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A Primer on Reverse Mortgages

You’ve probably heard of reverse mortgages before and probably already have a negative opinion on them.  You may have good justification for not liking them as they are fairly high interest mortgages that are targeted to seniors with low cash flow.  However, lets get into details a bit and see what they are really all about.

What is a Reverse Mortgage?

A reverse mortgage is basically refinancing a home (for seniors) in order to get the equity out today with no monthly payments until the full loan is due when the homeowner passes away or moves.  It provides tax free money to the senior homeowner in exchange for a hefty interest rate loan that compounds semi-annually over time.  The bright side is that the home owner will not need to make payments until the loan is due in full.  The problem is that by the time the loan is due when the home owner passes away or moves, there is typically very little equity remaining in the home.  This means nothing will be left behind to the next generation.

The Details

There are very few reverse mortgage providers in Canada with the largest being Canada Home Income Plan (CHIP).  CHIP will reverse mortgage up to 40% of the value of the home for homeowners age 60 and over.  Of course, the older the homeowner and the more the equity that is in the home, the closer to the 40% loan to value (LTV) they will receive.  They provide a variety of payment options from monthly equity payments to lump sums

As you can imagine, the interest rate charged on reverse mortgages are higher than regular mortgages.  In addition to that, since no payments are made, they interest due grows very quickly (compounded semi-annually).  As of today, CHIP charges up to 8.95% on their reverse mortgages.  That means if CHIP lends you $100,000 today, in 10 short years, there will be over $240,000 owing on the home.

The Benefits

  • As mentioned above, it allows seniors with very low cash flow to draw on the equity in their homes to fund their lifestyle.  If the senior is not concerned with leaving an inheritance to the next generation, then a reverse mortgage may be a viable solution.
  • The reverse mortgage payments are tax free and does not affect income tested benefits (GIS and OAS).
  • The total owed will never exceed the value of the home.

The Downside

  • With the high interest rates, the equity in the home will disappear quickly as shown above.
  • If the homeowner keeps the reverse mortgage for a number of years until he/she passes, there will be very little left for the next generation.

Conclusion

Getting a reverse mortgage is an expensive choice, but it can be a viable solution depending on the situation.  In my opinion though, a reverse mortgage should be the last resort after considering other options like selling and downsizing or renting out a portion of your home.







22 Comments, Comment or Ping

  1. 1. The Reverend

    I think the need to leave an inheritance is sometimes overdone, epecially for the very elderly. Hopefully if you’re kids are in their 50s, their fairly self sufficient and not relying on whatever you leave them after you’re gone.

    Obviously there are situations where family is in great need, but often it ends up being the frugalness of the elderly funds the lavishness of their kids.

  2. 2. Al

    I despise those CHIP adds. They suggest that it’s a good idea to get one of their mortgages to do renovations or vacations or the like. Non-necessities. Using a reverse mortgage should be a desperation move only. If there is a move into a smaller place or an assisted living residence at the end of the CHIP, there is a good chance the mortgagors are done for. Instead of leaving something for the kids they become totally dependant on them. This isn’t all bad if the kids can afford to help, but the parents may feel stupid having put this burden on their kids so they could take an extra vacation or whatever. And of course the kids may find their retirement plans going up in smoke to bail out their parents.

  3. At least the reverse mortgage gives the elderly another way of owning their home while getting a different income stream. The problem of course is that whatever they are getting from a reverse mortgage is a “return of capital” as opposed to a return on capital, which also explains why this “income” is not taxable.

    Why can’t these seniors simply sell their house and move to a cheaper place ( a rural place) using 40% – 50% of the proceeds from the sales. The rest could easily provide a cash flow for them in retirement and they will have something to pass to their kids or favorite charity..

  4. 4. Novice

    @ Dividend Growth – while I too dislike reverse mortgages (I think there are lots of fees as well as interest) I can understand why an urban senior who’s lived in the same house in the same neighbourhood with all their friends for the past 30 years might be reluctant to leave and move to a rural place where friends, family, and medical care are not closeby; especially since their car mobility might be limited.

  5. 5. DAvid

    Based on Al’s comment, the decision to enter a reverse mortgage should be taken after discussions with your children, as they may end up addressing the financial future of the parents eventually. It strikes me that it might be useful to see if other family might be prepared to take on the mortgage, instead of having it fall to the bank. At least in that fashion, the base asset remains in the family, and is available to fund future care.

    DAvid

  6. 6. cannon_fodder

    I suppose if you are in an area where your home value goes up at a greater rate than the interest rate on a HELOC, you could, in theory, withdraw money from a HELOC and readjust it every so often to take advantage in the growth in your home’s value while still not tapping into more than 80% of your home’s equity.

