Home Equity Is Illiquid

Home equity is an illiquid asset that can typically only be extracted through home sale or mortgaging the property. However, reverse mortgages provide a mechanism for senior households to withdraw equity from their home without home sale or monthly mortgage payments. The most prevalent form of reverse mortgage, comprising more than 95 percent of the market since the mid-2000s, is the U.S. Department of Housing and Urban Development’s (HUD) federally insured Home Equity Conversion Mortgage (HECM). The objective of the HECM program is to provide seniors with a vehicle to “supplement social security, meet unexpected medical expenses and make home improvements” (U.S. Department of Housing and Urban Development 2006). The primary obligations for the homeowner are upkeep of the home, and paying property taxes and homeowner’s insurance. As of February, 2012, 9.4 percent of all active HECM loans were in default for not paying property taxes or homeowner’s insurance (Consumer Financial Protection Bureau, CFPB, 2012), placing more than 54,000 senior homeowners at risk of foreclosure. This issue has prompted, for the first time in the reverse mortgage market, a requirement for lenders to underwrite HECMs taking into account borrower financial and credit risk characteristics (Mortgagee Letter 2013-28).

While these sorts of underwriting guidelines are a standard component of forward mortgage lending, the introduction of such criteria for HECMs is new. Previously, homeowners over the age of 62 could qualify for a HECM as long as they could pay off existing mortgages, other property liens, and cover closing costs and fees with the proceeds of the HECM (or pay the difference in cash). Because a reverse mortgage does not require a monthly mortgage payment, “ability to pay” was not considered a qualifying factor. A significant challenge for the reverse mortgage market will be to establish the appropriate criteria to reduce default risk while not unnecessarily excluding households from the market. Unfortunately, there is a lack of prior empirical data and research on reverse mortgage default to inform these criteria.

Research is needed that systematically evaluates the relative importance of different factors, and the likely impact of particular underwriting thresholds or other policy restrictions. Several factors have been anecdotally associated with higher rates of default; however, there has been no systematic analysis to date of borrower attributes and program characteristics that contribute to tax and insurance default among reverse mortgage borrowers due to the lack of comprehensive data. For example, it is unknown the extent to which factors such as credit scores, debt, or income are significant predictors of tax and insurance default among reverse mortgage borrowers, as credit and income data 4 were not collected. One of the primary theoretical determinants of default in the forward mortgage market, negative equity, is not applicable for reverse mortgages. Rather, lack of financial resources, liquidity constraints, and poor financial management are likely more important. Further, the way in which borrowers structure their withdrawals of equity from reverse mortgages, principally the proportion of funds distributed as a lump sum at closing, may exacerbate or reduce default risk.