How do reverse mortgages work?

Image by zinkevych via Adobe Stock

Imagine a home loan that actually gives you money and doesn’t require you to make any immediate repayments. Sounds too good to be true right?

Believe it or not, this is a type of mortgage that actually exists. It’s called a reverse mortgage and it’s typically available to people over the age of 65 who want to borrow money by using the equity in their home.

But (as always) there’s a catch.

• What is a reverse mortgage?
• How does a reverse mortgage work?
• Reverse mortgage eligibility requirements
• How much equity is needed?
• How much will a reverse mortgage cost?
• Risks of a reverse mortgage
• Alternatives to reverse mortgages

Reverse mortgages in Australia

While growing in popularity overseas, it’s safe to say reverse mortgages have a pretty bad wrap in Australia. Reverse mortgages can help older Australians with their short-term or immediate financial needs, but many people either just don’t know or stop to think about the significant long-term implications of reverse mortgages. 

A recent review by ASIC found the common view among retirees, and even many finance brokers and lenders are that many equity release products like reverse mortgages take advantage of vulnerable elderly people. The review also found that many borrowers who take out a reverse mortgage don’t really understand how it works.

What is a reverse mortgage?

In a nutshell, a reverse mortgage is a way for older homeowners to access the wealth that’s tied up in their home.

It is a type of equity release product (ERP) that essentially allows older Australians to borrow money by using the equity in their home as security for the loan. You can choose to receive the loan as either a lump sum, a regular income stream, a line of credit, or as a combination of any of these options.

Unlike a regular mortgage, you don’t have to repay a reverse mortgage until all borrowers on the loan either sell the house, move into aged care, or die (sorry to be morbid). However, many lenders may allow you to make voluntary repayments if you want to. You must repay the loan in full, including interest and fees.

Reverse mortgage interest rates

Interest rates on reverse mortgages are often significantly higher than a regular mortgage because of the fact you don’t have to immediately repay the loan. The average variable rate on a reverse mortgage is around 6 to 7%, though this number can vary between lenders.

Compare that with these low interest rates on home loans at the moment.

How does a reverse mortgage work?

A reverse mortgage allows borrowers over the age of 60 to convert the equity in their home (the value of the property they own minus any mortgage debt) into cold hard cash. Many borrowers will use this money for daily expenses, bills and debts, home improvements and car expenses.

Because the loan doesn’t need to be repaid until all borrowers on the loan have either died, sold the house or moved into aged care, a reverse mortgage compounds the interest charged. This means the balance of the loan will continue to increase as the interest builds up – even if you don’t borrow additional funds. Over time, interest will accrue on the interest already charged, plus on any fees or charges added to the loan.

Are you eligible for a reverse mortgage?

To qualify for a reverse mortgage, many lenders require the borrower to be at least 65 years of age and have paid off their home loan, or discharge the home loan as part of taking out a reverse mortgage.

Generally, there are no income requirements for reverse mortgages, but responsible lending requirements means not everyone will be eligible for this type of loan.

How much equity is needed for a reverse mortgage?

Generally, reverse mortgage providers say you should have 100% equity in the property (i.e. it’s mortgage-free), otherwise any outstanding mortgage must be repaid with the reverse mortgage.

The amount of equity that can be released will depend on the value of the property and the age of the borrower. Most lenders will allow you to borrow anywhere between 15% and 45% of the property’s value.

The amount that can be borrowed under a reverse mortgage will be a certain percentage of the total value of the borrower’s home equity. In home loan jargon, this is what’s called the loan to value ratio (LVR).

The older you are the more you can borrow, although different lenders may have different policies about how much they will let you borrow. As a general rule, if you’re 60 the most you can borrow is likely to be between 15% and 20% of the value of your home. This is so there’s enough equity left to draw from later on if needed.

The amount you can borrow using the equity in your home is protected in two ways by government regulations:

1. You can’t go into negative equity. This is known as the ‘no negative equity guarantee’ (NNEG). You can’t borrow more than the value of your home or be required to repay more than what your home is worth. Before this measure was introduced, borrowers faced the risk of eventually owing more on their loan than what they could recover from selling their property. The Government introduced this measure in 2012 to protect borrowers from owing the lender more than what the home is worth. When the loan contract ends and your home is sold, the lender will receive the proceeds from the sale and you can’t be held responsible for any debt that exceeds this.
2. You can’t borrow more than a certain loan-to-value ratio (LVR). You can only borrow up to a certain percentage of the value of the home. LVR limits effectively restrict the amount of interest that can accrue on new loans, which means borrowers are less likely to completely deplete the amount of equity in their home.

How much will a reverse mortgage cost?

The cost of a reverse mortgage will depend on the interest rate and fees. The biggest issue with reverse mortgages is that as the interest compounds, the debt grows. The longer you have the loan for, the more interest compounds and the bigger the amount you need to repay.

