Reverse Mortgages and Borrower Maintenance Risk

Abstract

This paper develops a theoretical model of the problem of maintenance risk in reverse mortgages (RMs) and home equity conversion instruments generally. By maintenance risk we refer to the incentive homeowners will have to reduce maintenance expenditures as their equity in the house falls during the term of the RM. The underlying reason for this tendency is the limited liability feature of RMs, given that a borrower's obligation to the lender at maturity is limited to the value of the house. The results of the model show that lenders will respond to this problem either by limiting the amount of RM loans in order to guarantee that maintenance risk is not a threat, or by charging an interest rate premium to cover the expected cost of default. Unfortunately, there do not exist data to test the importance of maintenance risk as a possible limitation on the extent of the RM market.

JEL Classification: D1, M00