Avoiding the traps surrounding reverse mortgages

Financial advisers will still need to be very cautious in recommending reverse mortgages to their senior clients, despite the proposed protections around this product. Anna Mirzoyan writes.

Reverse mortgages offer asset-rich but income-poor homeowners the option to borrow against the equity they have built up in their home to improve their standard of living in retirement.

Whilst there are variations in the product features in the marketplace, they all allow repayments to be capitalised on the loan, therefore don’t require the borrower to make any repayments (principal or interest).

Importantly though, once the homeowner decides to sell or the last surviving borrower passes away, the outstanding loan (which includes compounded loan repayments) needs to be repaid.

The Consumer Credit and Corporations Legislation Amendment (Enhancements) Bill 2011, which was introduced recently, amends the National Consumer Credit Protection (NCCP) Act 2009 and relates specifically to reverse mortgage contracts.

The proposed Enhancements Bill 2011 introduces new obligations for persons who engage in credit activities in relation to reverse mortgage contracts. 

The key elements of these requirements are: 

• Specific obligations will be introduced on credit providers and persons engaging in credit services in relation to reverse mortgage contracts. This includes ensuring the homeowner has received legal advice before entering into a contract; and using a website approved by the Australian Securities and Investments Commission (ASIC) to show borrowers projections of the potential effect a reverse mortgage may have on the equity of their home and also provide the borrower with a copy of these projections.
• Licensees must ensure the borrower is provided with sufficient information to be able to make an informed decision before entering into a reverse mortgage contract. They must also ensure an information statement is available on their website or upon request by a consumer.
• Introduction of a no negative equity guarantee protection, through a prohibition against credit providers requiring or accepting repayment of the loan for an amount which exceeds the market value of the mortgaged property.
• New obligations will be introduced on credit providers where they have given a default notice to the borrower. The credit provider will have an obligation to contact the borrower in the event of default and ensure they understand they are in default and therefore provide them with an opportunity to rectify the default.

Who are reverse mortgages appropriate for?

As noted earlier, reverse mortgages may be appropriate for retirees who have equity in their home and would like to increase their standard of living.

Reverse mortgages may also benefit those who:

• Need urgent access to money for a special purpose such as medical expenses, travel, home improvements or the purchase of a vehicle;
• May be considering downsizing to improve cashflow in retirement, but would prefer to stay in their home. It should be noted that by taking out a reverse mortgage, additional issues arise.
  Reverse mortgages can impact the value of the estate left behind. It is possible that there would be no equity left in the property when it is eventually sold. Therefore, it is important to involve the family when considering taking out a reverse mortgage.
• In an environment of rising interest rates, borrowers need to be aware that the compounding effect of interest charges and fees capitalised can cause the loan to balloon to unforseen levels in a very short period of time.
  For example, at an interest rate of 8 per cent per annum a $50,000 loan could become $87,000 in seven years or $111,000 in 10 years. At 9 per cent per annum a $50,000 loan would become a debt of $93,000 in seven years and $122,000 in 10 years. 
• There may be periods of time where properties actually decrease in value, which will result in a reduction of the value of the remaining equity.

Features of a reverse mortgage

Interest rates on reverse mortgages are generally higher than standard home loan rates. The rate can be fixed for a term or for the life of the loan or be a variable rate. Repayments may be made at any time, but some providers may have additional charges in such instances.

The no negative equity guarantee is a vital feature where a reverse mortgage loan is being considered as it ensures that the homeowner (or their estate) can never owe more than the value of the home, no matter how long they stay in the home.

However the guarantee is dependent on borrowers’ meeting the terms and conditions of the loan, such as keeping the home insured and well maintained. 

Another feature that is available is the protected equity option. This feature allows homeowners to ensure they retain a portion of the home's future value upon sale.

This feature can be particularly attractive where the homeowner is concerned about leaving an inheritance.

The protected equity option ensures the family will receive a pre-determined amount of the equity regardless of what happens to the balance of the loan or property prices in the future.

However by taking out the protected equity option, the maximum amount that the homeowner can borrow will be reduced.

For example, if the homeowner wishes to ensure that the beneficiaries of their estate receive 20 per cent of the future sale price of their home, they need to choose a protected equity option of 20 per cent. However, this will reduce the maximum amount they are eligible to borrow by 20 per cent.

Impact of reverse mortgages on Centrelink Age Pension

If an age pension recipient receives a reverse mortgage, the amount drawn is not counted as income by Centrelink.

However, the amount drawn may be subject to Centrelink means tests when the amount is held as a financial investment. 

In general, when the reverse mortgage is drawn down in small amounts and used to meet everyday living expenses, then it should not affect the borrower’s eligibility for the age pension.

If, however, it is accumulated or the entire amount is drawn, then it may have an impact on the borrower’s eligibility for the age pension. 

Where a large amount is drawn, Centrelink allows up to $40,000 be exempt from assessment for up to 90 days. After that period has elapsed the entire amount (if unspent) will be subject to Centrelink means tests. 

For example, if a person takes out a home equity conversion loan of $80,000 and leaves the proceeds in the bank account, then:

• The first $40,000 is exempt from Centrelink’s means tests for 90 days
• The remaining balance of $40,000 would be counted towards the Centrelink means tests from the day the funds are received. 

Once the 90 days has elapsed then the whole balance of $80,000 (if it remains unspent) will be subject to the Centrelink means tests. 

The homeowner status under the assets test will not be affected by taking out a home equity loan. 

Summary

When a reverse mortgage is taken out against a client’s property, it is important to be aware of the possible consequences, such as the compound effect of interest charges, property prices, family and estate planning issues and the impact of capital drawdowns on a person’s Centrelink Age Pension assessment. 

Anna Mirzoyan is a technical services officer at Fiducian Portfolio Services.