The Reverse Mortgage: an underutilised retirement planning tool?

160430.Reverse Mortgage

Australians’ wealth concentrated in the family home …

We have long been of the view that Australians, in general, have too much wealth tied up in the family home. For those at or near retirement, a corollary is that they often have insufficient investment assets to support their desired lifestyle for an extended period without needing to downsize or being prepared to survive beyond some unknown future time on the age pension.

This unsatisfactory situation is revealed by a measure of financial independence that we call the “Investment Wealth Ratio” (“IWR”). As a “rule of thumb”, we suggest that at retirement at least 55% of total wealth should be held in investment assets and, correspondingly, less than 45% in the family home and other lifestyle assets. But most Australian households either approaching or in retirement have an IWR significantly less than 55%.

There are a number of reasons why there is such a heavy overweighting of wealth to the family home, including:

  • Its capital gains tax free status;
  • Its exclusion from both the age pension assets and income tests; and
  • The transfer costs associated with downsizing to more appropriate housing as children leave home.

For many, there is also a strong emotional attachment to the long held family home that results in a reluctance to sell despite the financial sacrifices that are often made to hold on to it.

Reverse mortgages are a low risk way to access home equity

But what if there was a product that allowed you to both remain in the family home and give you a high chance of living your desired, apparently excessive, lifestyle, despite retiring with an IWR that is much less than our benchmark 55%. You would think that providers of such a product would be knocked over in the rush.

Such a product does exist but, no, providers are not being knocked over in the rush. The product is called a reverse mortgage and is offered by a number of lenders. The Commonwealth Government even offers a restricted form of reverse mortgage under the Pensions Loans Scheme for those of age pension age that don’t qualify for a full pension.

A reverse mortgage effectively allows you to borrow against the equity in your home, up to a predetermined value, to meet personal spending needs. The loan may be drawn down as a lump sum, as a regular income stream and/or for irregular needs and may be repaid at any time. Unlike a normal loan, while interest is charged, you are not required to pay it for as long as you live in the home. The interest accumulates (i.e. capitalises) and is added to the balance of the loan.

While you must repay the loan in full (including interest and fees) when you sell your home, die or move into aged care, a key feature is that the amount owing can never exceed the value of the home. The lender bears the risk that the value of the home is less than the loan balance outstanding. Because of this, the interest rate on reverse mortgages is generally higher than for a normal mortgage.

The major apparent negatives of a reverse mortgage, that may adversely affect the demand for the product, include:

  • The possibility that the combination of the loan principal and accumulating interest may totally erode the borrower’s equity, meaning nothing will be available for the estate; and
  • The related issue that the loan balance may rise to such an extent that aged care requirements can’t be met.

The table below illustrates the number of years it takes for a reverse mortgage to accumulate to the value of a home (assuming it grows with inflation) for the illustrated real (i.e. after-inflation) reverse mortgage interest rates and lump sum borrowings, as a percentage of initial home value:
 

 

It reveals, for example, that a 65 year old that borrows 30% of the value of their home at an indicative real interest rate of 5% p.a. should expect to erode all their equity within about 25 years i.e. by age 90.

This may not be palatable for many, particularly those who regard their home as an investment rather than primarily a place to live. But another way to look at it is that beyond age 90, while the borrower may no longer have equity in the home, they are able to live there without any repayment obligations until a loan termination event occurs.

Reverse mortgages have a role, but not for everybody

While a reverse mortgage definitely will not suit everyone, it offers a potential solution to retirees who wish to stay in the family home indefinitely and continue to enjoy a lifestyle beyond what their investment wealth is able to support.

In next month’s article we will examine in more detail how a reverse mortgage might be used in two scenarios:

  1. The scenario primarily focused on in this article i.e. remaining in the family home despite insufficient investment wealth to support a desired lifestyle; and
  2. Bringing forward an estate plan, to provide support for adult children now rather than on the parents’ death.


Receive monthly notification of new articles by signing up to our Smart Decisions blog now.

Print Friendly

Leave a reply