Reverse mortgages: badly judged or just misunderstood?

The reverse mortgage market has faced a great deal of criticism over the years. Angela Faherty looks at the issues facing the sector and asks whether it can ever shake off its bad reputation.

Reverse mortgages are often condemned as risky and complex financial products.

Consumers have very little understanding of these retirement solutions and what they can offer and many financial planners have generally given them a wide berth, opting instead to concentrate on an investment portfolio that focuses on wealth generation rather than retirement planning.

Add to the mix the negative perception of reverse mortgages in the mainstream press and the frequent debates at industry and government level on the risks associated with the products and it is no wonder the market is in something of a quandary.

Yet in spite of all these factors, the reverse mortgage market is growing and demand for information from clients is also becoming more frequent.

According to the Deloitte SEQUAL Reverse Mortgage Study, the reverse mortgage market consisted of 38,000 reverse mortgage facilities with a total value of $2.6 billion at the end of June 2009, up 5 per cent from December 2008.

This represented a total of 2,350 new borrowers in a half-year period.

Growth in the sector shows the reverse mortgage market certainly offers potential and many Australians approaching or in retirement are exploring alternative avenues to finance their latter years.

So why is the sector tainted with a negative image and why have so many financial planners previously shied away from a market that seemingly offers a wealth of untapped potential?

Kevin Conlon, chief executive officer at SEQUAL, says one of the reasons lies with the scope of advice expected of the financial planning community.

“On the whole, advisers should have seen this coming and should have been adopting a more holistic financial plan for consumers where the family home and the retirement options were included.

"Cash flow, not asset wealth, is the problem many retirees are now facing and this is a result of having a financial plan that does not look at the whole picture.

"That said, I have sympathy for advisers in the current environment as there is, and has been, no guidance on what is expected of them when it comes to providing advice on this topic.”

Conlon’s point rings true when the longevity risk facing this country is taken into account. Australia is currently in the midst of a demographic shift, with an ageing population and a diminishing tax base poised to present a significant systemic challenge within the next 20 to 30 years.

Currently, 42 per cent of the workforce is from the baby boomer generation and will be subsequently entering retirement within the next 20 years.

This, combined with the fact that 72 per cent of Australians own their own home in addition to the fact that there is an estimated $349 billion in equity in those homes belonging to the over 60s, means tapping into this equity is a plausible solution.

Simon Dehne, national manager for non-core products at Mortgage Choice says: “All the figures point to the fact that there is certainly a market for reverse mortgage products in Australia.

"On paper it looks like a simple product, but the problem in the past has been that people have not understood how the product works and the risks that are involved.

"For many, the family home is the one major asset many hold, but the emotional weight it carries means this is a very delicate subject matter,” Denhe says.

The complexity and risks associated with the reverse mortgage market is a constant battle for the sector, yet getting to the heart of this problem is no mean feat.

Clearly, as statistics show, the demand for the product is there, but past miss-selling practices and negative press have badly tarnished the sector’s image.

Paul Intagliata, lead financial adviser at Aged Care Financial Services says if the problem posed by an ageing population is to be addressed, education and improved access to these products is essential.

“There has been a lot of negative press surrounding reverse mortgages, and rightfully so.

"In the early days the products were sold through door stepping mortgage brokers who did not necessarily have a full understanding of the product.

"Nor did they provide the adequate explanation of exactly what the products entailed. However, there has been some change with regard to this and with an increased interest from clients, the Government and the industry as a whole, things look set to change,” Intagliata says.

One of the key problems facing the baby boomer generation as they approach retirement is the inadequacy of the age pension.

This combined with insufficient savings and any debt that may have been accumulated over the years may prompt some retirees to seek an alternative form of revenue in order to maintain their existing lifestyle.

Michael Sherris, Professor of Actuarial Studies at the Australian School of Business, University of New South Wales says it is here that reverse mortgages can play a role.

“The reverse mortgage market is growing and has the potential to grow further, typically because it offers large potential to unlock wealth.

"Australians across the board have $3.3 trillion tied up in dwelling ownership and almost half of their assets are locked in the family home, and as the age pension is not enough, an increasing number of people are looking at the wealth in their homes as a means of financing retirement,” he says.

Despite having its staunch critics, Professor Sherris says reverse mortgages are a valid product, provided consumers are advised on the product and fully understand what it means both financially and emotionally.

“The problem is that people are not familiar or comfortable with the nature of the product and that has been a major stumbling block in the market.

