Tapping into the family home

Three ways to release equity from your home.

Summary: Longer lifespans mean that more Australians will run out of cash in their senior years. Tapping into the equity in the family home is one way of relieving the problem, but doing so is fraught with danger and retirees should tread very carefully.
Key take-out: Reverse mortgages can substantially reduce future options for how the family home can be used in later life, such as for medical expenses or for aged care.
Key beneficiaries: Retirees. Category: Retirement.

Australia is at a demographic turning point, and it’s become painfully clear how ill-prepared we are as a nation.

Roughly 25% of the population will move into retirement in the coming decades, with about 130,000 turning 65 every year. The original ‘me generation’ may be expecting a comfortable lifestyle in their autumn years, but how exactly will such a retirement be funded?

Many baby boomers may be asset rich, but they’re also income poor. For the many who simply don’t have enough money or liquid assets to fund their desired lifestyle, a home equity release, such as a reverse mortgage, is a possible solution.

There are three common ways of releasing equity from the home. The first is to take out a reverse mortgage, the second is through a home reversion scheme, and the third is to downsize.

Of these three, reverse mortgages are the best-known and most controversial. The borrower faces substantial risks when taking out a reverse mortgage, and the level of debt that the borrower or inheritors are left with, could at its worst, be devastating. At the same time, and rather surprisingly, reverse mortgages are somehow seen as the future of funding for retirees who don’t have enough money to finance their retirement.

A reverse mortgage allows a homeowner to borrow money from a financial institution using the equity in their home as security. The loan can be taken as a lump sum or as a regular income stream and the borrower is not required to have any income to qualify. Interest is charged like any other loan, and compounds annually, but repayments are not required while the borrower lives in the home. Upon sale of the home, following the borrower’s death, or when they permanently move out of the home, for example if they move into aged care, the debt must be repaid in full.

New regulations on reverse mortgages that came into effect on June 1 will serve to benefit seniors considering this as an option. As of June 1, brokers and lenders must make reasonable enquiries about the borrower’s requirements and objectives regarding potential future needs, including the need for aged care accommodation and whether the borrower would prefer to leave equity in the property for their estate.

The need for this regulation is clear, as it’s vital retirees are made aware that the reverse mortgage can substantially reduce their future options for how the family home could have been used in later life, such as for medical expenses or for aged care. The graph below shows the debt accrued on a $125,000 reverse mortgage over a 25-year period. The market value of the home at the time the loan is issued is $500,000 and the borrower is assumed to be aged 65. The example sets the interest rate at 7% and no fees have been included.

Source: Moneysmart, ASIC

A second provision in the new regulations addresses the issue of the loan-to-value ratio. It states that reverse mortgages are unsuitable, unless the contrary is proved, if the LVR exceeds 15% for borrowers aged 55 and younger, and 1% higher for every year above that. That means that for borrowers aged 65, an LVR above 25% is deemed unsuitable unless the contrary is proved. For those aged 80, an LVR above 40% is deemed unsuitable unless the contrary is proved. But these should be the absolute upper limits, and borrowers would be much better off to have a low LVR.

Recent research by academics from the School of Risk and Actuarial Studies at the University of New South Wales found that reverse mortgage lenders are too risk averse and should consider raising the LVRs.

“Borrowers face a significant disincentive to go into a reverse mortgage because they are being asked to give their whole house as collateral for a relatively small loan,” said Katja Hanewald, one of the team of academics who conducted the study.

The team recommended that if lenders are serious about doing business in the equity release market, they should improve the terms of reverse mortgages.

“Lenders could consider increasing LVRs as a way of generating growth,” Hanewald said.

This could potentially generate substantial growth for the lenders, but would leave homeowners facing even higher levels of debt.

The lower the LVR, the less chance there is of the debt spiralling out of control. As can be seen from the graph below, a 65-year-old retiree who borrows $125,000 against a home with a market value of $500,000, i.e. a 25% LVR, will owe the lender $678,429 after 25 years. Assuming the value of the home rises at a rate of 3% a year, the remaining equity will be $368,460.

Below, you can see what happens if the value of the home rises at a rate of 1% over the same period.

Source: Moneysmart, ASIC

Such a large amount of debt at an age when a senior may need funds, for example to move into aged care, can be extremely distressing, both for the borrower and family.

In September 2012, the federal government introduced negative equity protection on all new reverse mortgage contracts that ensures borrowers can’t end up owing more than the home is worth. Prior to this, the vast majority of lenders were already operating with negative equity protection for borrowers.

There are, however, occasions where reverse mortgages can be used without inflicting too much damage. For those who need the money quickly, and only for the short term, they can be beneficial. The key is to pay them off quickly, say within five to 10 years, and not let the debt get out of control.

Reverse mortgage alternatives

Reverse mortgages are the most popular of the home equity release products, but there are alternatives. Debt-free equity release, also known as home reversion, is a lesser-known product available to seniors. There is only one provider in the market, Homesafe, and the product is only available to those living in Sydney and Melbourne.

Essentially, the homeowner sells a share of the house to a financial institution in return for a fixed amount of capital. When the house is eventually sold, in say 10, 20 or 30 years’ time, the final sale price is split on a pro-rata basis with the bank. The bank can make a significant profit if the market value of the home rises considerably, but the homeowner is guaranteed to hold onto a pre-agreed share of the home.

Finally, seniors can choose to downsize. Quite often, this option is dismissed due to the emotional attachment to the family home. While it may not appeal at first glance, downsizing can free up a significant amount of capital without having to be at the mercy of financial institutions. The thought of leaving behind an established social network and moving to another area can be daunting. The associated costs with downsizing, such as stamp duty and agent fees, as well as fears of the effect it could have on entitlements to the aged pension, also serve to dissuade many retirees from taking this route.

An initiative announced in the recent federal budget should see more seniors consider downsizing as an alternative to reverse mortgages. From July 1, 2014, seniors who have owned their home for at least 25 years and want to sell will have up to $200,000 of the proceeds exempted from Centrelink means testing for 10 years. (See Housing plan opens seniors door).

The industry will be waiting to see how this initiative plays out, and there has been some criticism, including that the $200,000 can’t be used for 10 years or it will be counted in the income and assets test. Nonetheless, it is a step in the right direction.

One way or another, we can no longer ignore the fact that many baby boomers don’t have enough money to live out their retirement. The age pension will be squeezed tighter and tighter, and the family home will more often become a source of retirement funding.