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Reverse mortgages: short-term gain, long-term pain

Residential property has long been a major store of wealth for average Australians. The home remains the primary asset for the majority of people, and the property market - particularly in major cities - has generally been kind for those who were in the market over the past decade or so.

But with the ageing of the population, the percentage of wealth locked up in residential property ($500 billion in home equity is held by people over 65) is both a blessing and a challenge.

According to the last Intergenerational Report in 2015, the number of people in Australia aged between 65 and 84 is forecast to double by 2054 to around 7 million, while the number of people over 85 is expected to more than quadruple.

Home ownership and a comfortable retirement

There is no disputing that owning your own home is a foundational step on the pathway to providing for a comfortable retirement. But the problem is perfectly captured for older Australians with the expression 'asset rich, income poor'.

The challenge for many in the post-war, baby boomer generation, is that while the house value may have risen well beyond their expectations, they can’t use it to pay for the groceries, house repairs or a car that needs replacing.

Downsizing has its advocates but comes with lifestyle challenges such as forming new friends and community contacts. So it is no surprise that there is considerable interest in developing a viable suite of products to release the equity locked up in the family home.

While the need is obvious, the solution less so, and products like reverse mortgages do not enjoy good reputations. A recent review by ASIC of reverse mortgage products acknowledged that a common view amongst retirees, and even among finance brokers and lenders, tends to be that equity release products take advantage of vulnerable elderly people.

That certainly accords with a personal experience of reverse mortgages courtesy of a family friend who, with her husband, took out a small ($50,000) reverse mortgage against the equity of their mortgage-free home. It certainly helped provide some short-term cash and lifestyle enjoyment, but after the husband developed cancer and passed away, an early exit condition was triggered resulting in a massive bill that wiped out almost all their household savings and left the wife wholly dependent on the age pension to live.

The ASIC review of the reverse mortgage market came after government changes in 2012 to strengthen consumer protections, including the provision of a no negative equity guarantee. That is, the borrower cannot be required to repay more than the value of the secured property at the end of the loan.

The ASIC report found reverse mortgages were satisfying the immediate or short-term needs of borrowers, as did the case study above, and often provided for an improved standard of living while letting people ‘age in place’.

Where ASIC found challenges in the market was with the long-term impacts on the borrower’s asset position and, in particular, the impact of the cost of the reverse mortgage products that was only fully understood when the home needed to be sold to provide a bond for entry into an aged care facility.

That was highlighted by many of the borrowers surveyed for the ASIC report who indicated that they had not seriously considered their possible future needs.

Complexity is not well understood

Reverse mortgages are complex and expensive products for both the borrower and the product provider, and the ASIC report does a good job at explaining the short-term benefits and the long-term risks and lifestyle implications that come with it.

The ASIC study tested the impact on the remaining home equity by the age of 84 (the average age of entering into aged care) if interest rates on the loan rise and if property prices grew more slowly than expected. It showed that 63% of borrowers may end up with less equity than the average upfront cost of aged care for one person ($380,000) by the time they reach 84.

The long-term risk for borrowers is that, because of the impact of compound interest, they may seriously compromise their future retirement lifestyle and ability to afford expenses such as aged care accommodation, medical treatment and day-to-day living expenses.

To illustrate the costs over the long-term, ASIC says the interest charges on an average loan of $118,000 are $100,963 over 10 years and $180,269 over 15 years.

One of the major warnings ASIC has for borrowers is the focus on short-term objectives with “limited or no attention” being paid to their possible future needs. The review of loan files ASIC did as part of the report found:

“approximately 92% of the loan files we reviewed did not record the possible future needs of the borrower in sufficient detail and contained no evidence that the broker or lender had discussed how a loan may affect the borrower’s ability to afford future needs”.

The bottom line is that there are no silver bullets that can magically solve the 'income in retirement' question but a clear message from the ASIC report is that you need to carefully balance both today’s needs and your likely future requirements.

The ASIC MoneySmart website provides a comprehensive guide to the risks of reverse mortgages.

 

Robin Bowerman is Principal and Head of Corporate Affairs at Vanguard Australia, a sponsor of Cuffelinks. This article is for general information and does not consider the circumstances of any individual.

For more articles and papers from Vanguard Investments Australia, please click here.