"There are lots of risks involved, such as paying a higher rate of interest than the house price growth rate.

"Similarly, not paying it back will result in compounded interest, and that can amount to a lot if you live longer than expected and the debt starts to accumulate,” he says.

The fact that people do not understand the products suggests that those selling them have not been doing a good job of educating clients on the pros and cons of reverse mortgages and, as a result, the products have been much maligned. In fact, the risks associated with reverse mortgages have been so well documented that the subject matter is accompanied by a great degree of cynicism across the board.

Consumers have been warned about the perils of taking out a reverse mortgage too early and potentially running up a debt that could result in the loss of their home.

Lenders too have been warned about the risks associated with covering the costs of reverse mortgages.

Earlier this year, the Australian Prudential Regulation Authority (APRA) issued a word of caution to lenders, instructing firms to keep capital levels topped up in order to cover their exposure to the loans.

The recommendation was a blow for a market already suffering from the effects of low capital, tightening credit margins and dampened profitability — triggers that prompted the market withdrawal of major player RBS a few months earlier.

Many other lenders have also pulled out of the market as the tightening of belts has forced many lenders to reassess core business models.

However, RBS has said it hopes to return to the market in the medium term, an indication that perhaps strengthens the belief that the market is headed for future growth.

While the market may be experiencing something of a temporary blip in terms of limited choice as a result of lender withdrawal, it is clear that foundations for future growth in the reverse mortgage market are being laid.

Therefore, understanding the issues surrounding the market is vital.

At the most basic level, reverse mortgages are easy to understand.

The client takes a loan out on the value of their home in the form of a lump sum or regular income while accumulating a debt on the loan.

The debt can be repaid early or can be repaid using the value of the home on its sale or on the death of the owner.

However, as with all financial products, things are not always as simple as they seem.

In addition to the higher interest rate and the risk of accumulating substantial debt by taking out a loan too early, there are many legal requirements and contractual issues associated with the products, Professor Sherris says.

“People taking out a loan should be made aware of the fact that there are certain stipulations within the contract that need to be met, such as the fact that the house has to be maintained and kept to a certain standard and that it cannot be left vacant for longer than a certain period of time or there is a risk of repossession.

"These are significant and crucial points that must be explained to clients,” he says.

Dehne agrees the terms and conditions of the loan play a major role in determining whether someone should take out a reverse mortgage.

“Understanding the terms of the agreement is vital because should the borrower fail to follow the conditions of the loan, they could find themselves defaulting and in a whole world of trouble.

"Similarly, if they borrow the maximum amount at an early age and their lifespan is longer than they expect, the financial impact could be significant.”

The financial risks and costs associated with reverse mortgages have been well publicised.

“The typical rate of interest applied to the loans is higher than the average rate of interest on residential home loans and is currently around the 7.5 to 8 per cent mark,” Dehne says.

“Plus, the fees attached to the loan are more costly. It can cost anything between $1,000 and $1,500 to set up the loan and then there is the obvious compounded interest on the loan itself,” he says.

Dehne says loan to value ratios are usually offered at up to 45 per cent, with the average borrowed loan amount sitting at the $60,000 mark.

However, if borrowers do not understand what they are doing and take out the maximum amount on their property just because they can, it could leave them in financial difficulty.

For example, taking out a loan worth 45 per cent of the property value if a house is worth $1 million would result in a $450,000 loan, which may be far more money than the borrowers actually need.

Professor Sherris agrees. “It is important reverse mortgages are advised correctly and consumers know the full details of the loan. They need to carefully consider what they want the money for before they even think about how much they will need to borrow.”

Sherris’ point is backed by Dehne. He says: “Really, it is important that people work out what they want the money for before taking out the loan. That is why advice is so important.

"Consumers need to know what they want to achieve and why they want to borrow against their home before they even see an adviser.

"They need to consider what they are giving up, whether downsizing is a better option and what it means in terms of their estate. It is a very emotive issue.”

Giving up the family home or choosing to sell it is a highly sensitive issue, which is why it is indeed not a decision to be taken lightly.

One of the main problems with reverse mortgages has been the lack of education and knowledge of the products — a matter that needs to be addressed.

Previously, some financial advisers, consumers, the media and to some extent the financial services industry itself, view reverse mortgages as a disaster waiting to happen. But is this view justified?

Admittedly, the products are high risk, but that is not something that has ever been questioned. Even staunch advocates of reverse mortgages openly admit there is an element of risk attached to the products.

