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University of Iowa Study Casts Doubt on Reverse Mortgages

By way of the Consumers Union report (“Examining Faulty Foundations in Today’s Reverse Mortgages”), I recently became aware of a groundbreaking study conducted by the University of Iowa in 2007. The study tested the cognitive decision-making abilities of older persons, and their conclusions strike at the very heart of reverse mortgages.

The researchers behind Orbitofrontal Cortex Real-World Decision Making, and Normal Aging began with the premise that natural aging processes significantly degrade the brain’s prefrontal cortex in a substantial portion of older people. The resulting neural dysfunction, they hypothesized, might explain why many older people engage in faulty decision-making, and appear to be particularly vulnerable to fraud.

The results were startling: “As many as 35 to 40 percent of elders they studied had flawed emotional responses that stem from abnormalities that develop in the brain’s prefrontal cortex. The study also determined that these flaws were leading the seniors to make financial decisions based in part on reward and ambiguity, which follow the same approach used by individuals with acquired prefrontal lesions (traumatic brain injury).” For example, the researchers observed that some of the participants were susceptible to the truth effect, whereby they were more easily persuaded by repeated information, regardless of merit.

Unfortunately, the onset of cognitive decline may coincide with a period of life in which many critical, long-term (financial) decisions need to made, related to “investment of savings and retirement income, purchase of insurance and living trusts, estate planning, and sudden changes in financial roles following the death of a spouse.” As if the constraints posed by limited finances, a lack of income, and general uncertainty about the future weren’t enough, it now turns out that many of these seniors might also lack the proper neurological capacity to make logical decisions on these matters.

If this is the case, then the reverse mortgage system in its current form is probably inadequate. For example, 90% of counseling sessions are conducted over the phone, where there is no way to certify the identity of the borrower, let alone his decision-making capacity. As if that weren’t enough, it seems that that most borrowers treat the counseling session as a mere formality. By the time they are required to complete it, they have already made the decision to obtain a reverse mortgage and are probably far along the process. Finally, due to the truth effect and related phenomena, seniors are probably more easily swayed by reverse mortgage marketing, which is full of rosy thinking misleading claims, and tend to play short shrift to downsides/pitfalls.

According to Consumers Union, there are a couple important implications. First, the guidelines for reverse mortgage should be strengthened with tighter, more balanced language requirements. Second, the counseling session needs to be modified, not only to protect borrowers from unscrupulous lenders, but in some cases, to protect them from their own shortcomings.

Reverse Mortgage Cultural Issues

When you consider the extraordinary number of people that are already (or will soon be) eligible for reverse mortgages, their $4 trillion in latent home equity, and the financial anxiety affecting senior citizens, you would think that the reverse mortgage business would be booming. While growth over the last decade has been impressive, however, 2010 was a fairly disappointing year, with only 100,000 new reverse mortgages issued. What’s holding the industry back? In one word: culture.

The statistics would certainly seem to suggest that Americans are comfortable with debt. Though this is undoubtedly the case, most borrowers nonetheless look forward to being debt-free. That is especially true when it comes to borrowing for a home, and there is a negative connotation associated with being a mortgage slave. After 30 years (perhaps more if the mortgage was refinanced) and hundreds of thousands of dollars in interest, being debt-free would be cause for celebration (and maybe even a ritual mortgage burning) by even the most stoic homeowners.

To then commit to obtaining a new mortgage might take more than some glossy brochures and a clever sales pitch. Why go through all of the aggravation of borrowing money to purchase a home and dutifully repay that loan, simply to undo all of that work with a fresh loan? After all, there is a certainly a tremendous amount of pride (not to mention security) in owning one’s home – the most fundamental possession – outright.

In addition, people naturally become more conservative as they age, and that is especially true when it comes to finances. Due to its costs and the fact that it represents an obligation, a reverse mortgage entails the assumption of risk. Those that have recently retired or are nearing retirement are not naturally inclined to take risks with their finances. In that sense, the only demographic that is eligible for the reverse mortgage is also perhaps the least likely to take advantage of it.

Finally, more than with any other possession, there is a great sense of personal nostalgia and connection attached to one’s home. Having lived in the same home long enough to repay a mortgage also means that many of one’s major life memories are associated with that home. By obtaining a reverse mortgage, a borrower must accept the strong possibility that the property will one day be sold to repay it. In other words, a reverse mortgage represents a sort of death knell for one’s home.

On the other hand, there may also exist the possibility that the home will need to be sold at some point anyway (either for financial reasons or simply because one’s heirs no longer wish to keep it), which means that this shouldn’t be a factor in obtaining a reverse mortgage. In addition, while there is something to be said for wanting to remain debt-free after repaying one’s primary mortgage, there is still a huge pool of eligible reverse mortgage borrowers that have yet to (or are unable to) repay their primary mortgages, and for whom financial conservatism isn’t realistic.

It is these borrowers that are best suited to obtaining reverse mortgages, and to whom the reverse mortgage industry should be spending the brunt of its time trying to convince.

Hybrid Medicaid/Reverse Mortgage System?

This is precisely what the Citizens League, an advocacy group based in Minnesota, proposed in their recent report, “Moving Beyond Medicaid: Long-Term Care for the Elderly as a Life Quality and Fiscal Imperative.” If current trends continue, Minnesota’s Medicaid system will be impossible to sustain in its current form, and the solution may involve reverse mortgages.

The report offers some grim statistics about the situation in Minnesota, which can also be seen as a microcosm for a national problem. In sum, “40% of the long-term care expenditures for the elderly in Minnesota in 2004 were financed by Medicaid…Medicaid funding for long-term care for the elderly could grow nearly fivefold in Minnesota, from $1.1 billion in 2010 to $5 billion in 2035.” Assuming that taxpayers balk at financing this entire burden using public funds, an alternative system for financing long-term care (for indigent residents) will nee to be created.

While a handful of potential solutions were laid out, I want to focus on the one that involves reverse mortgages. Basically, the Citizens League has suggested eliminating the home-exemption rule, whereby one’s home is not factored into eligibility for medicaid funds. Under the proposal, recipients of medicaid could be prodded to obtain reverse mortgages instead of or in conjunction with medicaid funds. Of course, the reverse mortgage would have to be redesigned in order to provide an additional level of protection for borrowers and to keep costs at an absolute low. Loan amounts would be small (in order to minimize risk and costs), and the proceeds could only be used for medical and long-term care expenses.

The benefits to state governments would be fantastic: “It has been estimated that replacing Medicaid’s home exemption with “reverse mortgages” could save Medicaid from $5 to $20 billion a year in the United States. When you consider that states are increasingly strapped for cash and that taxpayers are demanding cuts in public programs, this idea is a practicable way to shift some of the medicaid burden onto those that benefit directly from its services.