For In the Black in December 2005.
Ed Charles tells why reverse mortgages should be handled with care, and vetted by professionals.
This is a story about how a new car or a cruise might cost pensioners their home. It’s about the lucrative reverse mortgage, where banks will lend up to 45 per cent of a home’s value and compound the interest over a pensioner’s lifetime. It’s about the gap between compounded interest rates and increasing property values. And about how we may all live a lot longer than we expect.
Financial institutions are very clever in assessing risk, and understanding how to make money from compounding interest. The average person isn’t that good at working these things out and can make silly choices in deciding whether to borrow money in the long or short term.
For example, many of us prefer to borrow long term on low interest rates on our mortgages when in fact a short-term debt on a higher interest rate might be cheaper overall.
When we come to retirement age, some of us will have no choice, however. Many people are faced with minimal superannuation or investments and quite literally nothing but the family home to mortgage.
Enter the reverse mortgage – a misnomer as it’s really a capitalising mortgage – a relatively new financial product in Australia. In the past year the numbers of suppliers in the market has grown from four operators to 13.
So how does it all work? The reverse mortgage is exactly the same as a plain vanilla mortgage except no repayments are made. Interest is added to the loan and compounded until the mortgagee sells, dies or moves into a nursing home.
With interest rates at a 30-year low, reverse mortgages appear an attractive option. The interest rate on a reverse mortgage is typically 1 per cent higher that the regular mortgage rate to reflect the risks of a loan of an unknown term – currently about 8.5 per cent depending on the supplier.
The retiree taking out the loan takes on the risks relating to interest rates, property price increases and their own life expectancy.
The lender will only lose if the person lives too long.
Chris Benson, manager of financial planning at CPA Australia, modelled the life of three reverse mortgage scenarios over 10, 20 and 26-year terms assuming that house prices increase at 2 per cent per annum and 20 per cent of a property’s value was borrowed.
After 10 years the bank owns 37 per cent of the property and after 20 years it’s 68 per cent At 26 years the loan would exceed the value of the property.
With low interest rates, and predictions that the boom years of property are over, it is possible the interest rate differential between mortgage payments and property growth could increase, he says.
Paul Resnik is a financial consultant who advises Australian Seniors Finance. He says that many people often initially have an uncomfortable response to reverse mortgages. He says they react by saying ‘this doesn’t feel right’. ‘But once they start looking at it in context they get it,’ he says.
For many people the only option to raise cash may be to sell their home. But this could mean losing pension entitlements if excess cash is left. To generate an income of $12,000 a year – more than a senior would get from the government pension – would require more than $400,000 of capital. The reverse mortgage allows retirees to keep their pensions while accessing the equity in their homes.
As we all start to live longer, eventually many of us will run out of super and have insufficient investments to finance us through old age.
From a financial adviser’s point of view, the important thing is to ensure that a borrower really understands the consequences of taking out a reverse mortgage.
There are many factors to examine before taking on a reverse mortgage. For this reason, CPA Australia’s Benson says that seeing a financial adviser is a worthwhile investment. Most reputable lenders insist on a financial adviser signing an advice certificate.
Borrowers need to consider whether they want to borrow a lump sum up front, with interest accruing over the loan’s life, or whether to draw down incrementally.
Also, the family should be brought into the picture. Although children shouldn’t build inheritance into financial planning, they may anticipate inheritance, Benson says: ‘There’s going to be anticipation that there is some inheritance there, and it can be pretty shocking if they turn around to see that the house their parents have lived in for 50 years is actually owned by somebody else,’ he says.
The key thing to look for is a negative equity guarantee, which is offered by all lenders who are members of Senior Australians Equity Release Association of Lenders (SEQUAL). This means that no matter what happens, the lender will not seize control of the asset if the loan exceeds its value. Also, the lender will not chase the mortgagee’s estate for additional funds.
