Beware rising costs of reverse mortgages
By Nick Bruining
When there is no magic cash pool to dip into, your choices become pretty limited in retirement.
You can release some cash by selling your home and move into cheaper digs, or you can use the equity you have built in your home to take out a reverse mortgage.
The Australian Securities and Investments Commission released a report last week confirming that while reverse mortgages can be good if used well, there are risks that many folk do not understand.
“There is a short-term, longterm trade-off here,” report author Michael Saadat told Your Money. “The lifestyle choice of today, in 20 or 25 years, could have consequences that need to be considered.”
A reverse mortgage allows you to borrow against your home without making loan repayments.
The interest and ongoing charges are added to the principal and when the property is sold, the total amount owing is repaid.
Interest rates are typically one or 2 per cent higher than a normal mortgage interest rate
The magical effects of compounding interest for investors can become a nightmare of epic proportions for borrowers when interest is added to interest.
Borrowers can typically choose a lump sum amount, a regular drawdown amount or in some cases a combination of the two.
In the confusing world of finance, this looks like an easy option that can create unintended consequences, particularly for those getting a Centrelink pension.
In most cases, the security used for the reverse mortgage will be the family home.
It might seem perverse or unfair but taking out a reverse mortgage can see you lose that pension.
Let’s take a couple that needs $100,000 to help out a child that is in financial difficulties. The decision is made to leave the $350,000 they have invested in an account-based pension alone and to borrow $100,000 using a reverse mortgage.
To their horror, they realise that under the gifting rules, the $100,000 handed over to the child will see $90,000 counted as a gift for five years. That reduces the pension by a sizeable $270 per fortnight, or will cost them more than $35,000 in lost pension over the next five years.
That’s because the reverse mortgage debt is not offset against the asset.
Why? Any debts secured against the home do not count because the home is not counted under the pension assets test.
In Centrelink’s mind, neither the home nor the debt exist.
There is a key rule at play here.
In cases involving Centrelink benefits, use almost any other method available to raise funds and treat a reverse mortgage as a last resort.
You can borrow from family.
A new car funded by a documented loan from the kids can have its asset value offset by the loan.
The net effect on Centrelink benefits of the debt-funded car? Nil.
You can use your super and savings ahead of a reverse mortgage. The reverse mortgage can always be the tool of last resort anyway.
The interest costs of the reverse mortgage will be greater than the earnings on your investments on a risk-to-risk based measure.
For example, the best term deposit at present is about 2.8 per cent but the best reverse mortgage rate is 6.24 per cent.
Many discover the nightmare of compounding interest when it comes time to downsize or move into aged care, particularly if you need a big refundable accommodation deposit to get the right place.
The longer the loan runs, the greater the compounding effects of the the interest. I have seen a $50,000 reverse mortgage turn into a $129,000 debt after just 10 years.