Sometimes elderly people who are living happily in their own homes find themselves in a situation where they need a cash injection from an outside source to be able to finance things such as maintenance on the home, replace a motor vehicle, or pay for elective surgery, for example, because they do not have cash available in savings, and they cannot get a loan advance from a regular bank, because they do not have income flow to service the loan repayments.
A reverse mortgage may be a suitable option in such circumstances.
What is a reverse mortgage?
“Reverse mortgage” is the common term given to a type of secured lending which requires no loan repayments to be made until the borrower dies or sells the property which secures the loan.
There are two types of reverse mortgage:
- Home equity release, where money is advanced in one or more lump sums; and
- Reverse annuity mortgage, where regular, periodic advances are made, similar to annuity payments.
Who qualifies for a reverse mortgage?
Generally, a borrower must:
- Own their own mortgage-free property; and
- Be not less than 60 years of age.
How much can you borrow?
This will depend upon your age and the value of the property. An older borrower will be able to borrow more than a younger borrower because the duration of the lending period is likely to be shorter.
A borrower may be allowed to draw more than one loan advance.
How do reverse mortgages work?
The borrower signs a loan agreement and gives a mortgage to the lender, secured by the borrower’s property.
The borrower makes no loan repayments until the loan is repaid in full, either on the death of the borrower (if the loan agreement includes a lifetime occupancy guarantee), or the sale of the property, whichever is the earlier.
Interest is calculated on the amount owing from the date of the loan advance to the date on which the loan is repaid, and compounds, usually on a monthly basis.
Costs associated with reverse mortgages
The interest rate is variable, not fixed.
Interest rates for reverse mortgages are higher than the floating interest rate for a standard home loan, and, because of the compounding effect, the overall cost of the loan is high.
The compounding interest can easily erode the equity in the borrower’s property, sometimes to such an extent that the amount owing under the loan is more than the value of the property.
Some loan agreements have a “no negative equity guarantee”, which means that if the amount of the debt is greater than the value of the property on repayment, neither the borrower, nor the borrower’s estate is liable to make up the shortfall; the lender bears the loss.
The illustrations below show the impact of a reverse mortgage on the equity in a property of a borrower who takes out the loan when aged 81 and the property is worth $720,000. In the first scenario the value of the property increases by 3% per annum. In the second there is no increase in the value of the property, and in the third, the value of the property declines.
There are usually other costs associated with getting finance through a reverse mortgage, such as establishment fees and equity protection fees, as well as the cost of obtaining valuations.
What are the borrower’s obligations to the lender?
The borrower must maintain the property to a required standard and keep it insured.
The borrower may have to allow the lender access to the property from time to time to inspect the property and reassess its value.
Recommendations for borrowers
It is better to enter into a reverse mortgage arrangement when you are 70+ years old than when you are 60, simply because the duration of the loan period is likely to be shorter, and there is less risk of completely eroding the equity in the property.
Borrow a modest proportion of the equity in the property.
Obtain good, independent legal advice so that you understand the nature and implications of the contract you are entering into with the lender.
Published: 28 February 2020