Reverse Home Mortgage - How they work
Reverse home mortgage is the transfer of possession of a property by the reverse home mortgagor to the reverse home mortgagee for a particular consideration. The agreement incorporates the right of the reverse home mortgagor to redeem the property by paying the principal amount received during the transfer of possession. The contract also provides for the right of the mortgagee to collect income from the property to serve as interest for the money loaned to the reverse home mortgagor.
Contemporary reverse home mortgage evolved to provide incentives to banks to forward full payment without violating any law. There are two alternative actions. First, the bank buys the property and pays for it in full. It then acts as tenant collecting payment that is higher than the original purchase price to gain profit. Second, the bank makes full payment then resells the house at a higher price to gain profit. These alternatives benefit both the buyers and banks because the buyers do not pay interest with the banks gaining profit for their part in advancing full payment. This involves trust, payment of higher price by the buyer and non-imposition of an exorbitant price by banks.
Popular misconceptions regarding reverse home mortgage often stem from the assumption that it is a commodity, where prices alone equilibrate supply and demand. In fact, unlike most market debt transactions, which can largely be summarized in terms of prices and quantities, reverse home mortgage is a highly complex contract. This is because reverse home mortgage entails a promise to repay principal and interest on a loan or advance. It is a promise whose fulfillment is by its nature uncertain and will differ among the mortgagors. Key features of reverse home mortgage include different things such as quantity advanced; specification of interest, whether fixed or variable in relation to a benchmark rate; specification of maturity; collateral that the mortgagor must provide as security, if any; specification of the circumstances in which the reverse home mortgage is in default, thus giving the tender the right to seize the mortgagor’s assets. In the simplest case this will be failure to pay interest or principal; specification of the law under which default is to be adjudicated; specification of the seniority of the claim; pledges in relation to further borrowing, for example the lender can insist no further debt be incurred, or no further debt senior to it; any further commitments by the lender; provisions for transferability; whether or not the contract is standardized in terms of provisions or denomination; any tax exemption features; and call provisions.
The key difficulty is raised by the uncertain possibility that the mortgagor will default, given costs of bankruptcy, asymmetric information, and incomplete contracts. If there were no costs of bankruptcy, default risk would be of no concern to the mortgagor; assets to pay off the reverse home mortgage would pass smoothly to him in the case of default. In practice, resolution of default takes time and effort, the mortgagor may find that assets seized from the mortgagee have depreciated in value, and/or he may find that secondhand markets for such assets are weak or non-existent. But even given costs of bankruptcy, if there were no asymmetries of information or if the mortgagor were able to specify and verify the mortgagee’s behavior in every eventuality, then issue of reverse home mortgage would be a relatively straightforward transaction, because probability of default could be known or controlled precisely, and charged or collateralized accordingly.
Written by charles dennis on May 19th, 2007 with
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