For example, if you were to take out a reverse mortgage of $50,000, in 10 years’ time you will owe more than double that amount thanks to compound interest, as the table below demonstrates.

Loan term	Interest	Total amount owing
1 year	$4,420	$54,420
2 years	$9,230	$59,230
10 years	$66,632	$116,632

*This example assumed a fixed rate of 8.5% compounded monthly with no fees applying and no voluntary repayments being made.

Also, application fees, transaction fees and interest rates for reverse mortgages are typically much higher than for other types of consumer credit like your standard home loan.

Fees charged by lenders for reverse mortgages

Type of fee	Typical cost
Establishment fee	$500 – $995
Ongoing administration fee	$0 – $12
Loan discharge fee	$300 – $400
Application to increase the credit limit	$395 – $950
Application to lease, sub-divide or introduce an easement onto the property	$0 – $500

Source: ASIC 2018

Advantages of reverse mortgages

The most obvious benefit of a reverse mortgage is that it allows you to access the equity in your home without having to sell your house – plus without having to make immediate repayments.

Given the right set of circumstances, a reverse mortgage can fund your retirement and increase your income to cover living expenses, better your quality of life or pay off debts.

ASIC’s review of reverse mortgages found that each of the 30 borrowers included in their report said a reverse mortgage allowed them to resolve their immediate financial needs (paying debt, essential living expenses, holidays). 

However, each of these 30 borrowers also said they had been almost exclusively focused on fixing their immediate financial needs without considering the many long-term financial implications that can come with reverse mortgages.

Drawbacks of reverse mortgages

The 2018 ASIC review of reverse mortgage lending in Australia found that borrowers struggled to recognise the long-term implications of their loan.

According to ASIC: “most of the borrowers we interviewed had either not considered or actively avoided estimating how much equity would still be available to them several years from now. This may have influenced some borrowers’  perceptions about the long-term risks of their loan”.

ASIC questioned borrowers how their decision to take out a reverse mortgage might affect their financial situation in the long-term. As you can see, many said they hadn’t really considered their future needs. 

“The reverse mortgage means it diminishes in some way what we leave, but on the other side I just live for today and not worry about tomorrow”

“I’m not quite sure how much I took out, or the rate of interest in the end. But I don’t have any goals really – I haven’t got much of a future!”

There are five keys risks of reverse mortgages that borrowers should keep in mind for the sake of their financial future: 

1.  The interest rates and ongoing fees can be much higher than the average home loan

Reverse mortgages come with a number of fees, the common ones being ‘discharge fees’, ‘upfront establishment fees’ and ‘ongoing fees’.

Because you don’t need to make regular repayments to the loan, interest rates and fees are added to the loan amount every month, meaning that interest is also being charged on this amount for the life of the loan.

This could mean that a $1,000 establishment fee could quickly turn into $3,000 or more after 20 years of compounding interest has accumulated. 

Reverse mortgages also often come with higher interest rates than regular mortgages. The average variable interest rate on a reverse mortgage is around 6% to 7% – compare that with some of the sub-3% interest rates on home loans at the moment.

2. The effect of compound interest means that your debt can quickly get out of control

The effects of compound interest are underestimated by most consumers, particularly when it comes to reverse mortgages. While the principal amount owing on a regular home loan decreases over time as it’s paid off, the opposite is true for reverse mortgages.

Until any repayments are made, the debt owed will continue to compound. 

The figure below shows how compound interest could grow by almost $158,000 in interest if the interest rate on the loan were to rise by 2%.

Source: ASIC 2018

Due to the effect of compound interest over a longer loan term, borrowers who keep the loan for a longer period of time face the risk of an erosion of their wealth (equity) in their home. If too much equity is eroded, the borrower may not be able to afford future needs when the home has to be sold to repay the loan.

3. If the value of your home falls or doesn’t rise in value, you will have less money for future needs like aged care or medical treatment

The more money you borrow now, the less equity you will have in your home. If too much equity is eroded, borrowers could face the risk of not being able to afford future needs (such as the deposit for aged care) when their home has to be sold to repay the loan. The risk of this happening rises again if the interest rate on their reverse mortgage increases or if property prices grow more slowly than expected (or a combination of the two).

Despite the introduction of the No Negative Equity Guarantee (a guarantee that borrowers will not end up owing more than what their home is worth) borrowers can still face the risk of being left with not enough equity in their homes to pay for future needs. 

For example, ASIC tested a fixed amount of equity a borrower may need once they reach the age of 84, the average age people enter aged care. 

Figure 1 demonstrates how fewer borrowers would have at least $200,000 remaining in equity by the age of 84 if interest rates or property prices rice, or both. 

Source: ASIC 2018

Figure 2 demonstrates that even fewer borrowers would be left with at least $380,000 by age 84 – which is the average self-funded upfront cost of aged care for one person according to ASIC.