    If you had a $250,000 home you could withdraw $1,000 per month + whatever interest charges incurred by the HELOC the previous month and that may last you until you pass away yet still retain some equity in the house.

    Highly dependent on each individual’s circumstances, but perhaps a better approach.

  7. 7. Mortgages

    Great information. Mortgages in general can be difficult to understand. IT’s good to have articles like this that can help.

  8. Frugal Trader – generally an excellent post and one worth writing given our changing demographics…but I’d like to discuss this point that you made:

    “The problem is that by the time the loan is due when the home owner passes away or moves, there is typically very little equity remaining in the home. This means nothing will be left behind to the next generation.”

    That’s a pretty broad generalization…can you back it up?

    I think the flaw in your argument is that it assumes zero appreciation on the value of the home over time. Let’s do the math:

    Home value $300k. Maximum CHIP loan 40% of that which equals $120,000. (Keep in mind that if you’re 60 you can’t get the max…you’re more likely to get 20-25%. The older you are under CHIPs underwriting guidelines, the more you qualify for as it creates less risk to you AND the lender).

    Typical home appreciation over time = 4%. CHIP interest rates currently – 8.95% (although there are less expensive options based on Prime).

    Just using simple interest for now – if the $300k appreciates at 4% then the value goes up by $12,000 per year (more if you’re compounding annually). $120,000 at 8.95% is $10,740 in interest annually. So, even if you did get the maximum of 40%, your likelihood of rapidly reducing your principal is very small – especially when you’re probably 80 years old or more to get the max loan.

    There may be some equity erosion, but I think it’s false to claim that everyone who does a CHIP will leave nothing to the next generation. It’s its entire history CHIP tells me they’ve only ever had negative equity situations twice – and those are guaranteed by CHIP.

    Let’s think about the logic, setting aside the math for a moment. Would CHIP put people in a product that’s almost guaranteed to erode not only the equity, but CHIP’s security? That wouldn’t be a very prudent move. In all likelihood, CHIP intends to stay in business for a long time…so a complete erosion of their leverage would be catastrophic.

    One final comment…most of the reverse mortgages we’ve been doing for folks through our Horizon Equity division have been for folks who either want to access the funds for investment purposes, are retired and want to improve their cashflow (and don’t qualify for a traditional mortgage because of the lack of income) or who are, unfortunately, in a position where their only remaining asset is their home. No income, no investments, and want to stay in the home you’ve lived in most of your adult life…what would you do?

    I hope this helps. I’m glad you took on the subject but I think it’s important to have all the details.

  9. Thanks for the feedback.

    Say the homeowner borrows $120k @ 8.95% compounded semi annually, and the home appreciation @ 4% compounded annually. The values are:

    Loan Owed: $288k after 10 years, Home Value is: $444k
    Loan Owed: $446k after 15 years, Home Value is: $540k
    Loan Owed: $691k after 20 years, Home Value is: $657k

    Yes, you are right in the fact that at the 10 year mark, there “may” be equity left in the home assuming that your appreciation numbers are correct. Problem is, we are making assumptions that there is going to be appreciation during those 10 years. Where the mortgage rate is a guarantee. What happens if the house needs major repairs during those years (likely)? Where will the money come from?

    Also, as we can see above, as the reverse mortgage approaches 20 years, the equity is completely wiped out.

  10. I have to admit, I have never understood the negativity around the idea of reverse mortgages – what is wrong with a senior wanting to “partially sell” or “pre-sell” their house if they choose?

    I don’t see any better alternatives for someone who wants to stay in their house. Downsizing and taking in roommates? No thanks.

  11. Awesome – thanks for doing the real numbers.

    Ultimately we’re both right – the challenge is in the assumptions. IF someone borrows 40% of their equity AND lives in the home for 20 years, THEN they won’t have any equity left (but CHIP will make sure they don’t owe anything).

    I guess CHIP knows that the likelihood of that happening is pretty slim or else they wouldn’t be in business. That’s why the older you are, the more you can borrow. They know that the likelihood of an 80 year old living in the home for another 20 years without needing some sort of long-term care (i.e. having to sell) or dying is pretty slim.

    I guess that’s why they hire actuaries. For little to no risk at all a Senior who either needs or wants to access the equity in their home (i.e. their own money) can do so without paying tax on it (unlike an RSP) and can drastically improve their personal cash-flow or they can invest (maybe purchase some sort of life insurance policy perhaps?) and do it all without having to qualify on income or credit.

    Not for everyone, but it’s a good tool for the right people.

  12. 12. Steve

    I’ve always thought these reverse mortgages were stupid, however something occurred to me while I was reading the comments that I had missed previously.

    I always thought, if you are a Sr, and you own your home, why not just mortgage part of it to get the cash? Yeah, you have to make monthly payments, but considering the difference in interest between conventional mortgages and the CHIP ones, it always seemed with CHIP like YOU WERE PAYING HUGE INTEREST TO AVOID THE FEELING OF MAKING MONTHLY PAYMENTS.