So if critics and supporters agree reverse mortgages come hand in hand with a degree of high risk, then what exactly should the industry debate? The answer, it seems, is education.

“One of the main problems with reverse mortgages so far has been that half the loans have been taken out directly with banks or brokers, and although information has been provided, it hasn’t been explained,” Professor Sherris says.

“The financial literacy of most Australians is very low and that is why it is so important to focus on the education side of financial advice. There has to be a better way to educate consumers and improve their financial literacy,” he adds.

Professor Sherris also points to announcements made by Prime Minister Julia Gillard for greater protection for consumers with a reverse mortgage and a statutory protection against negative equity as positive moves, but the industry itself has been actively following these measures for some time.

For example, all SEQUAL members provid a no negative equity guarantee (NNEG) to protect consumers from potential negative equity further down the track.

However, such measures still do little to educate and inform consumers about exactly what the products do — which it seems is the real issue facing the market.

The financial planning industry also needs educating, says Conlon, with many shying away from the products.

“Financial advisers have been missing in action from retirement planning and this attitude needs to change. By leaving out the family home in the majority of financial plans, advisers have ignored 70 per cent of an individual’s wealth, and as an industry we need to step up and get involved.”

Conlon says educating the industry can be challenging.

“It’s a narrow focus but it has a very broad reach and that is why the industry as a whole must work together.

"That said, we have sought the assistance of the Financial Planning Association (FPA) as a partner as well as the Mortgage & Finance Association of Australia (MFAA) and the Law Council of Australia to work together to try to stimulate discussion about how education among advisers can be achieved,” he says.

Conlon adds that tentative steps have been taken by the industry to improve rules and regulations and instil greater consumer protection, but admits significant change is a long way off. Nevertheless, progress is being made.

In 2007, the MFAA developed a code of practice for equity release loan writers to ensure consumers make fully informed decisions.

The process was designed as part of the association’s core education program and enables brokers to access greater knowledge and skills in the sector.

SEQUAL and the Law Council of Australia are also working collaboratively to develop a program they hope will set the precedent for legal advice on the subject. They plan to roll out the program in the early half of next year.

One of the problems at the moment, however, is the lack of clarity surrounding the advice process, Conlon says.

“It is understandable that in the current climate, these products are currently viewed negatively as there is no clear scope of advice.

"As it currently stands, advisers have to either provide limited advice or do a full financial plan if reverse mortgage and equity release issues are to be addressed.

"But often this isn’t what is needed, as many clients just want to get information for their retirement, so SEQUAL is calling on industry bodies to develop a scope of advice for equity release.

"By doing this, advisers will have a greater idea of what is expected of them,” he says.

A clear definition of the advisory process would certainly help to eradicate any confusion over what advice components are met.

It would also help to strengthen relationships between financial planners and legal advisers, who are also required to instruct consumers on the legalities of taking out a loan, as well as any third party brokers involved, a factor that has deterred many planners from advising on the topic, Intagliata from Aged Care Financial Services says.

“When people take out a loan they must also seek legal sign off as well as financial planner sign off, and I think this has added to the complexity of the advice process and the reason why many planners may have avoided advising on these products,” he says.

The complexity of both reverse mortgage products and its advisory process raises the question of whether there is a need for specialist advisers dedicated solely to this section of the financial planning market. As with most things in this sector of the market, opinion is divided.

“There is certainly scope for specialists in this area and a lot of financial planners are moving in this direction, but the most important thing is having a reliable professional correctly advising on the subject,” Professor Sherris says.

Intagliata disagrees, saying specialists are not necessarily needed.

“I don’t think there is a requirement for specialists in this area. If a financial planner working in this field has knowledge of credit related markets then they can advise on reverse mortgages. 

What financial planners should be doing is tailoring the advice process to each individual because like all financial services plans, it is all down to individual circumstances,” he says.

Whether the reverse mortgage market starts to see an emergence of specialist planners is anyone’s guess, but the sector is certainly starting to see an element of change.

With greater focus being placed on education and continued debate from industry and government surrounding the sector, the financial planning industry is certainly starting to pay attention to this niche area of the market.

Clearly those working in the sector are keen to alter the market’s perception and education is the key to tackling this.

The sector certainly has growth potential and the untapped source of wealth for financial planners and consumers is evident.

But whether the pull for information from consumers is enough to increase financial planner interest and alter market perceptions remains to be seen.