Breakeven Determination of Loan Limits for Reverse Mortgages under Information Asymmetry

Abstract

Since the loan limit of a reverse mortgage is a major concern for the borrower as well as the lender, this paper attempts to develop an option-based model to evaluate the loan limits of reverse mortgages. Our model can identify several crucial determinants for reverse mortgage loan limits, such as initial housing price, expected housing price growth, house volatility, mortality distribution, and interest rates. We also pay special attention to the important implication of information asymmetry between lenders and elderly borrowers with respect to the beliefs on housing market risk. In reverse mortgage markets, elderly borrowers typically hold far less or no information about the characteristics associated with lenders’underlying property pools compared to the lenders. Such information asymmetry leads these two categories of market participants to generate different perspectives on the risk of the collateralized properties, which can be identified to be important in determining the maximum loan amounts in this analysis. We further find that the maximum loan amount of a reverse mortgage decreases in the correlation between the systematic return and the idiosyncratic return on its underlying housing property but increases with the number of the pooled reverse mortgages.

Keywords: Reverse Mortgages, Heterogeneous Beliefs, Information Asymmetry, Loan Limits

JEL Classification: G21, G22, J14, R2