Benson initially was negative about reverse mortgages. Now, however, he has modified his views, as long as those using reverse mortgages are advised by qualified financial planners. Reverse mortgages are more of a financial planning product than a loan, he says.
‘It’s the long-term financial implications of these products which are going to be the cause of problems down the track if advise given isn’t appropriate,’ he says.
‘There only needs to be a 6 per cent differential between the mortgage rate and house price increases for the bank to totally own the property after 26 years.
‘Nowadays we are all living longer,’ Benson adds. ‘Someone who takes out a reverse mortgage at the age of 65 may at the age of 90 find themselves wanting cash to finance nursing home care, but may be left with the bank owning their only asset outright.
Says Benson: ‘And over that period of time you’ve paid the rates on it, you’ve paid the repairs on it, you paid the insurance on it, yet your interest in the house has just diminished year on year.’
Many of the loans are devised with the help of the Australian Life Tables compiled by the Australian Government Actuary. For a female aged 70 these tables would predict that she would live for another 17.08 years. Or at the age of 75, she would live for another 13.33 years.
In reality, these tables need to be adjusted to accommodate increased life expectancy. Actuary Peter Szabo, the brains behind the Bendigo Bank-funded Homesafe Equity relief scheme (see article, right), uses tables adjusted for this with a 70-year-old female living 21 years and a female aged 75 living another 16 years. He says the important thing to remember is these lifetimes are only averages. About 52 per cent of those aged 70 would live longer than 21 years, and 53 per cent of those aged 75 would live longer than 16 years. This means there is a good chance that many people will find their stake in their property eroded to nothing.
These products aren’t being accessed by the poorest pensioners in Australia; they don’t own their homes. They are used by those who own their own homes but don’t have the super to fund their lifestyles, need a new car or have a health disaster.
According to Bluestone Mortgages, the products used to be the loan of last resort. But now reverse mortgages are being pushed as a financial planning product to help decelerate the erosion of superannuation, or to help pay for that cruise or a new car.
Typically, Bluestone lends between 15 per cent (for a 60-year-old ) and 45 per cent (for an 83-year-old) of a home’s value. The average loan is 23 per cent of a home’s value, the average age customer is aged 68. And 40 per cent of borrowers are single females.
At St George Bank the major reason for a loan is to buy a new car. Jane Reid, senior product manager specialised mortgages at St George, says about 30 per cent of all new loans are for new cars. About 15 per cent are home renovations. Third most popular on the list is lifestyle, followed by medical expenses. She says sales of the product have exceeded expectations since being launched.
Equity release
Peter Szabo has approached the problem of releasing cash from a home from the point of view of an actuary rather than a lender. In partnership with Bendigo Bank, this year he launched the Homesafe Equity Release product.
The end result for someone needing cash is the same as a reverse mortgage. But the risks of losing one’s home are minimised by Homesafe taking an equity share in the home in return for a cash advance.
Szabo says that one of the attractions of equity release over a reverse mortgage is that there is less risk for the retiree. In a reverse mortgage, the borrower takes on the interest rate (unless the product is fixed), property growth and longevity risk.
With Homesafe those risks are transferred to a pool, in this case an unlisted property trust financed by Bendigo Bank.
Homesafe is not for everyone, though. It cherry picks the best properties. It will not lend to country areas or apartments to minimise its risk. It will take a maximum stake of 50 per cent in a home, and the amount advanced will depend of the property value and age of the borrower.
For example, a 75-year-old female borrowing $100,000 of an $800,000 home would sign over 21.48 per cent of the home to Homesafe.
Further reading
Going into reverse by Michael Rice, Asset, October 2005 Mortgages in reverse by Liam Egan, Money Management, 29 September 2005 On the house by Karin Derkley, Personal Investor, August 2005 Reversing the money by Ross Clare, Superfunds, December/January 2003/2004 Til death do us part by Derek Parker, Australian CPA Magazine, July 2004
Reference: December 2005, volume 75:11, p. 47