Source: ASIC 2018

A lack of understanding of how this works can lead borrowers to take out bigger reverse mortgages – which reduces the ability for these borrowers to afford important future expenses like aged care. And this is unfortunately exactly what’s happening, with ASIC data revealing most borrowers tend to apply for the maximum credit limit, leaving them unable to afford aged care accommodation and medical treatment later on.

4. The loan can affect your eligibility to receive the pension

One of the big risks of a reverse mortgage is that it could make you ineligible for the pension or other government benefits. This is because money received with a reverse mortgage may be subject to the income and assets test for Centrelink payments.

The risk of this happening is even more likely if you choose to receive the reverse loan as an upfront lump sum, or if the pensioner gifts the money from a reverse mortgage to someone else (such as for their grandchild to put towards a house deposit). Why? Because monetary gifts can be counted towards the assets and income tests. The risk for borrowers who gift the money from their reverse mortgage can be even bigger because they risk losing their pension without even getting to enjoy the money they’ve borrowed.

5. Conflict with family 

If the borrower dies or moves out, other people living in the secured home can be forced to move out so the home can be sold to repay the loan. Besides being a massive pain, this can have serious implications for the surviving partner or others living in the property who relied on the borrower to make all the financial decisions. 

Some reverse mortgages come with a tenancy protection warning to warn borrowers of this risk. 

As a reverse mortgage can reduce the amount of equity in the home, this can leave little proceeds at the time of sale once the loan has been repaid – leaving beneficiaries with little to no inheritance.

Alternatives to reverse mortgages

Suddenly a reverse mortgage doesn’t sound quite so appealing does it! The ASIC review found that many borrowers believe a reverse mortgage is the “only option” to address their immediate financial needs. 

But there are a few alternatives out there which include:

1. Sell and downsize

The most obvious solution to access the equity in your home is to sell it. After all, if you’re at the age where you’re eligible for a reverse mortgage, it may be time to downsize from the big family home anyway. 

Clearly this won’t appeal to everyone, particularly if your aim is to stay in the home. Luckily there are other things you can do.

2. Pension Loans Scheme

The main alternative to a reverse mortgage for those who want to stay in their home is the Pension Loans Scheme. This is a type of reverse mortgage loan offered through Centrelink that allows older Australians of pension age who own their home to receive a voluntary non-taxable fortnightly loan to supplement retirement income. 

Borrowers can choose the amount they want to receive fortnightly which can be up to 1.5 times the maximum rate of the qualifying pension. 

The loan can be repaid at any time but it’s usually repaid from the proceeds of any eventual sale of the secured property.

3. Homesafe Wealth Release

If neither of these options appeals, there are products that allow you to unlock the equity in your home by selling a share of your home for an upfront price. One of these products is called the Homesafe Wealth Release, offered by Homesafe Solutions. 

Homesafe provides an upfront payment to the homeowner (usually a percentage of the equity available in the home) in return for a bigger percentage share of the proceeds of the sale of the home at a later date. 

Unlike a reverse mortgage, there’s no compounding interest.

4. Rent out a spare room 

Of course, you could always just rent out your spare room on a flatmates website or list it on Airbnb to bring in some more cash. Renting out a portion of your home on a monthly basis can bring in a side income to help fund essential living expenses, and it provides companionship. 

Just make sure you thoroughly screen prospective candidates first so you don’t wind up living with a psychopath.

Savings.com.au’s two cents

As you can see, reverse mortgages are very different from a standard mortgage because they don’t require any immediate repayments. But while borrowing money through a reverse mortgage may be a band-aid solution for short-term cash problems, it pays to be aware of the long-term implications of a reverse mortgage.

A reverse mortgage isn’t something that should be entered into lightly, so make sure you do your research, are aware of the risks, and consider alternatives.

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Disclaimers

The entire market was not considered in selecting the above products. Rather, a cut-down portion of the market has been considered which includes retail products from at least the big four banks, the top 10 customer-owned institutions and Australia’s larger non-banks:

• The big four banks are: ANZ, CBA, NAB and Westpac
• The top 10 customer-owned Institutions are the ten largest mutual banks, credit unions and building societies in Australia, ranked by assets under management in November 2019. They are (in descending order): Credit Union Australia, Newcastle Permanent, Heritage Bank, Peoples’ Choice Credit Union, Teachers Mutual Bank, Greater Bank, IMB Bank, Beyond Bank, Bank Australia and P&N Bank.
• The larger non-bank lenders are those who (in 2019) has more than $9 billion in Australian funded loans and advances. These groups are: Resimac, Pepper, Liberty and Firstmac.

Some providers' products may not be available in all states. To be considered, the product and rate must be clearly published on the product provider's web site.

In the interests of full disclosure, Savings.com.au and loans.com.au are part of the Firstmac Group. To read about how Savings.com.au manages potential conflicts of interest, along with how we get paid, please click through onto the web site links.

*The Comparison rate is based on a $150,000 loan over 25 years. Warning: this comparison rate is true only for this example and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate.

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