 

10 Comments
james walker-powell
October 22, 2018

Reverse mortgages are a reality of not saving enough for retirement period .
For most its the last resort . Solution is put money away now for the future so you dont have to take out a R M

SMSF Trustee
October 22, 2018

Harsh, jw-p For most people, the cash flow they earn on average weekly earnings (or less) means they can afford a mortgage to buy a house, or they can top up their super above the minimum, but not both. They have to feed and clothe the kids too!

Matt
October 19, 2018

I agree with Steve. Reverse mortgages are an extremely expensive administration service. Much better solution is to have a vanilla mortgage largely/fully offset at retirement (or more specifically just before retirement so you can get approved!) and just draw on the offset account as needed (for both living and interest expenses).

Susan
October 19, 2018

Like any financial product Reverse Mortgages need to be used correctly. If they are used for your latter retirement years the debt has less time to accumulate and it is better to draw down in gradual instalments as opposed to a large lump sum. Yes, retirees will give up some equity in their homes but it would be the same effect if they sold the house and downsized incurring both selling and buying costs. Yes, there will be situations where they dont work
ie lower value properties and if you dont use them correctly you can end up with a high debt but it makes no sense for retirees to have sub-standard retirement lives when they have enormous equity in their homes.

Alexander
October 19, 2018

Reverse mortgages have a place where an older person is asset rich (their home) but cash poor and living a completely compromised lifestyle, with the likelihood of gifting millions to their children. Crazy to live in abstinence for the last 30 years of your life. If the loan against the house is not more than say 25%, there will be plenty left for aged care needs.

Steve Schubert
October 18, 2018

Good article Robin, thanks. A key observation from ASIC is the goal to provide an "improved standard of living while letting people ‘age in place’". The effectiveness of a reverse mortgage to support this goal is affected by the way they are used. Drawing down a significant amount while you still have 15+ years to live will inevitably make a big dent into your equity. An alternative is to draw amounts in instalments, preferably later in retirement. This has two key benefits - it reduces the chance that the drawings will affect social security entitlements and it significantly slows the compounding of interest.
If the "average" reverse mortgage loan is $118,000 as stated, the impact would be greatly reduced if it were drawn down as, say, $10,000 p.a. for 12 years.
This suggests that reverse mortgages could be useful as a way of topping up retirement income, particularly after self-funded savings are largely depleted (e.g. to supplement the age pension). Making a lump sum drawing earlier in retirement for travel or other major expenditure will lead to much higher interest costs.
Of course drawing down by instalments is not ideal for providers as they will incur more administrative costs and I expect people are incentivised to sell larger mortgages up front rather than a facility to draw down small amounts over time.

Franco
October 18, 2018

On those ASIC figures of interest over 15 years on loan of $118000 of $180000, we can say that homeowner owes approx. $300000 after 15 years. If they borrowed this on an average Sydney property of say $900000 at 70 years of age and assuming their home does not appreciate during those 15 years. They are left with $600000 reduced by inflation ,leaving approx $450000 equity in todays dollars. If the original loan allows them to enjoy those 15 years more than they would have without the loan, then I see it as a worthwhile action.

Laurent
October 19, 2018

Are you serious?

To get $7,867 per year for 15 years from a bank, someone in their right mind would give up half of their $900,000 home ?

This is a solution for a childless English-speaking person. Anybody from a background where family solidarity still means something can get an infinitely better deal.

My kids have cost me $1 million each to raise. I hope that they would give me $7,867 per year if I needed it ... If not, they would lose half of my house to the bank.

Albert Uo
October 21, 2018

Ah !! Hope ........

Caron
October 21, 2018

I don't know about the maths in your comment, but as an English-speaking person born into a family, and having raised a family, I think the slur that english-speaking people are not from a "background where family solidarity means something' is quite unfair and very wrong.
All my English-speaking friends (of various ethnic backgrounds) are providing abundant support to their children. Many pay their children's HECs fees, a number have financial arrangements that have enabled the family to support young adults into apartments of their own, most lovingly have adult children live at home to enable them to save to start their lives, and many, many cannot do enough for their grandchildren out of both love and sense of duty.
I have english speaking friends of a non Anglo-Australian background as well, and they are doing the same for their families. I don't think ethnic background is relevant to family love, support and duty.
Laurent, your insinuation about personal ethnic background was a lowball generalisation and incorrect.

I will let those who are childless make their own comment, but those I know are particularly devoted to their elderly parents and demonstrate strong family connections.

 

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