Reverse Mortgages as a Pension Instrument

In many countries the retirement landscape is subject to a rapid change in form of a sharp decline in traditional pensions coupled with low saving rates and longer life expectancy. Therefore a lot of people are at risk of having insufficient resources in retirement. One gleam of hope for some pensioner is housing equity, which is mostly the largest asset in a household portfolio. Until now the common way to finance private consumption out of owner occupied property is either to sell the house or to raise a loan. The former possibly would not be the first choice of elderly who do not want to leave their home and bequeath their homes their children. Furthermore, a comparison of this alternative with a reverse mortgage bears the difficulty due to the different utility of rented and owner occupied homes. The former requires reinvestment of the loan in combination with repayment of the mortgage and thus implies the necessity to finance additionally the interest spread of investment and mortgage. Additionally, many financial institutions do not borrow substantial amounts to elder people. The finance model of reverse mortgages was first introduced in the United States in the late 1980s, in a real estate market, where many people are home owners. In recent years, in many countries the introduction of reverse mortgages is discussed. In a reverse mortgage contract, the borrower receives payments as a lump sum, as a lifetime annuity or as a line of credit. Repayment are only required at the time the borrower leaves the home for good, sells the home or dies. Furthermore, the repayment is limited by the sale price of the property. We will discuss different alternatives to unlock equity which is held as an owner occupied home. Especially we compare (i) liquidating a home by selling it on the real estate market and renting a new home, (ii) raise a mortgage and reinvestment on the capital market, and (iii) other possibilities of entering a reverse mortgage contract. As previously mentioned, pensioners possibly would avoid selling the home. But there are also disadvantages of reverse mortgages. They do not only provide a way for unlocking equity bounded in a privately owned home, they also involve various costs from the borrowerís perspective like an upfront payment or high interest rates. We show through simulations how lifetime expectancy, housing price, cash requirements and the spread between credit interest and debt interest influence the optimal choice between selling the house and receiving a reverse mortgage.