In a recent conversation, someone I know shared that their in-laws had taken out a reverse mortgage. And now, years later, the family is trying to piece together what to do next.
Years ago, the family noticed the in-laws seemed to be living more freely with their cash. But later, they turned to their family for advice when a costly home repair came up. Now the in-laws carry a new debt, owe more on their property and struggle to keep up with the maintenance costs on their limited income.
Why have reverse mortgages become so popular recently?
The answer is worth sharing because more retirees or adult children of elderly parents should understand the financial implications.
What is a Reverse Mortgage?
Strip away the marketing language, and a reverse mortgage is a loan that lets you borrow against the equity in your home.
In Canada, you can access up to 55% of your property's appraised value, dependent on the financial institution’s approval. No monthly payments are required. The loan balance grows over time as interest compounds, and the full amount is repaid when you sell the property, move out permanently, or pass away.
The two parties in the agreement, the financial institutions and homeowners, are expecting that the property will hold or increase in value over time and that the homeowner can afford the expenses.
This arrangement appeals to individuals with limited incomes. They also usually do not want to move. They may feel emotionally attached to their home and imagine they can easily manage the property.
Two Choices for Cash From Your Home
Anyone considering a reverse mortgage is simply looking for a source of funds. The reverse mortgage appears to be an elegant solution to keep your home and get paid from it.
But anyone at this financial crossroads should be aware that there are two different paths to choose from, with different implications.
Option One: Take the reverse mortgage.
Retain ownership of the property. Receive up to 55% of its appraised value. Stay as long as you are able. Repay the loan when you sell or leave, with compounded interest at a rate that is always higher than a regular mortgage.
Option Two: Sell the property.
Receive 100% of its value. Make investment decisions on your own terms, with full control of the capital and no compounding loan working against you in the background.
Consider the Higher Interest Rates
Interest rates on reverse mortgage products are higher than conventional mortgages because lenders assume greater risk and charge accordingly. Current rates could be as high as 9%. But for this scenario, let’s assume a 7% interest rate.
Imagine a 60-year-old homeowner in Calgary with a $1 million property. In Canada, the maximum reverse mortgage borrowing amount is 55% of the property's value, providing the owner with $550,000 in cash.
At 7% interest, compounded annually over 20 years, the $550,000 loan grows to approximately $1,023,000.
This means the home must sell for more than $1,023,000 to break even.
Whatever remains after repaying the loan goes to the borrower or the estate.
At 9%, the same loan grows to roughly $1,347,000 over 20 years.
This person will also pay property taxes and maintenance costs, which are likely to increase each year and continue annually.
Lender can force a sale
Some people think this might never happen, but in a worst-case scenario, if a homeowner cannot pay property taxes or maintain the property to the lender's specifications, the lender has the contractual right to force a sale.
Fast forward, and now the borrower is 80 years old. They have spent the original $550,000 over two decades. This person could find themselves with no funds to cover a $10,000 property tax bill or to keep up with repairs. Failing to maintain the property may devalue the home.
The worst-case scenario is that the homeowner spent all the loan money and needs to vacate the home, which sells for less than expected.
Timing Tricky When Health a Factor
Reverse mortgages are presented as an easy option before committing to downsizing. The promise is to stay in a home for as long as possible, which, for some, fulfills a wish to maintain or upgrade their lifestyle and avoid change.
For these people, the extra cash may feel like a well-deserved treat to spend on travel or something else.
Aging adults might look for extra cash if they suddenly face a difficult health period to help cover care costs.
On paper, this looked like a reasonable plan for a widow I know who entered into a reverse mortgage for some financial breathing room while caring for her husband before he passed.
Years later, she realized how quickly the mortgage debt had grown from the higher-than-expected interest rate. Making matters worse, her property value plateaued.
To eliminate the loan, she sold most of her investments to pay off the mortgage. She walked away holding onto her house. Fortunately, she remained healthy and stayed in her home for another 15 years.
By this time, the property market had improved, and she ultimately sold the home, walking away with $700,000. She was able to move into assisted living at $5,000 per month.
Her situation was saved by closing out the reverse mortgage. Had she continued with the loan as long as the bank allowed, without paying it off early, her options for housing and care would be limited at a time when she was most vulnerable.
The Strategic Alternative
Downsizing is a hard conversation for some.
Many retirees wish they had made the move sooner. Once they make the change, they realize how a simpler workload saves energy and cash that they can direct into healthy pastimes. Downsizers also find new communities where their neighbours are also retired, and they suddenly find themselves surrounded by new social connections.
Moving is easier for people who are still healthy and mobile. If you have family nearby, you might be surprised by how supportive they become regarding your fresh start. They may also be willing to help with downsizing or tasks related to selling.
When you consider downsizing, you get 100% of the property's value after your expenses. It gives you more options for reinvestment and managing expenses.
Getting out of a Reverse Mortgage
A reverse mortgage is not easy to undo. Once the agreement is in place, unwinding it requires satisfying a series of conditions, which may include penalties, legal costs, and full repayment of the balance. Always read and understand the fine print.
What is right for you?
A reverse mortgage is a specific tool that can serve a specific purpose in specific circumstances. It comes with obligations you will want to carefully understand.
You can keep your home and borrow against it with a compounding loan. Downsizing means you sell the property, take the full value, and make decisions when time and finances are on your side.
Whichever direction appeals to you, first get independent advice from professionals and a discussion with trusted family members, and consider all potential outcomes.
