An Introduction to Reverse Mortgages for Retirees
It is common to hear retirees described in Australia as being, "asset rich but cash poor". Often this means they own their own house but struggle to make ends meet and maintain a house that has often become far too large for their needs.
In general terms, we think it is inevitable that the value of an individual's main residence will eventually be taken into account when determining access to social security, including age pensions - regardless of the fact that the Government continues to "rule it out". With funding under increasing pressure, particularly post the corona virus pandemic, it will be perceived as inequitable for pensioners to occupy homes of significant value while being paid a pension - with the value of the estate potentially passing tax-free to their beneficiaries. Whether it takes the form of main residences over a certain value being included in the asset test, or otherwise, changes will occur and the strong emphasis should be on ensuring that this occurs in a fair and equitable fashion.
In these circumstances, and also because of diminishing fixed interest returns, reverse mortgage can play an important role in providing retirees with safe access to an income stream. Yet, like annuities to a lesser degree, they are a rarely used in Australia. They suffer from clear reputational issues - having clearly been mis-sold in the past - and a lack of awareness in the community. They certainly have a role to play in retiree finance but it it is vital that any retiree seek professional advice before making any commitment to a reverse mortgage.
The intention of this page is to provide existing and potential retirees with a general introduction to reverse mortgages, so that they can better have an informed debate with any adviser - and much of this general discussion also applies to the Pension Loan Scheme, although that scheme only provides access to an income stream, not a lump sum.
What is a Reverse Mortgage?
A reverse mortgage (RM) allows you to borrow money using the existing equity in your home as security. The loan can be taken as a lump sum or a regular income stream, a line of credit or a combination of these options. You remain the owner of your house and may remain in it as long as you like, with no repayments required (interest compounds and adds to your loan balance), unless a trigger event occurs. This can include the death of the owner(s), the last borrower leaving the property or breaches of particular clauses.
Eligibility and Borrowing Limits
Generally, the older you are the more you can borrow as a percentage of your property's value - and where there are joint borrowers the age of the youngest person determines eligibility. The minimum borrowing age is typically 60, but differs depending on the lender, as does the maximum size of the loans, and the maximum loan to valuation ratio (LVR).
Under the Responsible Lending principles of the National Consumer Credit Protection Act, qualifying applicants can borrow up to specified margins against the security of their primary residence. In this context and as a guide, you may expect to be able to borrow 15-20% of the value of your house at age 60 and and 1% more per year of age thereafter - so, a maximum of 25-30% at age 70 and 35-40% at age 80.
It's important to appreciate that in 2012 the Government introduced statutory 'negative equity protection' on all new reverse mortgage contracts - meaning that borrowers cannot end up owing the lender more than their home is worth. So, disregard marketing literature which trumpets this as a feature of any particular product, it is a legal requirement of all products.
This is a more complex product than ordinary mortgages and lenders apply higher interest rates and charges than apply for normal home loans - generally, slightly more than 1% above standard mortgage variable rates. There are account fees and you need to carefully review and understand the loan contract - it may contain clauses which require you to maintain the property to a suitable standard and to have regular valuations carried out which may be for your account.
Einstein once said,“The most powerful force in the universe is compound interest”. In the case of a reverse mortgage however it works against you, with the mortgage payment ballooning over time; however, so does the value of your house and basically it is the competition between the two items that determines how your home equity position changes over time.
You need to understand how a reverse mortgage might apply in your individual circumstances against varying assumptions regarding both interest rates and increases in house values over time. We would suggest familiarising yourself with how the variables interact by using ASIC's reverse mortgage calculator. For example, in the graph example below we assume a RM of $200,000 on a house initially valued at $1M, a mortgage interest rate of 5.5%, and an annual increase in house values of 2.5% per annum over 15 years - for simplicity purposes we have not included an establishment fee or month account fees (assume about $1,000 and $15pm).
At the end of 15 years the mortgage has grown to a value of $455,517, but home equity has increased to $992,781 - remember however that all figures need to be deflated to reflect the value of money in 15 years. The figures are of course very dependent the assumptions such as market growth - and while 2.5% per annum is quite conservative over a long period you can expect volatility, and even negative growth, over shorter timespans. Conversely, we expect that there is clearly scope for interest rates to decline on these products, as we have seen over the last 12 months, particularly if there is a wider market uptake.
ASIC Review of Reverse Mortgages - 2018
ASIC published a review of reverse mortgages in Australia in August 2018, and it makes interesting reading for individuals and couples researching this type of finance. The review looked at reverse mortgage lending over the period 2013-17, including data on over 17,000 reverse mortgages and 111 consumer loan files. We've provided a copy for download, but our major takeaways are as follows:
- Reverse mortgages helped older Australians achieve their immediate financial objectives - "Each of the 30 borrowers in our consumer research indicated that their reverse mortgage enabled them to achieve their original objectives for the loan."
- The enhanced consumer protections have eliminated the risk of negative equity -the introduction of the no negative guarantee in these products with effect from 2012 has achieved its objective and protected borrowers from the prospect of eventually owing more than the value of their house.
- Borrowers may not be sufficiently aware, and be receiving appropriate advice, regarding how these products might affect their future needs. In this regard, we wholly support the suggestion that adequate advice is not being received in many cases, but are concerned at some suggestions within the report that each individual should be ensuring that they have a minimum of $380,000 capital available to them, as that is the "average self-funded upfront cost of aged care for one person". That is a simplistic, and for many people, unrealistic objective - see our discussion about how these sort of figures over-estimate the actual costs of aged care accommodation. Nevertheless, we certainly feel more comfortable supporting reverse mortgages in situations where individuals have very significant capital available in their main residence.
- Options for borrowers were limited due to a lack of competition - we absolutely agree, as we mention above, there are very few providers in this market and the product is hampered by relatively high interest rates and fees.
- Some loans might not protect other residents in the home - this is an important issue. In the absence of a tenancy protection clause, "once the borrower vacates the property or passes away, borrowers or their estate can often only afford to pay off the loan balance of a reverse mortgage by selling the secured property. This can require non-borrowers still living in the home (non-borrower residents) to move out."
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