How does a Reverse Mortgage (“RM”) work?
It is a mortgage loan, usually secured over a residential property, that is typically available to older homeowners over the age of 60.
It enables access to funding using the unencumbered value of a property. The credit provider does not mandate regular loan repayments. Rather, interest is calculated on the balance outstanding, and added or “capitalised” to the loan on a monthly basis.
Due to this capitalisation, the starting LVR (“Loan to Value Ratio”) is much lower than a typical home loan. Typically this is capped at around 40% of the property’s independent valuation.
RM’s usually offer multiple draw-down options, including a lump sum advance, regular advance or a reserve facility.
In most cases, loan repayments can be made any time or the loan paid off in full without any penalties.
The mortgage must be discharged when the last borrower moves permanently from the home. This may be when the property is sold, or when the borrower moves to aged care or passes away.
After the withdrawal of many participants (including major banks) from the segment, the RM market is now typically the domain of specialist credit providers.
The spread in Interest Rates between a home loan and a RM has pushed out from around 1.5% to around 3% in recent times. This means an interest rate in the 6-7% range with application fees. This premium in rate must also be considered in the light that the average loan amounts are considerably smaller than traditional mortgages.
Borrowers are generally required to seek independent financial and legal advice as part of the process too, which adds another cost to the borrower.
As an initial comment it is obviously critical to get the right advice. Some outcomes for the borrower include:
– Customers can fund home improvements, consolidate debt, upgrade a motor vehicle, etc.
– Allows existing income to be supplemented and improve the quality of retirement.
– Peace of mind to protect against for future needs such as medical expenses.
– Still get the benefit of growth in property value.
Whilst there are benefits, borrowers must be wary of the growth of their loan balance when interest is capitalised. This obviously can defray the available equity in their home.
ASIC have some great resources on their website including a calculator below. Consider an example:
John & Sandra are both 67 years old. Their home is currently unencumbered and is valued at $1,000,000.
They seek a lump sum advance of $250,000 (Representing a LVR of 25%) with the following terms:
8.50% Average Interest Rate (Applying a Buffer to the current rate)
Projected Capital Growth of 2.0% per annum
If this facility pushed out for 15 years (to age 82), with no loan repayments their financial position would have the following profile:
Projected Home Value: $1,345,868
Owe to Lender: $890,663
Net Home Equity: $455,205
Loan to Value Ratio: 66.17%
The example is a reminder that good planning and forecasting is necessary should you access one of these products.