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:

Age 63 70 75 80 85 90 95
Loan to value 15% 20% 30% 35% 40% 45% 50%

Example

Property value 700,000 700,000 700,000 700,000 700,000 700,000 700,000
Amount borrowed 105,000 140,000 210,000 245,000 280,000 315,000 350,000

Example

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.

Outcomes

  1. 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 $
0 140,000
1 150,121 10,121
2 160,973 10,852
3 172,610 11,637
4 185,088 12,478
5 198,468 13,380
6 212,815 14,347
7 228,199 15,384
8 244,696 16,497
9 262,385 17,689
10 281,353 18,968
11 301,692 20,339
12 323,501 21,809
13 346,887 23,386
14 371,963 25,076
15 398,853 26,889
16 427,686 28,833
17 458,603 30,917
18 491,756 33,152
19 527,305 35,549
20 565,423 38,119
21 606,298 40,875
22 650,127 43,829
23 697,125 46,998
24 747,520 50,395
25 801,559 54,038
  1. 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
0 140,000 – – –
1 134,828 6,883 12,054 5,172
2 129,392 6,618 12,054 5,436
3 123,678 6,340 12,054 5,714
4 117,671 6,047 12,054 6,007
5 111,357 5,740 12,054 6,314
6 104,720 5,417 12,054 6,637
7 97,743 5,078 12,054 6,977
8 90,409 4,721 12,054 7,334
9 82,701 4,345 12,054 7,709
10 74,597 3,951 12,054 8,103
11 66,080 3,536 12,054 8,518
12 57,126 3,101 12,054 8,954
13 47,714 2,643 12,054 9,412
14 37,821 2,161 12,054 9,893
15 27,422 1,655 12,054 10,399
16 16,490 1,123 12,054 10,931
17 5,000 564 12,054 11,491
18 40 64 12,054 4,960
  1. 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.

  1. Impact on Cashflow
Status quo With reverse mortgage
Age pension $31,688 $31,688
Other income (lump sum drawdown) $nil $12,054
$31,688 $43,742
  1. Impact on Net Assets – Year 17
Status quo With reverse mortgage
House value $700,000 $700,000
Lump sum cash left over $nil $5,000
Loan owed to bank $nil – $458,603
Net assets $700,000 $246,397

Conclusion

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.

This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2011 Moore Stephens Australia Pty Limited. All rights reserved.