Funding retirement: Retirement Interest Only mortgages
A large number of Australians do not have enough money saved to fund a comfortable retirement. According to the Association of Superannuation Funds of Australia (ASFA), Australians need 70% of their annual pre-retirement income during retirement – with the average Australian falling 40% below this benchmark.
Australian retirees do have wealth – it’s just that this wealth tends to be tied up in illiquid assets. On average, Australian retirees own homes worth $1.1 million, 40% more than the median value for properties in Australia’s state and territory capitals. This situation is driving Australians to seek other means to fund their retirement. In other words, Australian retirees are asset- rich and cash-poor, which means they must look elsewhere as they secure their retirement funds.
This is typically due to a lack of liquid cash flow.
For this article, we are examining some of these alternative sources of funding, looking at how Australians can secure a high quality of life post-retirement. So far, we have looked at annuities, shared appreciation mortgages, and guaranteed investment products. This is the fourth article in the series we are focusing on retirement interest only mortgages.
Understanding Retirement Interest Only mortgages
A retirement interest-only (RIO) mortgage is essentially a secured loan that is open to people of retirement age. Individuals borrow a sum of money, using their existing property as collateral. In this sense, the RIO mortgage is similar to a standard mortgage – both are loan products that are taken out against the value of a property.
But RIO mortgages differ from standard mortgages in other senses. Firstly, there is no requirement to pay the loan principal back over a series of monthly payments. With an RIO mortgage, the borrower only needs to pay back the interest on the loan. The total amount of the principal can be paid back at a future date – most commonly at the end of a fixed loan term or, if a lifetime mortgage, then when the retiree moves into a residential care facility and no longer needs their home, or when they pass away, whichever occurs first.
The word “retirement” is also important. This form of loan is only available to those who have already retired. In other words, it is specifically designed as a retirement funding product.
The advantages of Retirement Interest Only mortgages for retirees
As retirement interest only mortgages are specifically designed as retirement funding instruments, this would suggest that they provide significant benefits to Australians in this category.
- Australians can release equity from their property assets without downsizing
As discussed above, many Australian retirees have significant property assets but lack the cash flow to cover retirement. RIO mortgages can help retirees access some of the capital that is tied up in these assets, without needing to downsize or sell the property.
- Monthly repayments are greatly decreased
When compared to a standard principal + interest mortgage, RIO mortgage repayments are significantly lower. This is because only the interest needs to be repaid during the loan termLoan interest will not deplete the property’s capital value
Unlike reverse mortgages, RIO mortgages are charged as simple interest (not compounding interest) because the loan interest has to be paid monthly as it is incurred.
As a result, there is no danger of interest “roll-up” that can deplete the total property value.
The disadvantages of Guaranteed Investment Products for retirees
RIO mortgages are common in the UK. However, despite the advantages listed above, and despite the fact that these mortgages are designed specifically as retirement funding products, take up in Australia remains very low. There are a number of reasons for this, but the key factors are the disadvantages of this form of retirement funding.
- The property is put at risk
As with any finance product where a loan is secured by a property, this property is put at risk. If the required payments are not made, the retiree may lose their property.
- The principal is not reduced with each repayment
The retiree is only paying off the loan interest – they are not reducing the principal of the loan with each payment. This means the total principal remains payable for the full duration of the loan term.
- Outstanding debt will be passed on to their estate
Many Australians want to pass on their property and other assets to their children once they pass away. A retirement interest only mortgage is generally settled through the sale of the home, either after the retiree has passed on or when they have moved into residential care. Unless the debt is paid in some other way, beneficiaries will not be able to fully inherit the home as a result.
- Available capital might be limited
We’ve already touched on the shortfall that most Australians are experiencing as they approach retirement. With this in mind, retirees may need a high level of cash flow to support retirement. RIO mortgages will be limited by the value of the property and by the available income of the retiree to service the monthly interest payments, which may make the product unsuitable for making up this shortfall.
- Other borrowing restrictions
A borrower needs to read the fine print to understand other borrowing restrictions. The lender may advertise RIO mortgages up to a maximum of 50%-60% LVR, however, typically, the actual amount borrowed is limited to 8.5 time annual earnings. For an average retiree on a fixed or allocated pension this would limit the borrowing to around only $50,000.
- Servicing the cost of the loan
RIO mortgages may be talen out from aged 55 years. If still working, the borrower may be able to service the loan interest each month without difficulty. However, if the borrower is retired, the lender will simply take some or all of their fixed or allocated pension, leaving the retiree with little or no cashflow. It really does not make a lot of sense to provide a relatively small loan to retirees which is insufficient to fund their retirement, leave them without adequate disposable income for day-to-day expenses and still have a debt of the principal borrowing amount at the end of the loan term. By any measure, this is not a fiscally responsible retirement solution.
A better alternative to the Retirement Interest Only mortgage
In most cases, retirees will not have funds required to pay off the total principal of a RIO mortgage, and so the proceeds from the sale of the property will have to cover this. This leads us to one of the main disadvantages of the product – the property has to be sold to pay off debt when transitioning into aged care, leaving them short of financial assets to pay a residential aged care refundable accommodation bond (RAD) or daily accommodation payment (DAP) in addition to their daily care fees or, upon death, the home is sold and is not passed on to the family.
This renders RIO mortgages unsuitable for any retirees who want their children to inherit their property assets. Compounding this, the available loan funds from an RIO mortgage are insufficient to fund retirement or may not be sufficient to make up any retirement fund shortfall – remember that the average Australian’s post-retirement income is 40% below what is required. For most retirees, RIO mortgage products are simply not fit-for-purpose.
This is why the team at Futureproof is bringing to market a more equitable and sustainable alternative for retirement funding – the Equity Preservation Mortgage®. It’s a new, lower risk-weighted and fiscally responsible smart mortgage that is designed with retirees in mind.
Among Australian retirees, the rate of homeownership is 76%, compared to 80% in the USA and 74% in the UK. Of these Australian retiree homeowners, the average property value is A$1,100,000, compared to only A$542,000 in the USA and A$887,000 in the UK.
To put it simply, Australia’s retirees can draw upon assets of significant value. This is why they need to be able to access tax-free equity income with no depletion of home equity. Futureproof’s Equity Preservation Mortgage® is designed to provide this.
The Equity Preservation Mortgage® will be released in Australia and UK in 2025.
