencies would greatly facilitate the develop-

io Reported in The Wall Street Journal, page B1, August 21,1992. Industry sources confirm that current accounting rules pro-vide a significant disincentive to offering reverse mortgages.

March/April 1994 New England Economic Review 25

ment of a secondary market for reverse mortgages. Atpresent, the Federal National Mortgage Association(Fannie Mae) is working on the development of astandardized conventional reverse mortgage that itwould purchase.

VL ConclusionIn 1990, an estimated one-quarter of all elderly

households who owned their homes could haveincreased their income at least 25 percent from areverse mortgage, making the potential market verylarge. And the number of elderly can only increaseover time. Over 37 million persons are elderly today.According to the Census Bureau, that number isexpected to increase to 41 million by the year 2000,and to almost 66 million by the year 2020. Theavailability of reverse mortgages may also increasedemand for housing among the elderly, becausefewer elderly homeowners will need to sell theirhomes to get access to housing equity to finance otherconsumption. This might offset some of the effectsforeseen by the Mankiw and Weil hypothesis thataggregate demand for housing will fall over time.

Difficulties on the supply side must first beaddressed, however. Regulatory and accounting un-certainties would have to be resolved. If properlystructured, reverse mortgage loans could be pack-aged and securitized, giving rise to a secondarymarket. This would result in reduced risk and greaterliquidity for lenders.

The widespread use of reverse mortgages byelderly homeowners could have important conse-quences for the future magnitudes of intergenera-tional transfers, though the net effect on such trans-fers is not obvious. On the one hand, consumptionby some elderly households could increase,~while thefuture consumption of those among the youngergeneration who would have otherwise receivedlarger bequests could be reduced. At the same time,widespread use of reverse mortgages could reducethe pressure on the welfare system, thereby reducingtransfers from the younger to the older generationand at least partially offsetting the first effect.Whether intergenerational transfers ultimately rise orfall, however, reverse mortgages will improve thewelfare of elderly households that are now unable togain access to most of their wealth without sellingtheir home.

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