Reverse Mortgages

A reverse mortgage is a relatively new mortgage product that allows home owners to convert some of their home equity into cash.

It is called a reverse mortgage because the payment stream is essentially the reverse of the payment stream associated with a traditional home mortgage.

Back in the old days, when you could count the number of mortgage products on one hand, the standard home loan mortgage product was a credit fonciere loan. It had a variable rate of interest and was usually taken out to assist with the purchase of a home. The monthly payments were initially fixed at a level that would ensure that the loan was repaid over say 25 years. If interest rates rose, either the term of the loan was extended or the bank would tap you on the shoulder and require a higher monthly payment.

The first payment was mostly interest with a dash of capital repayment, while the final payment was mostly capital repayment with a dash of interest. After making the final payment, you owned the home, free and clear. Yippee.

A reverse mortgage is something entirely different. Rather than providing funds to assist with the purchase of a home, it is a way of releasing some of the value of the home without actually selling it. You borrow a specified amount and mortgage your home to the lender as security for the loan. Interest accrues on the loan and the accrued interest is added to the principal outstanding at regular intervals, usually monthly. In other words, the interest is capitalized. Interest then accrues on the original loan amount and the capitalized interest, and so on.

The loan is usually repaid from the proceeds when the home is sold, or using funds from other sources.

A quick comparison of the respective loan profiles for a credit fonciere loan and a reverse mortgage leaves little doubt as to why a reverse mortgage is called a reverse mortgage.

The main risks associated with a reverse mortgage are:

	the variable interest rate, which can obviously rise as well as fall
	the fact that interest is capitalized, which means interest accrues on interest
	uncertainty about how long you will live, or wish to remain in your home.

The following table illustrates how a base amount of $10,000 can grow over a ten year period at different interest rates, assuming that interest is calculated and capitalized monthly.

Year	5% pa	6% pa	7% pa	8% pa	9% pa	10% pa
0	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000
1	$10,512	$10,617	$10,723	$10,830	$10,938	$11,047
2	$11,049	$11,272	$11,498	$11,729	$11,964	$12,204
3	$11,615	$11,967	$12,329	$12,702	$13,086	$13,482
4	$12,209	$12,705	$13,221	$13,757	$14,314	$14,894
5	$12,834	$13,489	$14,176	$14,898	$15,657	$16,453
6	$13,490	$14,320	$15,201	$16,135	$17,126	$18,176
7	$14,180	$15,204	$16,300	$17,474	$18,732	$20,079
8	$14,906	$16,141	$17,478	$18,925	$20,489	$22,182
9	$15,668	$17,137	$18,742	$20,495	$22,411	$24,504
10	$16,470	$18,194	$20,097	$22,196	$24,514	$27,070

As you can see, the capitalized interest can rapidly eat into your home equity. The longer the loan remains outstanding, the faster the interest accrues at any given interest rate.

At the very least, borrowers and lenders must ensure that the amount borrowed is appropriate having regard to:

	the value of the home
	the short, medium and long term outlook for the property market
	the short, medium and long term outlook for interest rates
	the life expectancy of the borrower.

The following interactive calculator, which is provided by Artog, may be of assistance:

You should be aware of the impact the arrangement could have on your ability to make alternative accommodation arrangements in the future. For example, if you later wish to move to a retirement village, you may find that the net proceeds from the sale of your home, after repaying the loan and the accumulated interest, effectively limit your choices.

Similarly, you should be aware of the impact the arrangement could have on the value of your estate. The net proceeds from the sale of your home, after repaying the loan and the accumulated interest, may limit the amount that would otherwise have been available for distribution in accordance with your will or in accordance with the rules of intestacy if you die without a valid will.

It is essential that you obtain appropriate financial and legal advice before you take out a reverse mortgage. Most reputable lenders will probably require that you obtain such advice as a condition of taking out the loan. Among other things, you should make sure that you clearly understand:

	the up-front costs, including establishment fees, valuation fees, legal costs, stamp duty etc.
	the ongoing costs, which may include periodical valuation fees
	the circumstances in which the amount outstanding becomes immediately due and payable, which will usually include permanent vacation of the premises and the death of the last remaining spouse
	who bears the loss if the proceeds from the sale of your home are not sufficient to repay the loan and the accumulated interest.