MORAL HAZARD IN HOME EQUITY CONVERSION: Improvements in the Home

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Let us consider another example of likely homeowner behavior when the owners of the home have a risksharing contract such that they have in effect ownership of only half the value of the home. Suppose again that the home is currently worth $200,000. The homeowners would like to upgrade the kitchen for $10,000. The investment would increase the value of the home by $6000. If the homeowners did not have the risk-sharing contract, they would lose $4000 but gain the benefit of a better kitchen until the home is sold. Without the risk-sharing contract this might seem like a good tradeoff. However, with a risksharing contract, the homeowners regain not $6000 but only $3000 on resale (their share of the $6000) and so the effective cost of the renovation would be $7,000, not $4,000, and so the homeowners might well decide not to make the improvement.


Of course, risk-sharing contract provisions could be written in order to take account of such improvements. But, again, there is a problem, a difficulty defining the value of the improvements. What if the homeowners want to renovate the kitchen themselves, as an amateur job? How much should the homeowners be compensated for this? Moreover, with renovation jobs, whether amateur or professional, there is a substantial possibility that the renovation will detract from the value of the home, rather than add to it. What if the renovations are done in unconventional taste? What if the renovations are done for idiosyncratic needs (a home doctor’s office with waiting room, or an elevator for a disabled person)? Homeowners largely know that such renovations may not increase home value, and therefore have an incentive to stay with conventional improvements and with professional renovators to keep resale value up. But, if they bear little risk in the contract, then homeowners will have less incentive to do so.