    From this perspective, these CHIP products seem utterly unnecessary.

    However, I had never considered before that Sr, who are living mostly off CPP and OAS can’t quality for any conventional lending, HELOC or mortgage, even if they have no debt.

    The reverse mortgage in this case may be the only option.

  13. Although this is a viable option for the senior people I see to too “expensive” to just have the comfort of living in your old home.

  14. 14. cannon_fodder

    Steve,

    Your idea is similar to mine. If you set up a HELOC on your house long before retirement, then you should be able to proceed. And, you take money out only in installments with a HELOC – you don’t have to take out the entire $120k as in the example posted by FT.

    Here is an example. Imagine a $300k house that appreciates at 4%/yr annually and you can get a HELOC for 6% compounded monthly. You take out $1,000 each month plus any accrued interest charges. For this example, there is no increase due to inflation. One could argue that is realistic (as we tend to get older overall expenses tend to go down and this is to supplement income rather than be the prime source).

    Here is what we have:

    Year……….House Value…………. HELOC balance……….House+HELOC

    0……………$300,000………………..$0………………………..$300,000
    5……………$363,805……………….-$68,428…………………$295,377
    10………….$442,624……………….-$162,069……………….$280,555
    15………….$538,520……………….-$288,377……………….$250,143
    20………….$655,192……………….-$458,747……………….$196,445

    Now, even though you still have about 30% equity in the home, the interest costs alone are going up so fast that even if you stopped taking out your $1,000 every month (which wouldn’t be worth much 20 years from now) in year 21, you would hit that 20% threshold before year 25.

    But, at least you could sell the house and still walk away with some money (albeit probably it would be worth at least 40% less in today’s dollars due to inflation).

    If you only needed $10k/yr additional income then with everything else the same, you could do this for 40 years no problem.

  15. 15. Sam Li

    I wouldn’t take reverse mortgage unless I had no choice. And as it’s known you always have a choice. :-)

  16. 16. Gates VP

    The CHIP stuff seems like a clear case of last resort to me.

    This falls under the “I have no other income” camp.

    As mentioned, there are lots of options that honestly sound good to me: like downsizing the home. Most family homes aren’t built for seniors anyways. Too many stairs, high cupboards, requirements on lawn care and snow-shoveling and more space than two people really need.

    And really when you have nothing but time, the most important thing is having friends and family around.

    Yes there are exceptions everywhere. But I just don’t see many people living healthy lifestyle actually needing the CHIPs.

  17. 17. Houska

    Interesting discussion. I am also struck in the huge 3% interest rate differential between the reverse mortgage and the HELOC. I don’t know how much of that is profit and lack of competition versus how much is appropriate premium for risk that CHIP is taking (the risk that the mortgagor will live long enough to wipe out all equity and more, essentially).

    Two clear lessons -
    - Near-retirees who at all contemplate eventually “cashing in their house” for living expenses should make sure to set up a HELOC or a “umbrella” type mortgage (like Scotia STEP or other comparables) while they still have solid income
    - Seniors who are exploring a reverse mortgage who do have heirs could – if their family circumstances allow – explore formally or informally arranging an income stream direct from the heirs, since the family might either be well prepared to loan the money at a lower rate of interest, or alternatively “investing” in Granny’s house at 8.95% might be a good investment for the family if they do have investable cash flow they will not need for many years.

  18. 18. Daniel

    As it is right now I do not have any liquid equity in my house. It is all tied in with a Smith Maneouvre that I plan to keep in place until I die at the age of 130.

    I have a $200k loan against my house at this time. With the loan I purchased a fund that pays me $2300 a month. I pay the interests, and pay down my mortgage with the rest. I should be done paying the mortgage part in about 15 years leaving me with a Investment loan of $200k and a portfolio of $200k at market value and $1200 net cash flow each month.

    Man I wish they’d thought this stuff when I was in school.

  19. 19. Steve

    Daniel,

    you have a fund that pays out 13.8% gross return per year? Your post implies this payment is fixed or very secure. (12*2300/200,000 = 0.138).

    Are you sure your fund distributions are not mostly Return of Capital?

  20. 20. Jamie

    13.8% per year means high risk, and/or return of capital, without a doubt.

    Doesnt’ seem very wise to use all of your home equity to gamble with, in a time when house prices are dropping.

  21. 21. Nanaimo

    I think it is also worth noting that if the homeowner enters into the reverse mortgage and then decides that they made a mistake, there are significant prepayment penalties to pay when paying out the lender.

  22. 22. c nusm

    The senior should be aware of their cost to setup
    a CHIP reverse mortgage, now around $2500+

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