What do you think about when you hear the word “mortgage”? I think most people visualize a youngish person or a couple borrowing money to buy a home. A mortgage loan has an interest rate, amortization, terms and conditions, and a payment amount. Over time, as they pay down the mortgage it gets smaller and smaller until one day they have a mortgage burning party. Let’s call this traditional way a “forward mortgage”. The prevailing mentality of homeowners is to pay down this mortgage before retirement, otherwise, I’m going to have to keep working to make the payments. After all, there are only so many Wal-Mart greeter positions around.
Now, what do you think about when you think of “reverse mortgages”? For many, I think there is a level of discomfort, people tend to think its supposedly only for desperate situations. Perhaps you think it means losing ownership of the home or being subject to the whims of the bank. You may have heard horror stories from the U.S. media about homeowners being bilked from their hard-earned property.
Perceptions aside, I want to show you how a reverse mortgage actually works and how they can act as an effective solution for accessing your wealth.
First, let’s look at two stereotypical examples that would greatly benefit from a reverse mortgage:
- Fred, age 79. He has worked and lived in his home for 30 years. He does not have much savings left and has relatively low monthly pension income. He’s facing increased medical care costs because he needs a home caregiver to help him and also needs to repair his house. He really doesn’t want to move to a nursing home and dreads the thought. What he does have is some equity value locked away in his home. This is perfect for a reverse mortgage. He’ll receive some upfront funds to make his renovations and/or monthly income to live on and pay his caregiver.
- Ethel, age 88. She wishes to see her legacy in action. For her, she resonates with the saying… “do your giving while you’re living, so your knowing where it’s going”. Traditionally, we wait until we die and then leave our financial assets to those as directed in a will. However, a reverse mortgage can enable Ethel to see her legacy lived out through gifts to kids, grand-kids, charities, or churches.
For others, the issues and solutions may be subtler: it might be that someone retires and can’t afford their current mortgage payments, it may be a renovation on the home is required or it could be as simple as needing some money to join a country club, money to travel the world, etc.
What is a reverse mortgage?
Essentially, it’s the same thing as a regular mortgage - a loan secured against the value of your home. However, it has a huge difference: you are not required to make mortgage payments. It’s called “reverse” because you are taking equity out of your home instead of building it up. Perhaps it should be call “backwards mortgages” because it’s in the backwards direction of the traditional mortgage.
With a traditional “forward mortgage”, what happens when a borrower loses his/her job and is unable to make mortgage payments? Assuming they can’t work out a temporary solution, the bank will initiate a power of sale proceedings in order to take possession, sell the home, recover the outstanding debt. Any remaining proceeds after fees are paid to the homeowner. If you’ve never witnessed the stark reality of how shocking this can be to homeowners, you should watch the first 20 minutes of the movie 99 Homes.
With a reverse mortgage, there are no payments to make. Obviously, it’s not free so, how is the interest paid? The interest cost simply gets capitalized (added on top) onto the loan amount. Won’t that be a problem and won’t the bank come knocking eventually? No, the rules of reverse mortgage state that you will never be forced to sell your home.
In Canada, with a regular mortgage, you borrow a certain amount and gradually pay it back throughout the amortization (the life of the mortgage). Not so with a reverse mortgage. The bank advances you a lump sum or in stages and you make no monthly payments. As a result, the accrued interest is added to the loan balance, and the mortgage steadily grows.
For most people, it is counter intuitive to everything we are taught which is to pay off your home mortgage first and retire on your savings. However, the reality is “life happens” and everyone’s situation is different.
When are they appropriate?
I like to think of reverse mortgages as a compassionate product of sorts. It unlocks the money in a home without selling it so that a real life financial problem is resolved. It does this without any consideration of the usual lending qualifications such as income and credit scores. Real life problems happen and many are financial in nature.
What are the advantages of a reverse mortgage?
The property’s title stays in the owner’s name. It can never be sold or foreclosed by the bank. Ever. The only time it comes due is when the owner dies or decides to move. Other advantages are:
- No monthly payments
- It is not taxed
- Does not affect any other benefits such as Old Age Security (OAS)
- Flexibility to receive a lump sum and/or regular monthly amounts
What are the downsides?
The biggest typical concern as financial planners often say, is the compounding effect. It can have negative consequences towards equity growth. This is due to the compounding of payments which reduces available equity when you die. But isn’t this the point?! You can’t take it with you so you might as well spend it. Maybe the children whom are eagerly waiting for their inheritance don’t want to see their parents spend it.
Other concerns can be a higher interest rate than a traditional lending product. At current time, the variable rate for a reverse mortgage is roughly Prime plus 2.29%. This is higher than the rate on a secured line of credit by 1.49%. Taking into consideration that the product does not require interest payments, it’s non-callable by the bank, and doesn’t require underwriting, it’s actually a very reasonable rate.
What about escalating payments and fees/costs associated with having a reverse mortgage? These are disclosed up front and applicants are not charged unless they decide to proceed with fee triggering transactions. Besides, many of the fees are the same as one would encounter with a traditional home loan therefore not exposing you to unfair costs.
Who is eligible for reverse?
- 55 years or older (no maximum age)
- If joint, both registered owners must be 55 or older
- No income requirements
- Must be a first position mortgage (not a second)
- All taxes are up to date
Are they provided by a safe financial institution?
Reverse mortgages in Canada are funded by HomEquity Bank. They are a schedule I Canadian Bank in operation for 30 years. They are regulated by the same stringent regulator of all Banks – OSFI (Office of the Superintendent of Financial Institutions) which have a firm grip on the safety of our banking system.
Fixed Rate Update
Fixed rate mortgages are heavily driven by the yields in Government of Canada (GoC) bonds. The bond yield of the 5 year (GoC) bond has increased significantly in the past two weeks in anticipation of the Bank of Canada raising the overnight rate. On June 4th the bond rate was 0.96% and as of today it is 1.44%. The rates offered vary from lender to lender and depend upon the factors such as transaction type, product features, insurability, amortization, LTV, credit score, closing period, etc. Today, I’m seeing a range in 5 year rates from 2.34% to 2.99% in the marketplace.
Variable Rate Update
Variable rate mortgages are based on the prime rate of the lender. The common prime rate with lenders is 2.70%. The Bank of Canada is next meeting on July 12 and it’s expected rates will increase a bit. The discount to the prime rate varies from lender to lender and are impacted by many of the same factors as fixed rate. The rates offered on variable rates can be had for as low as 1.90% to 2.40%.
About the Author:
Ian Mucignat, CFA, is an independent mortgage agent at TMG The Mortgage Group. He graduated from Wilfrid Laurier University with a Bachelor of Business Administration, minoring in Economics and is a CFA Charterholder. Ian has worked in the mortgage industry since 2000 at lenders, banks, and brokerages. If you are purchasing, renewing, or refinancing your mortgage don’t hesitate to contact Ian directly for a free consultation.