For many seniors who have only modest retirement savings, their home is their most valuable asset. They are often asset rich but cashflow poor. Reverse mortgages are relatively new products that were introduced to allow seniors (generally at least age 62 or above) to access the equity in their home to help fund their living expenses.
How do they work?
A homeowner can borrow against the equity in their home to take funds as either a lump sum, regular income stream or a combination of both. The loan is secured by a registered mortgage over the borrower's home. The amount that can be lent is determined by the age of the youngest borrower and the value of the property. Interest is charged at standard commercial rates but, unlike a normal loan, the borrower does not have to repay the loan but instead lets the interest capitalise (accrue and compound over time). Typically on death the house is sold, the accumulated loan (which may have grown substantially) is repaid to the bank and any surplus paid to the beneficiary (often the Estate).
Many reverse mortgages are limited in recourse which simply means that if the value of the loan eventually exceeds the value of the property realised on sale, then the lender wears the loss. In addition, the lender cannot force the borrower from the property once the debt exceeds the value of the property.
How much can you borrow?
The amount that can be lent is determined by the age of the youngest borrower and the value of the property. Typical lending parameters are as follows:
|Loan to value||15%||20%||30%||35%||40%||45%||50%|
John is 72 and Joanne is 70. They live on the Age Pension and have almost exhausted the savings they had built up prior to retirement seven (7) years ago. The Age Pension is not sufficient to cover their living expenses and so they are exploring the option of a reverse mortgage to provide them with sufficient cashflow throughout their retirement. The bank they visited engaged an independent valuer who assessed the property as being worth $700,000. Based on the youngest age, the maximum amount they can borrow is $140,000.
- Impact on amount borrowed
Joanne has the longest statistical life expectancy of 17.42 years. As they do not pay any interest on the loan, after 17 years the balance outstanding on the loan has grown to $458,603 (assuming an average interest rate of 7.00%p.a. over the term).
|Yr||Principal $||Interest $|
- How much income can the $140,000 generate and how long will it last if drawn down?
Assuming they invested the $140,000 lump sum at 5%p.a., then this would allow them to drawdown an extra $1,005 p.a. over 17.42 years (Joanne's statistical life expectancy) before the money would run-out.
|Yr||Pension Balance||Income generated||Pension Payments||Capital Reduction|
- Impact on Age Pension
The $140,000 lump sum is subject to the Age Pension deeming rates but the total deemed annual income of $4,439 is below the annual income free threshold of $7,176 (combined) so this strategy won't end up impacting upon their pension.
- Impact on Cashflow
|Status quo||With reverse mortgage|
|Other income (lump sum drawdown)||$nil||$12,054|
- Impact on Net Assets – Year 17
|Status quo||With reverse mortgage|
|Lump sum cash left over||$nil||$5,000|
|Loan owed to bank||$nil||– $458,603|
In most instances reverse mortgages should be viewed as a strategy of last resort. This is because interest compounds rapidly if not repaid, and can eventually erode the value of the equity in your family home. Further you are effectively borrowing at the mortgage rate (say 7%p.a. over the long term) to generate an after tax return that will usually be lower than that (unless the borrower is prepared to take a moderately high level of investment risk, which more often than not, they can ill afford to do). A reverse mortgage can also potentially have adverse Centrelink consequences for Age Pension recipients.
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