Who does a reverse mortgage suite?
What are the benefits of reverse mortgages
What are the potential disadvantages of reverse mortgages
Accessing reverse mortgages
Potential problems with reverse mortgages
Chapter 5 - Special purpose debt -
Reverse mortgages are loans taken out against property (via a first mortgage), where the amount borrowed is sufficiently small to allow the borrower to capitalise the interest and other charges as part of the loan. Typically, the loan remains unpaid until the asset is disposed.
Who Does A Reverse Mortgage Suit?
Reverse mortgages are typically undertaken by older people, who are ‘asset-rich but cash poor.’ They own their home, with no debt on it, but find that their income is less than they need/would like to live.
What are the Benefits of Reverse Mortgages?
The most obvious benefit is that the older home owner is able to finance a better quality of life, without selling their home. Aged pensions are not generous. For a single person, the maximum aged pension in Australia is $877 per fortnight. For a member of a couple, the maximum aged pension in Australia is $661 (each) per fortnight. These are not large amounts. The average annual wage for working Australians is around $1,400 per fortnight.
The reverse mortgage allows a borrower to ‘free up’ some of their capital, allowing them to enjoy the benefits of the wealth they have accumulated while still living in their own home, and continuing to benefit from any appreciation in the value of that home.
Another major benefit of a reverse mortgage is that it reduces the need for older people to sell their homes and move to something cheaper. Such sales can be disadvantageous for at least two reasons.
The first of these reasons is lifestyle. Urban lore is full of stories of older people whose health has started to deteriorate when they have moved out of a home they have lived in for many years. The move can be disorienting, both intellectually and emotionally, and moves into ‘facilities’ such as aged care homes or retirement villages can mean different things to different people. Some older people embrace such moves. But for others, the move can be a very real demonstration that they are approaching the end of their life. It is quite dispiriting and anecdotal evidence suggests it can even hasten the end of a person’s life.
The second of these reasons is financial. Older people who have owned their own home for a number of years possess an asset which is worth more than they paid, even when the purchase price is adjusted for inflation. In the period from 1995 to 2015, for example, the annualised rate of growth of urban residential property was more than 10% (source: ASX/Russell). This was well in advance of the inflation rate, meaning that the real value of property rose substantially across the period.
Hopefully you are familiar with the concept of compound returns, whereby the rate at which a growth asset appreciates, as a percentage of the purchase price, is greater the longer the asset is held. This is because the later growth includes ‘growth on growth.’ Selling the family home ends this compounding. This slows – in fact in many cases ends – the rate at which the individuals’ wealth increases. In addition, it entails selling costs, and if another property is purchased, purchase costs such as stamp duties as well. These costs permanently diminish the wealth of the older person.
By taking a reverse mortgage, the older person can continue to receive the wealth enhancing benefits of home ownership.
What Are the Potential Disadvantages of a Reverse Mortgage?
Reverse mortgages are a debt product. As such, the success or otherwise of a reverse mortgage will depend on the behaviour of the borrower. It will also depend on the conduct of the lender.
The most obvious potential disadvantage of a reverse mortgage is that the debt grows. This is because the borrower typically does not even pay off the interest. Thus, the debt might grow to the point where it exceeds the maximum amount the lender is prepared to lend. Such a situation might see the lender foreclose on the loan, forcing a sale upon the borrower. This situation is obviously more likely in the event of higher interest rates, which may also coincide with a fall in property values, meaning the sale occurs at exactly the wrong time.
The prospect of the debt getting out of control is largely derived from the amount borrowed. For this reason, people undertaking a reverse mortgage need to understand that the mortgage is not a bottomless pit. The borrower must ensure that they borrow a small amount relative to the value of the house. Of course, the need for discipline is the same with all types of debt. But it is especially the case for reverse mortgages, where interest is capitalised.
That said, the obvious risk of reverse mortgages is such that there are substantial rules governing the behaviour of lenders in this segment of the market. These rules were released in 2012. You can read about these rules, and also read further about reverse mortgages, on the ASIC website here.
This article from the Australian Financial Review also discusses the new rules and the way they operate:
A commonly cited disadvantage – albeit one that does not really stand up under close scrutiny – is the idea that the debt reduces the wealth of the individual. In the first case, even if the strategy did reduce their wealth, given that the borrower is typically near the end of their life, this situation is not such a problem. Why shouldn’t an older person enjoy some of the benefits of the wealth they have created over the years? You can’t take it with you, as they say.
Notwithstanding this, when done properly the reverse mortgage will often actually increase the wealth of the individual, in the same way that leveraged investments generally increase wealth. Because the borrower retains ownership of what is typically a growth asset, they retain access to the long term capital growth of that asset. This long term capital growth typically exceeds the interest expense each year, especially considering that the debt is substantially lower than the value of the house.
Accessing a Reverse Mortgage
Not all lenders offer a reverse mortgage. Because the interest and other fees are capitalised, the lender has to wait to get its money. This extends the period of the loan, which may introduce a risk premium from the lender’s point of view. In addition, some lenders prefer not to lend to borrowers with low incomes, regardless of the circumstances.
Therefore, you may need to shop around for a lender who is prepared to offer a reverse mortgage. In some cases, lenders might only be prepared to get involved if offered further security, such as a guarantee from some third party. The obvious candidate is the borrower’s children, who stand to inherit the house when their parents die. This would be an example of children taking an involvement in their parent’s affairs while their parents are still living. If prudent and possible, this involvement can be a good thing for all concerned.
Of course, in situations where the children have sufficient resources, a formal lender may be unnecessary. The children, either in their own right or via a family trust or similar vehicle, could make the loan to the parents. This strategy would usually need to be formalized, to ensure that the parents retain their rights to the full aged pension, etc. The use of an adviser is encouraged in such cases. Liaison with Centrelink would also be prudent, to ensure their rules are not breached.
Potential Problems with Reverse Mortgages
One of the most common problems for reverse mortgages can be unwillingness on the part of elderly borrowers. Older people often belong to a cohort that was conditioned to believe that any debt is bad debt. They will often fail (or refuse) to grasp the mathematics presented by the models above.
But then, they are not the only ones. About twenty years ago, Adrian, one of the key staff at our AFSL, was working for the Victorian Department of Human Services. His responsibility was to manage the funding for various aged care facilities in the northern region of Melbourne. Another part of the service provided case management services to frail and disabled people in the same region. One day a case manager approached Adrian to describe a situation with an elderly client of theirs. This man, in his eighties, needed a $3,000 refurbishment of his bathroom to allow him to stay in his own home, in a recently gentrified inner suburb. They wanted to know if Adrian knew of any funding that he may be able to access.
There was no funding available, but at the time vacant blocks of land in that area were selling for $400,000. When Adrian established that this man owned his home with no debt, he suggested a reverse mortgage. The social worker to whom Adrian was talking was aghast at the idea of asking this man to take on debt to finance the works, and did not make the suggestion. Thus, for the want of a loan of $3,000 secured against a $400,000 property, an old man was forced to leave his home of forty years and enter aged care.
From a personal point of view, this was a tragedy – the man left a much loved home unnecessarily and moved into care. From a financial point of view, it was a disaster. Over the next five years, properties in that part of the world doubled in value. Had the man borrowed $3,000 to finance the works, he would have retained an asset that increased by $400,000 over the next five years.