Home equity conversion mortgage

A variety of financial mechanisms are being developed to convert the dormant assets of the aged, specifically their home equity, into retirement income. Although the homes of many aged persons have appreciated in value since the original purchase, the overall financial situation of the aged person or couple may not have kept pace with the cost of living. These persons are sometimes referred to as being "house rich and cash poor." The first section of this article examines some recently developed home equity conversion plans and discusses their relevance as an adjunct to the basic protection provided to retired workers and their families under the Social Security Act.

The potential role of these plans in providing new income for the aged in illustrated in the second section of the article. Data from the Social Security Administration's 1979 Retirement History Study are used to show how home equity conversion plans could affect four specific demographic groups: Married men, unmarried men, unmarried women, and surviving spouses. Each group is subcategorized according to dependence on social security (old-age, survivors, and disability insurance, or OASDI), that is, the proportion of total income from OASDI. Information on home equity and its income potential under three representative plans in presented for each of the subcategories. All of the findings are given in the context of mean total income of these populations.

For many aged units (that is, married couples or nonmarried persons aged 65 or older), total money income is low; 23 percent of such persons are below the poverty level. As shown in table 1, the median income for all aged units in 1982 was $8,790. When the social security program began, it was assumed that retired persons would have three sources of income: Social security, a second pension, and asset income. In 1982, about 23 percent of the aged had only one of these sources; their median total income was $4,670. For 58 percent of the aged, social security was the only retirement pension; their median total income was $6,310.

Some social security beneficiaries whose total income is low may have untapped or dormant assets that could be used to help defray their living expenses. One study indicates that home equity is the most important asset for the population aged 64-69. It was more important than liquid or other illiquid assets. I 1975, 42 percent of the total assets of this population were in the form of home equity. In 1979, 71 percent of the respondents to the Retirement History Study owned their homes. A very high proportion (83 percent) of these persons owned their homes outright--with no debt--and an additional 6 percent owed less than $5,000.

Although median home equity may represent an unused asset with the potential for creating new income, in absolute terms this equity does not appear to be high. The tabulation in the next column shows median home equity by marital status and age for respondents in the 1979 Retirement History Study.

Several alternatives face a person with some substantial equity in a home who would like to use the equity to increase income. One possibility is to sell the home and move--a kind of "do it yourself" home equity conversion. Here the person can invest the sale proceeds in an annuity, money market fund, or whatever, and move into a smaller house, condominium, or rental unit. For example, consider a couple owning a $75,000 home free and clear. They sell the house and buy a condominium for $45,000. They invest the remaining $30,000 in a money market fund yielding (at 10 percent) $3,000 per year of new income. (Of course, if settlement charges are deducted from the proceeds of the sale, the amount available for investment would be reduced.)

But many persons want to remain in their home: they are comfortable in it, familiar with the neighborhood, and unwilling to exchange their home for a lower-priced one. Further, they may fear relinquishing an asset that provides an assured shelter. If they sell and then rent, they face unpredictable rent increases. And it is possible that their now-liquidated asset could shrink if the rate of inflation becomes greater than the interest or divident rate. Home equity plans are one of the possible answers for those persons who want to continue living in their home but who need to get income from their home equity.

Types of Home Equity Conversion Plans Available to the Aged

Home equity conversion plans can broadly be divided into loan plans and split equity plans. In the loan plans, the aged homeowner accumulates a debt to be paid off at some future time. In the split equity plans, the aged person sells the house and the equity is split into ownership rights that belong to the buyer-investor and occupancy rights that are maintained by the aged person for life.

Loan plans can be divided into those that guarantee lifetime tenure and those that do not. The former involve a nonrepayable debt--that is, the debt does not have to be repaid until the aged person dies or sells the house. The latter involve a repayable debt--that is, the debt is repaid over a given term. Bot loan and split equity plans may use public subsidies.

All these characteristics are considered in the discussion that follows. Each plan is described and evaluated according to the income it provides to the aged person and what the aged person has to give up in return. All plans have advantages and disadvantages that need to be understood and carefully weighed before a decision can be made as to which is preferable in one's individual situation. A tabular summary at the end of this article compares the characteristics of the various plans discussed.

Fixed Debt Loans Without Guaranteed Lifetime Tenure

Description. These loans are rising debt repayable loans with a given term, usually 5-10 years. The debt rises to a predetermined limit and then is due. Under such a plan, the lender would loan up to 80 percent of the home's equity at a market interest rate. (The loan would not be for the full equity value to protect the lender against the risk of property deterioration.) For example, consider a home worth $50,000 that is owned free and clear. Assume a 9-percent annual interest rate compounded month over a 10-year period. The 80 percent loan-to-equity ratio enables $40,000 to be converted into a term reverse annuity mortgage (RAM). The aged person receives $206.70 each month for 10 years--a total income of $24,804. At the end of 10 years, the aged person owes the lender the full $40,000. The difference between the $40,000 loan and the $24,804 income is $15,196--interest to the lender.

The RAM differes from a traditional home equity loan in that it does not require any periodic repayment or even interest payment. Payment is deferred until the end of the term, when a maximum loan balance is reached. If the aged person is not living, the estate pays the debt. The RAM also differs from the usual mortgage loan in that the borrower is not gradually reducing a large lump sum through repayment of principal and interest. On the contrary, the borrower receives periodic payments and gradually accumulates a debt. This receipt of installments is the "reverse" aspect of a RAM.

The pioneer implementer of RAM's is the San Francisco Development Fund, which, working with lenders in California, arranged about 35 RAM's in the early 1980's with houses having equity values of at least $100,000. This group also developed a graduated payment RAM. In the preceding example, then, instead of receiving the same level payment of $206.70, one could start with a smaller payment and have it gradually increased, by say 6 percent a year, to meet an anticipated increased cost of living. Yet another variation provides an initial lump-sum payment with smaller monthly payments.

Advantages. This type of loan is especially appropriate for someone waiting for a pension to begin, or who needs limited income to make home repairs, or who plans to sell and move within a few years. Its major advantage is that the maximum debt is known and the aged person does not risk loss of possible appreciation in the house's value. If the house appreciates, the borrower may be able to refinance or may choose to sell, pay off the debt, and still have a substantial profit. Further, the debt can be paid off before the end of the contract term.

Disadvantages. At the end of the term the debt must be paid or the lender could foreclose. The aged person would then have to sell and could be in the position of having neither home nor money. A further disadvantage, as with all fixed-rate loans, is that the interest rate could fall.

Fixed Debt Loans With

Guaranteed Lifetime Tenure