Reference no: EM132798032

Explain the nature of adverse selection and moral hazard resulting from tenure loan, versus cash out?

As the baby boomers approach retirement, there is growing concern that many have not adequately prepared for their retirement. Efforts are underway to promote higher savings and adopt appropriate investment strategies for building retirement income. Another approach is to find ways to provide for retirement income from the assets retirees already have.

At a basic level, a reverse mortgage is a mortgage loan (from a finance company) that allows to the homeowner (the borrower) to access income tied up in their home equity. There are several requirements for acquiring a reverse mortgage:

1. The borrower must be 62 years of age or older

2. The house must be the primary residence of the borrower.

3. The borrower must own the house outright, or have substantial equity.

4. Borrower's income, assets and monthly living expenses are evaluated in order to determine the ability of the borrower to maintain property, pay taxes and home insurance premiums.

5. The maximum that can be borrowed against the house is based on the appraised value of the property, the age of the borrower and limits set by law.

6. Borrowers may choose to receive a lump sum payment (cash out), or monthly payments for a fixed period (line of credit), or payments as long as they live in the house, sell the house or die (tenure).

7. Borrowers must commit to maintaining the property and paying property taxes and home insurance. Violations can result in foreclosure.

8. Heavy upfront fees are charged for acquiring a reverse mortgage and the borrower receives reduced payments in the initial years.

With this basic knowledge, let's consider the following examples.

Example 1

Profile: Ms. Jones 63 years old and currently working. She estimates that her house would be appraised at $250,000. Ms. Jones has total savings of $30,000 in her savings account.

Monthly take home salary: $3,750

Average monthly Property Maintenance: $400

Average Monthly Living expenses: $2,800

Average Monthly Savings: $300

Monthly Home Insurance: $100

Monthly Property Taxes: $250

Ms. Jones is not financially shrewd. Hearing TV ads on Reverse Mortgage, Ms. Jones decide to apply for a reverse mortgage at the local bank. Her objective was to grow her savings before retirement, using the cash from the reverse mortgage payments.

Ms. Jones was given an estimate of total fees of $7,000 for a formal appraisal, title search, insurance, underwriting, and other compliance related expenses. She was advised that the bank would consider a reverse mortgage for only 52% of the appraised value, around $130,000 and Ms. Jones would receive, if approved, about $600 a month.

Decision: Ms. Jones decided not to make the application for the reverse mortgage. She felt that the initial fees were too high and would eat away at her current savings.

Example 2

Profile: Mr. and Ms. Martin are above 65 years of age. They are both retired. They estimate that their house would be appraised at $550,000. They have total savings of $250,000 in financial investments.

Monthly social security: $4,000

Monthly Investment income: $1,000

Average monthly Property Maintenance: $600

Average Monthly Living expenses: $3,5000

Average Monthly Savings: -$100

Monthly Home Insurance: $400

Monthly Property Taxes: $600

Mr. and Mrs. Martin received a brochure offering Reverse Mortgage and decided the contact the lender. They hoped that the payments from the Reserve Mortgage would ensure a more secure financial future.

They were given an estimate of $8,500 in fees for a formal appraisal, title search, title insurance, underwriting and other compliance related expenses. They were advised that the bank would consider a reverse mortgage for only 52% of the appraised value, around $280,000 and if approved, would receive, about $1,100 a month.

Decision: Mr. and Mrs. Martin decided to apply for the reverse mortgage, but was turned down by the underwriter for negative monthly savings.

Example 3

Profile: Mr. and Mrs. George are above 65 years of age. They are both retired. They estimate that their house would be appraised at $800,000. They have total savings of $650,000 in financial investments. Mr. George is healthy, but Mrs. George suffers from chronic health problems

Monthly social security: $5,000

Monthly Investment income: $5,000

Average monthly Property Maintenance: $700

Average Monthly Living expenses: $5,000

Average Monthly Savings: $2,600

Monthly Home Insurance: $700

Monthly Property Taxes: $1,000

Mr. and Mrs. George consulted a financial advisor regarding Reverse Mortgages. They explained that although they are comfortable with their financial situation in retirement, they wished to travel and enjoy some of their favorite activities more fully. They hoped that the payments from the Reserve Mortgage would give them the extra cash to enjoy their retirement.

They were given an estimate of $10,000 in fees for a formal appraisal, title search, title insurance, underwriting and other compliance related expenses. They were advised that the bank would consider a reverse mortgage of only 52% of the appraised value, around $420,000 and if approved, would receive, about $1,800 a month.

Decision: Mr. and Mrs. George decided to apply for the reverse mortgage and received approval for tenure loan of $1,800. They did not inform the lender of Mrs. George's health problems. A combination of large medical expenses and a recession that depressed home prices placed severe stress on their financial status. They stayed on track with home insurance and taxes, but failed to maintain their property adequately. The lenders delayed foreclose on the Georges for fear of reputational risk. Eventually, the Martins lost their home and moved in with family.

Example 4

Profile: Mr. and Mrs. Law are above 65 years of age. They are both retired. They estimate that their house would be appraised at $1,000,000. They have total savings of $350,000 in financial investments. Mr. and Mrs. Law are healthy at the time of the loan application

Monthly social security: $6,000

Monthly Investment income: $3,000

Other income: 5,000

Average monthly Property Maintenance: $1,000

Average Monthly Living expenses: $8,000

Average Monthly Savings: $2,100

Monthly Home Insurance: $1000

Monthly Property Taxes: $1,900

Mr. and Mrs. Law wished for a more active retired life - more travel, more active social gatherings, theater, etc. They hoped that the payments from the Reserve Mortgage would give them the extra cash to more fully enjoy their retirement.

They were given an estimate of $12,000 in fees for a formal appraisal, title search, title insurance, underwriting and other compliance related expenses. They were advised that the bank would consider a reverse mortgage of only 52% of the appraised value, around $500,000 and if approved, would receive, about $2,000 a month.

Decision: Mr. and Mrs. Law decided to apply for the reverse mortgage and decided to take the cash up front, rather than receive monthly payments. They received $500,000 in cash. After five years of aggressive spending, they ran out of cash and became derelict in maintaining their property, paying taxes and insurance payments. Mr. and Mrs. Martin were given the option of paying back the loan, or foreclosure.