Funding retirement: analysing Reverse Mortgages
Across a 5-part series of articles, we examine the leading financial products that Australians can use to fund their retirement, weighing up the advantages and disadvantages of each option. So far, we have taken a closer look at annuities, shared appreciation mortgages, guaranteed investment products, and retirement interest-only mortgages. In the fifth instalment of this series, we examine reverse mortgages.
Calculations made by the Association of Superannuation Funds of Australia (ASFA) identified that Australians need to be able to draw upon 70% of their annual pre-retirement income after they have left work. This benchmark is sufficient to provide a comfortable living standard, but too many Australians are not able to hit this level. As it stands, the average Australian’s post-retirement income is 40% below this benchmark.
Generally, this is not due to a lack of overall wealth but is instead caused by a lack of liquid cash flow. In Australia, the average retiree owns a home worth $1.1 million. This value is 40% higher than the median price for residential property across Australia’s capital cities, and this translates to a significant level of asset wealth. Unfortunately, this status of asset-rich and cash-poor is driving Australians to seek retirement funds elsewhere.
Understanding Reverse Mortgages
A reverse mortgage is essentially a loan from a financial institution or mortgage provider. It represents a way for individuals to monetise the value of their property asset – typically their home – and then receive liquid funds as an early return of capital. However, this option is only open to individuals who are of retirement age.
The individual is essentially borrowing against the equity they have already built up in their home. While a standard mortgage is used to purchase a property asset, the reverse mortgage is the opposite – it releases funds from the property asset – hence the instrument’s name.
There is no need for the homeowner to make loan payments against the amount borrowed, as the balance will be settled at the end of the loan term. This loan term will come to an end either when the individual (or their spouse or partner if they are also a named borrower) passes away or when they sell or move out of the property.
Advantages of Reverse Mortgages
Retirees can experience some advantages of reverse mortgages.
- Retirees can access home equity without selling. Retirees are able to monetize some of the value of their property without selling. This means they can remain living in their own home throughout their retirement.
- There are no additional payments to be made during the loan term. Additional payments can harm cash flow for retirees. With a reverse mortgage, there is no obligation to make either repayments of loan principal or loan interest payments during the loan term.
- Instruments are regulated under the National Consumer Credit Protection act. Retirees gain peace of mind through strong regulation. Reverse mortgage instruments are regulated according to the NCCP Act of 1992.
- Some flexibility in income payments. It is possible to receive a regular income, a lump sum, or a line of credit from the reverse mortgage.
- No negative equity guarantee is required by Regulator to be given to borrowers by the reverse mortgage lender. This does not protect the borrower from losing some or all of the equity in their home, but it does mean the lender cannot pursue any additional amount of debt owing over and above the market value of the property. This no negative equity guarantee is important because, typically, a reverse mortgage depletes all home equity and falls into negative equity around 20 years into the loan term (depending on interest rates, amount borrowed, and house price movements). Essentially, the lender is betting against the longevity of the borrower, long-term growth in home value and the effectiveness of the protections affiorded by the age and LVR loan limits.
Disadvantages of Reverse Mortgages
There are also a number of disadvantages for retirees.
- The loan amount is not paid off incrementally. The loan principle is not being paid off in regular instalments. Instead, the loan amount will need to be covered at the end of the term, typically through the sale of the property.
- Interest is added to the total loan amount. Interest is capitalised and added to the total loan amount. As there are no interest payments made over the term of the loan, this interest builds up and can become a very significant cost.
- Interest rates tend to be higher. Interest rates tend to be higher on a reverse mortgage when compared to a regular mortgage. Typially a reverse mortgage is charged at an interest rate of between 150-250 basis points more than a forward mortgage. This will leave the homeowner with much more to pay at the end of the term.
- Compounding interest is charged
Unlike a forward mortgage that uses simple interest, a reverse mortgage charges compounding interest. In other words, every month unpaid loan interest is accrued and added to the loan balance. This results in new interest being charged each month on previously accrued interest. Typically, this doubles the reverse mortgage debt every 9-10 years (depending upon amount borrowed, interest rates and property price movements).
- Loan to Value Ratio (LVR) is calculated according to age and is generally low. The LVR will differ according to the age of the homeowner. However, reverse mortgage customers generally receive a much lower LVR than they would on another form of loan or credit. These borrowing restrictions are designed to protect the lender against the risk of negative equity at the end of the loan term which they must carry as a lending loss or additional cost of the loan. Typically, a lump sum amount is limited to a maximum of only 18% LVR. The maximum borrowing for monthly income is generally higher, but still limited according to age. A useful guide is that a 60 year old may, typically, borrow up to 20% LVR and this increases by 1% for every year the borrower is above 60 years of age.
- Homeowners cannot pass the value of their home on to their descendants. Generally, the value of the property is used to cover the loan settlement. This means the property will not be passed on to beneficiaries of the homeowner’s estate and will instead be sold off to cover the outstanding balance.
- Homeowners cannot leverage additional funds later on. Once homeowners have unlocked the equity from their home and received their funds, there is no way for them to draw further funds later on. This can leave retirees in a difficult position if they exhaust their available equity.
- Financial assets of a retiree can be exhausted at their most vulnerable time of life. This will occur, in circumstances where the reverse mortgage has depleted the home equity after around 20 years. If the reverse mortgage was taken out at aged 60 years of age, then at aged 80 it is likely that one or both of the retirees need to move into residential aged care (whether into low care because they can simply no longer live independently ageing-in-the-home, or into high care as a result of illness or a medical episode). It is at this time that a retiree needs substantial financial assets to pay an aged care refundable accommodation bond (RAD) and/or daily accommodation payment (DAP) in addition to their daily care fees. The average accommodation bond for residential aged care is now $675,000 and in capital cities can easily be up to $1.3M – 1.5M. With the depletion of home equity, most retirees are left in a very difficult financial position when at their most vulnerable.
A better alternative to the Reverse Mortgage
As discussed above, lack of wealth is not generally a problem for Australian retirees. On average, 76% of retirees in Australia are homeowners, with an average residential property value of $1.1 million. While there are more homeowners among American retirees (80%), their properties are worth much less, at around A$542,000 on average. In the UK, only around 74% of retirees are homeowners, and their properties are worth A$887,000 on average. In terms of asset wealth, Australian retirees are in a good position. The problem lies in the lack of effective retirement funding products designed for asset-rich cash-poor retirees.
Being asset-rich can make reverse mortgages a useful option for some retirees, as it effectively translates a portion of that asset wealth into liquid cash funds. Indeed, reverse mortgages may be suitable if the amount borrowed is small or in circumstances where the retiree is using an unencumbered investment property and may be prepared to deplete their equity knowing that their principal asset (i.e. the family home) is untouched.
However, uptake in Australia remains low, simply because this form of mortgage is unsuitable for most retirees who, whilst being asset-rich and cash-poor, regard reverse mortgages as “products of last resort”.
The team at Futureproof are bringing to market a new alternative – a form of retirement funding that is fiscally responsible with retirement funding products that are fit-for-purpose. This is the Equity Preservation Mortgage™ (EPM) – a lower risk-weighted, smart mortgage designed with retirees in mind, that preserves all their home wealth.
We want to provide Australian retirees with the opportunity to leverage their property assets, achieving a tax-free equity income with no depletion of home equity. Futureproof’s Equity Preservation Mortgage™ now provides this.
Click on the links below to read the first four articles in our series:
Annuities – fixed, variable, market-linked
Guaranteed Income Investment Products